OZ Investing: Does Capital Flow Downhill? Implications of Disparate State Tax Rates
Discerning where one should invest, even with geographically-focused OZ capital, requires a multi-layered analysis that begins with understanding pre-OZ capital flows, how OZ capital is incentivized to behave, how conventional capital sources may respond and ultimately where the market might find equilibrium. In this post and the next we will discuss the directional impacts of OZ capital flows and where related alpha may persist when markets return to equilibrium. We will start by describing current real estate capital markets conditions, specifically in terms of how they reflect disparate tax rates across states, with a focus on assets > $50M. Building on this foundation, we discuss how OZ investors should behave relative to conventional taxable investors by factoring in state tax rates and state conformity to Federal tax law. Finally, next week we will explore the implications of space market characteristics (e.g. supply constrained urban core, urban emerging market and rural) which, together with the above, determines the potency of the expected Opportunity Zone after-tax IRR benefit in a given investment and will ultimately inform how OZ capital impacts capital market conditions across geographies.
OZ Census Tracts: Several Diamonds in the Rough
State leaders nominated certain census tracts for Qualified Opportunity Zone status from a broader list of tracts that largely qualify as “low income communities” (“LICs”) under code section 45D(e), although in practice, several of the tracts included are highly liquid institutional real estate markets with active capital markets and strong demand drivers. The criteria were that a tract’s poverty rate should be greater than 20% or its area median family income less than 80% of state AMFI if the census tract is not located in a metropolitan area (80% of the greater of state or MSA AMFI if inside one). Tracts adjacent to Opportunity Zone LICs and with median family income < 125% of its adjacent OZ, were also able to qualify, with this subset of tracts limited to 5% of the total number of designated tracts in a given state. Ultimately the Secretary of the U.S. Treasury certified those tracts for a period of 10 years. Whether qualifying as LIC adjacent tracts or due to developer lobbying, stale data, or the criteria’s blunt instrument approach, OZ census tracts include a cross section of prime and prime-adjacent submarkets such as Hollywood, Downtown LA and Uptown Oakland, CA, grittier urban emerging markets such as large swathes of Milwaukee, WI, Detroit, MI and West Oakland, CA, and rural areas. As such, investors are given the ability to choose their position along the market risk spectrum, and the extent to which they want to participate in the program’s articulated mission of revitalizing census tracts that have been left behind. To understand where OZ capital will flow, we must explore the incentives that guide the behavior of market participants. We start with institutions, which comprise nearly half of buyside dollar volume across the top 20 markets nationally.
Figure 1: Buyer Composition
Figure 2: Transaction Dollar Volume Across Primary & Secondary Markets
Source: Real Capital Analytics
Institutional Capital Flows
In the largest, most liquid markets, institutional capital flows dominate, such that large assets are priced to pre-tax risk-adjusted parity across primary markets. By institution we mean capital supplied by pension funds, endowments and foundations, which are not taxable. As such, these investors underwrite pre-tax cash flows, not pricing in variations in state taxes. Institutional capital shapes capital market conditions in the narrow set of markets labeled “primary” in the chart. Within these markets, if we segment the market into transactions above/below $50M, the bulk of the transactions above this price will involve institutional capital, with private capital, in varying forms, comprising an increasing percentage of broker bid sheets as we move down the dollar volume spectrum from there (or into secondary markets). Similar to institutions, REITs and publicly-traded real estate companies of scale also optimize outcomes for non-taxable institutional shareholders. As such, large creative office buildings in Seattle, for example, trade in a very tight unlevered, pre-tax IRR band with equivalent product (similar space markets, tenancies, risk profiles) in San Francisco or the San Francisco Peninsula. In secondary markets, institutions may bid on larger deals, particularly high-octane private equity in the case of distressed assets, but private capital plays a larger role.
Private & Corporate Capital Flows (we should all move to Nevada)
The influence of private capital is inversely related to market size and liquidity. Institutional capital tends to concentrate in primary markets due institutional preferences for greater liquidity and more efficient large assets. On a relative basis, the influence of private capital is greater in secondary markets. To understand how private capital might influence returns therein, we need to understand the implications of differing state tax rates for taxable investors.
