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Opportunity Zones Knock for US Retail

A federal investment program can breathe new life into America’s struggling malls and shops, but only a select few.

Private Equity Real Estate
June 30, 2019
By Kyle Campbell
Original Article: https://www.perenews.com/opportunity-zones-knock-us-retail/

The demise of American retail has been well documented by real estate professionals and amateur observers alike. One blog has a running tally of more than 450 dead or dying malls across the country and social media accounts abound with dystopian images of vacant sites succumbing to the elements.

Yet, one man’s photo fodder may be another’s tax haven thanks to a lucrative set of federal investment incentives. Created in late 2017, the qualified opportunity zones program allows investors to avoid paying taxes on capital gains by rolling them into assets in certain distressed areas. Some hopeful participants view the nation’s many troubled retail properties as prime opportunities.

There are 137 regional and super regional malls within the 8,000-plus designated opportunity zones, according to CoStar, a data and analytics firm. Collectively, those properties account for more than 7,200 acres – more than 11 square miles – of land that can be redeveloped for tax-free profits. Additionally, there are numerous freestanding big-box sites shuttered by the collapse of retailers such as Toys ‘R’ Us and Sears, which owned 284 and 425 stores, respectively.

Retail vacancy has crept up in recent years as the rise of e-commerce and shifting demographics disrupt the market. Regional and super regional mall vacancy has risen from a steady average of less than 8 percent in 2016 to more than 9 percent by the end of 2018, according to Reis, the real estate analytics arm of Moody’s. Neighborhood and community centers – home to supermarkets, drug stores, and discount retailers – have fared worse, with more than 10 percent of their spaces remaining unoccupied.

Investment professionals familiar with the opportunity zones program tell PERE it will be a valuable tool for raising capital to revitalize some struggling retail properties or even reposition them for new uses. Some developers are seeking to convert these complexes into mixed-used residential communities while others would replace them with warehouses for last-mile distribution.

“The fact of the matter is the incentives that exist by virtue of the opportunity zone legislation could materially enhance returns in the opportunity zone districts,” says Todd Henderson, head of real estate for the Americas at DWS Group, a German asset manager. “As a result, I think you will see investors willing to take more risk and try to redevelop some of these dark malls that are suffering from the shift of retail sales away from bricks and mortar to e-commerce.”

However, Craig Bernstein, principal and chief investment officer of OPZ Bernstein, an opportunity zones-focused manager, warns that pitfalls could await imprudent investors and the program should be viewed as an added incentive, not a cure-all.

“The opportunity zones program has the ability to make a good deal great, but it won’t make a bad deal good,” Bernstein says. “At the end of the day, the deal still needs to stand irrespective of  the tax benefits. You can’t, under any circumstances, let the tail wag the dog.”

Investors can receive a 15 percent reduction in the taxable basis for their capital gains if they roll them into qualified opportunity funds by December 31. Phillip Marra, national audit leader for KPMG’s US building, construction, and real estate practice, says other benefits can be had even if that deadline is missed, so investors need not make hasty decisions. A 10 percent basis step up is available for investments made before 2022 and gains from opportunity zone investments held for 10 years or more can be realized tax free.

Unique challenges

Finding suitable retail properties is a challenge in itself. Of the 137 malls in opportunity zones, 39 are without an anchor tenant, indicating significant distress. While other centers are reliant on shaky tenants –  such as the two dozen malls anchored by JCPenney department stores – anything that increases the value of a property adds burden to opportunity zone investors. The legislation’s substantial improvement clause requires investors to double the value of adaptive reuses. This only applies to the non-land value of the real estate, meaning if a building is bought for $1 million and $200,000 of that cost is land value, the buyer must spend an additional $800,000 toward improvements.

An original use provision allows investors to avoid the substantial improvement requirement, but it applies only to underdeveloped land or buildings that have been vacant for at least five years. Some defunct malls meet the latter criteria, but the best positioned of those properties have already been taken off the market. Amazon, for example, has acquired two former mall sites in suburban Cleveland to build fulfillment centers and is reportedly aiming to do the same at a property in nearby Akron, Ohio – all three are in opportunity zones but it is unclear if the company will make use of the program’s benefits.

Retail transaction volumes in opportunity zones increased substantially after the initiative was signed into law as part of the Tax Cuts and Jobs Act, going from $4.9 billion in 2017 to $7.2 billion in 2018, according to data provider Real Capital Analytics. Twelve fewer properties traded hands last year compared to the year prior, but the average sale price rose by nearly $4 million.

High costs may prevent some opportunity zone investors from acquiring whole retail complexes, but Marra says a more measured approach may be to purchase individual buildings or parcels of land. A big box apparel store might be bought and retro-fitted for medical offices, he suggests, or a swathe of an unused parking lot could be parceled off and sold for new development.

Limitations and restrictions

Converting a mall site to another use is also easier said than done. Local zoning may prohibit housing developments or neighbors could push back against traffic-heavy uses such as distribution warehousing. In anticipation of such hold-ups, a recent regulatory addendum allows additional time for capital deployment for projects delayed by local government inaction.

For investors that want to retain their properties’ retail use, the opportunity zones legislation does impose some limitations. Owners are not able to sign traditional triple-net leases with their tenants because of equity requirements in the law. Landlords must continue to operate at least some part of the property, Bernstein says, even if it is just the parking lot.

While investors can also use capital gains to seed startup businesses within opportunity zones, much attention has focused on real estate in the early days of the program. NES Financial, a San Jose, California-based financial services firm, has been approached to handle fund administration for more than 220 opportunity zone investment vehicles and roughly 80 percent of them are focused on real estate, Reid Thomas, the group’s executive vice-president and general manager, says.

However, only about 5 percent of those deals had a retail component. Bernstein has seen similar limited interest in retail, owing to uncertainties surrounding the property type and the strong demand for multifamily and industrial assets.

Ultimately, defunct malls and under-occupied shopping centers will be just a piece of the opportunity zones puzzle, but as the details of the program come into greater focus, it seems distressed retail in the US provides too large an opportunity to be ignored.

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What are Opportunity Zones? Read more about them here.

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