New Opportunity Zones May Help Finish California Projects, Not Start Them
California has put forward hundreds of census tracts for inclusion in the revamped opportunity zone program, but developers say the tax incentive’s next chapter will arrive in a market where soaring construction and borrowing costs remain the biggest obstacles to getting new projects off the ground.
The newly permanent federal program, which allows investors to defer and reduce capital gains taxes through investments in designated areas, is expected to unlock capital for stalled developments and make opportunity zone investing more attractive.
But while developers and investors are awaiting final Treasury Department approval of California’s proposed zones, many say today’s economics make it difficult to justify starting new multifamily projects from scratch, limiting the program’s near-term impact to sites that are already entitled, partially capitalized or otherwise well advanced in the development pipeline.
“I do think this program is going to help jump-start a number of projects that have been stalled, where [developers] already have some sunk cost,” Grubb Properties CEO Clay Grubb said. “To go out and think that you would buy a new site, spend all that money and time permitting — I think we’re still a ways away from that.”
Grubb Properties is a Charlotte-based developer known for the Link Apartments brand. The developer formed the Link Apartments REIT earlier this year and has more than $2B in assets under management. The REIT also operates an opportunity zone fund, although it hasn’t accepted capital this year, waiting instead for January, when the new OZ rules go into effect.
The state of California nominated 620 tracts for opportunity zone designation at the end of October. In Los Angeles County, the nominated tracts include some in Palmdale and Lancaster at the county’s northern edge, the Van Nuys and Panorama City areas in the San Fernando Valley, a concentration of tracts along both sides of the 110 Freeway through South Los Angeles, and a handful of tracts in San Pedro and Long Beach. The Treasury Department will make the final designation.
Since inaugural designations were made back in 2018 for the previous version of the OZ program, “much has been learned,” Novogradac & Co. partner Kevin Wilson said.
Among the most notable changes was the process for designating tracts, Wilson said.
The process under the office of Gov. Gavin Newsom involved multiple public webinars about the selection process and dialogue about the attributes that make a good OZ tract, including a public comment period for tract selection. The first wave of OZ tracts in the LA area was met with criticism that some tracts that received the designation didn’t really need it to attract investment.
Grubb Properties controls one existing opportunity zone project in Oakland’s Jack London Square and holds development sites in Berkeley and two in the Los Angeles area that will ultimately become Link Apartments projects. The development site projects are on hold until the market dynamics shift in favor of breaking ground, Grubb said.
California Department of Finance The state Department of Finance released a map of all the nominated tracts throughout California.
By Grubb’s count, the pandemic led to a 50% increase in development costs nationally, an estimate that aligns with the Associated Builders and Contractors’ midyear estimate compared to early 2020’s costs. The uptick in construction costs was followed by interest rate increases, which translated into the value of existing apartments dropping 35% nationally, Grubb said.
Prior to the pandemic, Grubb’s company could build in the Los Angeles market for less than $500K a unit, and it would be worth more than $600K when construction was complete. Today, it costs probably more than $700K a unit, including land costs and permits, and it is worth less than $400K when complete, Grubb said. It is that very disconnect that has him hitting pause on breaking ground on new projects for the time being.
Costs are so high that some multifamily developers aren’t quite so sure that the program will be as big a boon to multifamily construction as it had been previously.
Because the OZ tracts are in lower-income neighborhoods, some developers had concerns about being able to reap rents that justify the expense of new apartment construction. Rents in the LA market over the last year or so have grown by the low single digits, if at all. By some estimates, they are negative.
“In a lot of these opportunity zone locations where the rents may not be as high, it’s going to be very challenging to get a multifamily project,” Starpoint Properties CEO Paul Daneshrad said.
Daneshrad has built four OZ projects, three apartments and one industrial.
As he sees it, industrial development will be juiced by the revamped version of the program. Rural areas will be especially attractive because of the additional incentives to draw developers and investment to these areas.
“It’s just going to be easier to find the land at a basis,” Daneshrad added. “Right now, it’s also cheaper to build industrial than it is multifamily.”
Grubb has an advantage in this high-cost environment in that his company already owns those development sites, which makes the cost to finish it significantly lower than what it would cost if they were trying to complete a project from scratch, he said. It is these types of projects that he thinks stand to benefit the most from the updated OZ program, provided they lie in an eligible area.
While the tracts California nominated still require final federal approval, there will be fewer of them as a result of changes to the nomination process and a
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