No Shock

The Wall Street Journal reported last week that opportunity zone funds are falling short of capital raise expectations.  The article notes that opportunity zone funds, on average, have raised less than 15% of their goals, which I am taking to mean their offering size.  This shortfall comes as no shock, and it's not because of the neighborhoods where properties are located.

An investment in opportunity zone separates when capital gains taxes are due from from when capital can be removed from the opportunity zone to maximize the benefit.  Capital gains taxes must be paid in 2027, and this is a hard date no matter when the opportunity zone investment is made, but an investor must hold the investment for ten years to have all profits from the opportunity zone exempt from taxes.  Investors, therefore, must have other means to pay their capital gains taxes in 2027 than from funds they invested in the opportunity zone.

An opportunity zone fund investment triggers the capital gains tax event, where other investments can continue the capital gains deferral.  An investor in an opportunity zone fund must pay capital gains taxes in 2027, but an real estate investment in a 1031 exchange, for example, can continue to defer taxes.

As time goes by, I don't expect opportunity zone fund sales to increase because the time value of the deferral continues to decline.  By the end of 2020, all step-ups (added incentives) for investing in opportunity zones end, which reduces the incentive to invest in opportunity zone funds, but capital gains taxes are still due in 2027.

It seems to me that the opportunity zone provision was structured to benefit specific properties or one-time events, not as a sustained program to provide long-term benefits through continued opportunity zone investments.  Since I began to write and edit this post last week, I have read two news articles that confirm my opinion that opportunity zones were designed for specific, already in progress projects.   This story from ProPublica talks about Dan Gilbert in Cleveland, and the New York Times details Michael Milken's influence to qualify for tax breaks for his properties, including this passage:

The former “junk bond king” has investments in at least two major real estate projects inside federally designated opportunity zones in Nevada, near Mr. Milken’s Lake Tahoe vacation home, according to public records reviewed by The New York Times.

One of those developments, inside an industrial park, is a nearly 700-acre site in which Mr. Milken is a major investor. Last year, after pressure from Mr. Milken’s business partner and other landowners, the Treasury Department ignored its own guidelines on how to select opportunity zones and made the area eligible for the tax break, according to people involved in the discussions and records reviewed by The Times.

The unusual decision was made at the personal instruction of Mr. Mnuchin, according to internal Treasury Department emails. It came shortly after he had spent time with Mr. Milken at an event his institute hosted.

To make opportunity zone properties sustainable, the timing of capital gains payments needs to be adjusted to match the timing of investment.  The period when capital gains are due needs to be tied to when the investment is made, such as a fixed seven-year time frame, not just a random hard date (2027), which erodes the value of the deferral as the date approaches.  A 10% or 15% step-up should be a permanent incentive.  These changes would help encourage ongoing investment in opportunity zones by providing continued investment and incentive.

Even with political influence and map making that would make a partisan gerrymanderer blush, without a change to make opportunity zone investments attractive over time, I suspect higher values of many properties ascribed by the tax law will languish due to lack of long-term demand inside the opportunity zones.  Future opportunity zone articles are going to focus on the people who had projects in the works before the tax law changed, used their influence to get their properties included in an opportunity zone, then sold the projects a profit because of value of the tax benefit, and how future buyers experienced lost value due to lack of development tax incentives for surrounding properties.

Falling Up

The WeWork story opened a new chapter with SoftBank, WeWork's largest investor, agreeing to take it over.  The deal values WeWork at $8 billion, much lower than the $47 billion value SoftBank figured WeWork was worth in January.  WeWork's founder Adam Neumann will come out of this deal in fine fashion.  According to the New York Times' DealBook:

Yet Mr. Neumann will receive roughly $1.7 billion in consideration as part of the SoftBank deal, according to the people with knowledge of the offer. The Tokyo-based technology giant will buy roughly $1 billion worth of WeWork shares from him, and give him about $500 million worth of financing to repay a credit line from JPMorgan. Mr. Neumann also will receive a $185 million consulting fee.

I want to go on record to state that I am open to this type of deal.  I am willing to ruin a company and walk away with $1.7 billion in cash.  Heck, I will settle for the $185 million consulting fee, and I will even promise to do some consulting work.

Justice

Wow!  InvestmentNews (via Bloomberg) reports that Woodbridge Group of Companies' former CEO Robert Shapiro received the maximum sentence of 25 years for "running a $1.3 billion fraud." 

Can't Look Away

I am reading in the Financial Times this morning that WeWork is working on a $5 billion finance package that includes $2 billion of payment-in-kind debt.  The PIK portion is expected to have a yield of 15%.  (The PIK feature means that interest is paid in more bonds, not cash.)  The FT further reports that WeWork's bonds that mature in 2025 are trading at $.79 on the dollar, down from over $.90 on the dollar late last week.  Yikes. 

via GIPHY

Scary

The Financial Times keeps good tabs on the leveraged loan market.  Last summer the FT had an article (the article was published July 4) that stated that 80% of US loans are structured as "covenant-lite," compared to 20% in 2008 and 2009, which was during the Credit Crisis.  Covenant-lite means loans have been stripped of features to protect lenders, like coverage requirements, reporting requirements, and restricted payment clauses.  Restricted payment clauses prevent firms from borrowing money and then taking the money out of the business to pay big dividends.   Private equity firms, which are big leveraged loan borrowers, have been behind the push for weaker covenants. 

The Washington Post had an article last week about Fannie Mae, Freddie Mac, and FHA's exposure to risky loans.  The three government firms now guarantee $7 trillion of mortgages, 33% more than before the Credit Crisis.  Many of these mortgages are to borrowers that have high income to mortgage payment ratios, which are deemed risky as a large portion of borrowers' income is going to mortgage payments. 

The stock markets always get the headlines but I am watching the loan market, and some of the articles I am reading scare me.

WeWorked Over

I am late to the WeWork story, but in my speed education I find it fascinating.  The non-traded alt space is not the only place were reality can get suspended.  In August, WeWork was looking to go public at a $47 billion valuation, and some investment banks had its valuation close to $100 billion, and today, IPO shelved, WeWork is laying off employees and may have to face bankruptcy.  WeWork will inspire a book similiar to Bad Blood's telling of Theranos' rise and fall. 

WeWork's tale to me is simple, and does not involve Theranos' scientific shroud.  WeWork took venture money along with heavy debt and entered into long-term leases with expensive improvements, then leased the office space on a short-term basis.  The timing mismatch between WeWork's lease obligations and its revenue from short-term releases is enough to make me question the viability and sustainability of its business model.  Like Theranos, WeWork had a charismatic founder/CEO who was as able to get continued financing and continued increased valuations for up-round financing. 

The real-world reality of the WeWork story is that it is the largest tenant in New York City and one of the largest in London.  I bet there are some nervous major market landlords.