NATIONAL REPORT—With the implementation of the Tax Cuts and Jobs Act, many hotel companies are looking at opportunity zones: low-income census tracts nominated by states and certified by the U.S. Department of the Treasury—there are more than 8,700 designated places—into which investors can put capital to work financing new projects in exchange for federal capital gains tax advantages. But when is it right to invest in these types of projects?
The benefits of opportunity zones are numerous, as investors receive the following incentives: a temporary tax deferral on any prior gains invested in an opportunity fund until the earlier of the date on which the investment is sold or exchanged, or December 31, 2026; if the investment is held for longer than five years, there is a 10% exclusion of the deferred gain, and if held for more than seven years, the 10% becomes 15%; if the investor holds the investment in the opportunity fund for at least ten years, the investor is eligible for an increase in basis of the opportunity fund investment equal to its fair market value on the date that the opportunity fund investment is sold or exchanged.
“We think the hospitality space is uniquely structured and set up to be really accretive to this model,” said Brad Rahinsky, president/CEO, Hotel Equities, which has locked down roughly two dozen opportunity zone sites that it’s in the development phase with. “If you look at why the legislation was crafted, it was really to try to help the development in and around areas that have emerging opportunities and have been underserved as it relates to job creation and growth. What we do is all about job creation—and not just creating a job, but creating a career for our folks and taking what could potentially be a line-level position and creating a path for them to become managers, directors, VP of operations; there’s really no ceiling on that.”
Additionally, he said, “If you look at the way the hospitality space performs financially, many of the things we do match well with the new tax code.”
Certainly, it did for Midas Hospitality, which found that projects it had already committed to prior to the tax change were eligible opportunities. “These projects weren’t necessarily sought out as an opportunity zone investment originally, but, obviously, we utilized the opportunity zone legislation on projects we were already capitalizing on,” said J.T. Norville, co-founder and managing member, regarding the 129-room Aloft and 152-room Element in St. Louis’ Cortex innovation district and Prospect Yards community, slated to open in 2020. “This really checks all the boxes from a development standpoint,” he added.
“What we’ve identified is…about a 400 basis points difference in return, which is a significant boost,” he said. “You’re going from a project with a 14% after-tax IRR to 18%; that’s a significant boost over a long period of time. To really generate the best yield in the opportunity zone, you really need to hold it for the entire 10 years to get the entire benefit.”
Dana Tsakanikas, EVP of Stonehill, a part of Peachtree Hotel Group, agreed. “There’s a lot of focus on the five- and seven-year step up. Right now, there’s a drop dead date of 2026, so if you don’t invest this year and invest next year, you’re only going to get the benefit of the five-year step up—but there’s been, in my opinion, too much focus on that because that’s just a hedge against where capital gains rates might be at that time,” he said. “That’s not the benefit of the program. The benefit of the program is getting three times your money 11 years down the road, and those dollars being tax free. That’s been a bit lost.”
Tsakanikas noted that opportunity zones are a major part of his company’s strategy, as it has about 15 joint-venture and 10 in-house opportunity zone projects in the pipeline.
“We’re seeking out these projects, and we’re trying to help redevelop some of these areas as the program was intended to do,” he said. “This is another meaningful tool in our toolbelt; it gives us a 10-year bucket of equity money.”
However, while there are major benefits to the program, all agreed that the project has to be right and check all of the boxes in order for it to work.
The most important thing we tell all of our investors is it’s about the investment first and it will always be about the investment,” Norville said. “The opportunity zone benefits are there as an additional boost to the return, but if the original investment doesn’t work, there’s very little benefits to yield on the opportunity zone.”
For its part, Hotel Equities has the same philosophy. “We want to make sure when we’re doing these projects it’s still with the things we have in our model that are nonnegotiable: the right flags, the right markets with multiple demand generators that are protected against the downturn, markets surrounded by relatively high barriers to entry, so we know we have a defensive hedge in our development projects to ensure when we build there’s not going to be four or 15 building around us in the next 12 to 24 months,” Rahinsky said.
Tsakanikas agreed that all of the right ingredients have to be there. “We’re still looking for profitable projects that make sense, we’re looking at the same characteristics, the same risk profiles—we’re just willing to take a potentially lower return initially and go in a little earlier into the neighborhoods because of the tax advantages we pick up on the back end,” he said. “But we’re still looking for hotels that ultimately are going to be profitable, that have demand drivers or demand drivers coming to the area.”
One word of caution they did have for those interested in opportunity zones: Make sure you’re going about it the right way.
“We spent a lot of money with Morris, Manning and Martin on the legal side and Ernst & Young on the accounting side to form this fund and make sure we did it right,” Tsakanikas said. “There’s a lot of groups out there raising money, but look to the asset manager of the fund: Are they deploying them in profitable projects? Do they know what they’re doing? You can raise all the money you want, but if they’re not being invested in profitable projects or they’re not being invested in the timeline, and the fund is hit with substantial penalties for not keeping their good assets and bad assets in balance, for not deploying the funds within the timeframes, for not keeping the right amounts of working capital and what have you, it severely impacts the profitability of the fund.”
Rahinsky agreed. “If you open up any financial paper, you’ll see five articles around opportunity zones and it seems everyone is creating a fund,” he said. “I’d caution those investors to do their homework and vet those funds out to make sure there’s an operating model behind those funds. There are so many folks we’ve talked to that want to create the fund and get the money in hand so they can figure out where to deploy.”
But this is a problem, he noted, because “you’re on the clock. When you invest into an opportunity zone, there is risk for folks who don’t have that operating model in place to where that money will not be deployed in the appropriate amount of time.”
But when it all works, the executives are optimistic. “If our project is any indication of the capital that wants to go into opportunity zones, it’s a good indicator this will be a successful program not just for hotels, but for residential, retail, mixed use, office and businesses,” Norville said. HB