Figure 3: Top Marginal (individual) Income Tax Rates Across States
State tax rates engender after-tax risk / return imbalances across states. Firstly, Rampart Ridge, LLC is not a tax advisor. With that said, typically, the state income tax rate of an investor’s state of residence determines the minimum state tax rate that said investor will pay regardless of where it invests. For example, as a CA resident, I can invest in OR where state income tax is lower, but in terms of mechanics, if selling a Portland-based asset, I would owe OR 9.9% state income tax on capital gains and would receive a credit for said tax paid to OR on my CA return, ultimately paying nothing less than 13.3% CA tax (but with only 13.3% - 9.9% = 3.4% flowing to CA in this case). This means that if I live in a high tax state like CA or in NYC (city + state tax = 12.7%), I should be state tax rate agnostic just like institutional capital. Whether I underwrite pre-tax or post-tax cash flows won’t alter how I view the Seattle creative office deal relative to its Redwood City, CA equivalent; if ex-ante pre-tax cash flows are the same across investments, post-tax will be also.
Taxable investors with the ability to defer consumption have an additional reason to be state tax agnostic, the 1031 Exchange program. At a high level, the 1031 program enables investors to sell assets while deferring capital gains tax by rolling the entirety of asset sale proceeds, within 180 days, into a “like-kind” investment. While state tax conformance varies, in several states investors may defer capital gains tax even when redeploying into another state (such that the state in which the investor is selling not only defers receipt of tax revenue, but loses it altogether). In terms of investor behavior, the 1031 program should further reduce private investor observance of state capital gains tax differences, particularly in states wherein key markets enjoy supply constraints and strong economic growth (i.e. regions in which the bulk of investment returns derive from asset appreciation instead of operating cash flows, the same regions in which the OZ benefit is most potent). The question then, is in which states the ultra high net worth and corporate capital resides.
Figure 4: UHNW Families by State of Residence
Source: WealthX 2014-15 American Ultra Wealth Ranking; 2017 Wealth Report (major MSA data only)
UHNW capital is concentrated in the states with the highest tax rates, such that this capital should also underwrite on a state tax rate agnostic basis. Figure 4, while dated, indicates where wealth is concentrated along with corresponding marginal tax rates. Noting that half the UHNW wealth resides in the states with the two highest tax rates, to the extent that this capital is investing directly and across states, it would be state tax rate agnostic (will pay the same high state tax rate regardless of where it invests). Only 30% of UNHW families reside in no-tax states. Notably these investors hold a unique advantage; based on the weight of institutional and high tax rate state capital that is pricing to pre-tax risk adjusted parity, assets are priced as such. Investors based in no-tax states, when allocating capital between comparable investment positions in Seattle vs. Redwood City, CA, can avoid 13.3% CA state income tax by allocating to the former, earning substantially higher after-tax returns for identical risk. While this would be powerful, in reality, very few families have sufficient scale to justify investing directly across states. A short list of billionaire real estate families do so with the balance of UHNW likely investing locally through syndications or fund allocations. With few professional investors providing targeted access to investments in specific states, families desiring this type of customized, tax-efficient investing might need to seek expert tax guidance and invest through a platform like Rampart Ridge or an outsourced CIO platform with sufficient scale to deal with additional complexities of direct investing.
I would expect corporate capital gains to play less of a role in QOZ investing than those of UHNW families, but with state corporate tax rates and expected locational concentrations of capital gains not dissimilar from that of the UHNW families discussed above, corporations would likely not behave much differently than UHNW families in any programmatic sense. While a subset of financial institutions will have the corporate infrastructure, capital gains, and strategic justification for investing regularly in OZs, the balance of firms, particularly publicly-traded ones, will find it difficult to justify to shareholders why they believe they can generate higher risk-adjusted returns by investing in real estate as opposed to their core businesses, the implication being that shareholders should pull their equity to invest in real estate through professional investors instead. It is more likely that non-financials will utilize the program for the idiosyncratic property, plant and equipment construction. For example, AMZN could utilize an OZ structure to fund the development of a new campus.
In assessing the impact of corporate capital gains, we should seek to quantify the volume and location of corporate capital gains and the applicable corporate state tax rates. To estimate the former, I relied on naïve proxies such as the locations of firms within the Fortune 500, which includes private and public companies (no doubt some double counting between the subset of private companies and UHNW families categorized above but this isn’t a precision counting exercise). As such, I’m assuming company size correlates to capital gains generation and that capital gains are distributed evenly amongst firms on the list (underweighting states like AK, which has Walmart, although its incidentally not a firm I would expect to sell assets with frequency). Notably, the top three states by number of F500 firms is the same as the top three by number of UHNW families (different ordering). Intuitively, the respective top 10 lists bear substantial overlap beyond this. While CA and NY do not have the nation’s highest corporate tax rates, at 8.84% and 7.1% respectively (state tax rates range from 0% to 9.99%), they do still occupy the top end of the scale.
