Ackman-Ziff Opportunity Zone Equity Structuring Overview (Part II)

We recently released a white paper on Opportunity Zone (“OZ”) equity, highlighting how OZ equity allocators are structuring accretive preferred equity that has common equity like features that provide developers downside protection while avoiding the over leverage typical of traditional pref. In that paper, we touched on how today’s A-note underwriting standards have made cash-out permanent financing far more achievable than in the pre-2023 era, and how advantageous this can be for developer’s capitalizing projects with structured OZ preferred equity.

But what about OZ developments that were financed before 2023, when senior construction loan debt yields were 7-8%, and rents subsequently fell while operating expenses inflated? These projects today, are sizing to cash-ins, not cash-outs. The equity in these developments has significantly less ability to take on non-OZ preferred equity to fill the shortfall from agency financing because the main driver of the investment was to hold for 10 years and achieve the stepped-up basis. The pref behind agency market is expensive and limits the developer to a 5-year agency loan which will likely mature prior to the investment’s 10-year hold.

Many of these developments, if sold today, would result in a 50% or greater loss to the common equity. Below is a description of how we’ve been restructuring OZ investments capitalized in the “hot money” era of 2020-2023.

This is a common misconception and takes intimate knowledge of how OZs are structured from a legal perspective. Please note, we are not tax attorneys, and there’s a lot of nuances here. We’re always happy to connect you with leading OZ tax attorneys we work with.

For an OZ investor to receive the tax benefits, they must invest in a compliant Qualified Opportunity Zone Business (“QOZB”). Beyond holding for 10 years, the equity in the QOZB must (i) substantially improve the asset (i.e. doubling the basis over the first 30 months of ownership), and (ii) follow the safe harbor working capital guidelines. OZ funds can also satisfy the substantial improvement requirement when they acquire a property prior to certificate of occupancy (“Pre-TCO”).

What’s important, and often overlooked, is that once a QOZB achieves compliance, a Qualified Opportunity Fund (“QOF”) can make a follow-on investment, at any time including post-certificate-of-occupancy (“Post-CO”), into that same QOZB as long as the capital is used to (a) pay down debt or (b) fund capital expenditures. The key here is that the QOF is investing into the existing compliant QOZB and not returning any capital to the original OZ investors who substantially improved the property. If equity was returned, this would be a partial interest sale for OZ tax reporting purposes and remove any tax benefit(s). Also, the 10-year OZ hold period restarts upon the last dollar of OZ equity contributed to the QOZB.

Here’s a simple example of what today’s “distressed” OZ capital stacks looks like:

• In 2022, a developer capitalizes a $100M project

• Underwritten NOI: $5.5M [5.5% ROC]

• Stabilized cap rates were 4.0%, supporting $75M of debt [75% LTC | 55% LTV]

Fast forward to stabilization in a tougher market:

• Rents soften, concessions rise, and insurance/payroll expenses increase

• Stabilized NOI comes in at $5M instead of $5.5M

• Developer injects another $5M of equity to refill interest reserves or secure a new bridge loan

• Total equity invested: $30M

Now layer in today’s cap rate environment:

• At a 5.5% cap, the asset is now worth ~$90M

• Against the $75M debt balance, that leaves only $15M of equity value

• Roughly 50% of the original equity is wiped out

And this is where the pain really shows:

• With $5M NOI, the project supports only ~$62.5M of agency proceeds and the construction loan is maturing

• This results in a $15M refinancing shortfall/cash-in

Option A: Traditional Agency + Preferred Equity

• Suppose a 5-year, $62.5M agency loan carries a 5.0% interest rate; on an amortizing basis this leaves ~$1.0M of cash flow after senior debt service

• Agency lenders require the preferred equity to maintain a 1.10x DSCR; if a preferred equity provider requires an 8.0% current pay, the maximum preferred equity available is ~$11.35M, leaving roughly a $3.2M shortfall the developer must cover after borrowing a total of $72.85M

• The cost of this preferred equity would be ~14% (8% current + 6% accrued), resulting in a blended cost of capital of ~6.5%

• In 5 years, the developer faces two choices:

  1. Refinance into an $80M loan, requiring a 5.5% annual increase in NOI

  2. Or sell for ~$110M to achieve a 1.0x MOIC, requiring an 18% valuation increase

This scenario forces additional capital contribution, lacks flexibility, restricts distributions, and likely doesn’t align with the 10-year OZ hold period.

Option B: High-Yield Debt Fund Loan

• A few debt funds can lend up to 6.5% stabilized yields, but terms are expensive, roughly S+500 with a 3.0% SOFR floor [~8.5% cost of capital]

• A $77M “cash-neutral” loan covers the shortfall, but the incremental cost of capital for the additional $3.2M in proceeds is ~55%!

• Pros: no immediate cash injection required and more flexibility for a new capital event in 2-3 years upon seasoning occupancy

• Cons: permanent financing is unlikely to size to pay off this new loan; the developer may be forced to sell well before the OZ hold is satisfied, just like in Option A

Option C: Bring in a New OZ Equity Partner

• The most attractive option involves sourcing new OZ equity to invest into the existing compliant QOZB. This capital can pay down senior debt, lowering leverage while maintaining OZ compliance (since no capital is returned to existing investors)

• Taking the above example: retire the $75M construction loan and replace it with a $55M bridge loan [9% debt yield | 60% LTV]. The new OZ equity partner contributes $22M, bringing total new sources of capital to $77M (cash-neutral)

• The low-leverage bridge has a cost of ~5.80% [S+250 | 3% SOFR floor], and the new OZ pref equity costs 12% (200bps cheaper than pref behind agency). The blended cost of capital is 7.6%, 90bps lower than Option B

Accretive Benefits:

• The new structure allows for the investment to season and NOI to grow without being required to pay off the new equity investor at the next capital event given this is OZ capital and has 10 years of duration.

• Assuming 3% annual growth for 3 years, NOI increases from $5M to $5.45M

• Agency refinancing, based on the trended NOI, is $68.3M and pays off the $55M bridge loan, leaving ~$13M in distributable cash. Refinance waterfall structures typically return capital first to the new OZ equity partner until ~50% of their contribution is repaid ($11M to the new OZ partner, $2M to the developer)

• The new OZ partner’s capital account decreases from $26M to $15M, and the blended cost of capital drops to 6.25% (25bps lower than Option A) with far less risk

Ongoing Cash Flow & Exit:

• The cash flows with the new OZ equity partner are typically split by calculating the greater of (a) a 7.0% annual pref pay to the OZ equity partners outstanding accrued capital balance [7.0% on the $15M balance], or (b) their pro rata share of cash flows based on initial equity contributions

• Assuming continued 3.0% NOI growth, selling in 10 years at a 5.0% cap rate yields $140M in gross value

• After repaying the $68.3M agency loan, distributions first repay the new OZ equity partner’s capital balance, which on a 12% XIRR has accrued to $23M

• Next available distributions are made to the developer until a 1.0x MOIC of $30M

• Finally, $17M remaining cash flow available is split 90/10 (90% going to sponsor)

Outcome: When including the refinance event and operating cash flow distributions, the developer’s final return is a 1.95x – significantly better than the hope ticket of Option A and Option B to even achieve a 1.0x!

Similar to OZ structured preferred equity for development, the post-co execution acts much like an insurance product. It lets sponsors increase leverage without being forced to sell or refinance at stabilization. If things go well with permanent financing, the preferred equity is paid down early. If not, it provides extra runway for rents to grow or rates to reset.

While somewhat complex, we haven’t seen a solution with better risk-adjusted returns. The funds use the same math we outlined above, and this part of the market is extremely liquid. We’re fortunate to have closed, or be in the process of closing, six similar financings across the country with four different OZ funds.

The institutional OZ equity funds are gearing up to begin raising capital for OZ 2.0. Most of them have less than $100M of equity to be deployed and are seeking these exact transaction structures to market creative investing on roadshows for the new fund vehicles.

Wishing everyone a wonder holiday season and a happy & healthy New Year.

We’ll be back in January with a broader market update, our thoughts on the return of joint venture equity, and a look at where we’re seeing successes and navigating challenges.

Jordan Brustein; Andrew Rudy

E: [email protected]; [email protected]

M: (JB) 516-996-7722; (AR) 858-947-8738