If, as suggested above, the vast majority of real estate equity is state tax rate agnostic, differing state income tax rates can present alpha opportunities to those investors lucky enough to live in zero or low tax states, and have access to a fiduciary capable of managing risk / maximizing returns to investments in its home and other low tax states.
Novogradac’s Map of State Tax Conformance (illustrative purposes: not 100% accurate & designations are changing as states vote to conform, decouple, etc.)
Where should Capital Flow?
Setting aside space market considerations (e.g. that expected returns to investments in NYC or San Francisco are derived to a much greater extent from capital gains than in a “low barriers” market like Texas, thus making the OZ program’s impact on after-tax IRR greater in the former), OZs should have the greatest impact on returns in states with high tax rates that have chosen to conform to Federal law. The map to the right from Novogradac provides some indication on this topic. As a caveat, I found a handful of inaccuracies in this exhibit in performing a sampling of the underlying state code (e.g. Ohio’s top marginal tax rate is 5%) but thought it useful for illustrative purposes (designations may continue to change so not a reference piece anyway).
Overlaying the mapping of UHNW families to US states should give us a sense for which states will be sources or destinations of OZ capital. According to this logic, NY should be the clear winner, with the eighth highest marginal tax rate in the nation (8.82%), state conformance, and the second highest concentration of UHNW families nationally. Rounding out the top 10 conforming states (by declining tax rate) includes OR, IA, VT, WI, ID, CT, MT, NE, DE. Interestingly, this list only contains one primary market and one secondary (NYC & Portland respectively). That said, as noted above, no-income-tax states are just as attractive as a state of residency or destination of capital (more attractive actually, since the investor doesn’t owe state tax on the asset’s operating cash flow when investing between them). That said, conforming states with high tax rates are where QOZ benefits most materially change one’s after-tax IRR relative to conventional underwriting.
What does this Mean for OZ Investors?
Without more extensively treating space market characteristics (next week’s topic), we are limited in the conclusions we can make outside of the following:
To enjoy the full suite of QOZ tax benefits including state tax deferral / exemption, one must invest in / from any pairwise combination of a no income tax state (in gray on Figure 3), and a state that has chosen to conform with Federal law as to how it treats capital gains. Ceteris paribus, we should expect capital from conforming and no-income-tax states to invest disproportionately within the broader set of conforming and no-income-tax states.
Investors in conforming states have a greater incentive to utilize the program; we should expect OZ participation in these states to be higher. Figure 4 above shows us where the capital that stands to benefit the most resides.
If one’s state of residence doesn’t choose to conform to Federal treatment (some states may take longer than others to pass legislation to conform), investing in a “conforming” state won’t exempt one from taxes due to one’s home state. If one is a resident of CA, one will still owe CA state income tax on the capital gain one realized to fund one’s OZ investment, and one will still owe state income tax on gains generated by the OZ fund’s investment positions.
How the above influences optimal after-tax returns depends on space market conditions. An investment in Uptown Oakland may, as a growth market, present a higher proportion of its expected returns from (tax-efficient) asset appreciation, but its after-tax risk-adjusted returns, hamstrung by 13.3% CA state tax, might lag ex-ante after-tax risk-adjusted returns in lower growth, but state-tax-conforming Chicago (ceteris paribus).
Certain primary markets are highly attractive in terms of market fundamentals and state tax treatment (e.g. swathes of the NYC metro) but one must still consider the extent to which OZ capital flows will compete down after-tax returns to risk-adjusted-parity with analogous positions in other markets. As discussed above, institutional deals tend to trade at pre-tax expected return parity, so the exercise ahead is to presage the extent to which OZ capital flows will influence returns across space markets. The remaining after-tax IRR spread, adjusted for compliance risk, presents alpha.
End Notes
It takes substantial scale for investors to invest successfully across multiple states in institutionally sized assets (a short list of billionaire real estate families do with the balance likely investing locally through syndications or fund allocations).
By efficient I mean in terms of operations (lower OPEX), lower cost of construction, scale (the ability to amortize the cost of a full suite of amenities across more square footage), and capital placement (CBD office deals enable investors to place large slugs of equity relative to those possible with smaller multi-housing assets).
Capital flow composition varies materially through the cycle, due to changes in acquisitions appetites / asset allocations, fluctuations in cost of capital across investor types, and general lumpiness of the data (large deals shifting between quarters or years can speciously support what appears to be a trend). In the "Buyer Composition" exhibit, I made an (admittedly innsufficent) attempt to address this by the cycle by averaging 2018 and 2017 data (though the market has been at peak conditions across both years with little variation in composition).