Episode 10: Show Notes.
If you’re interested in diversifying your real estate portfolio, eliminating the usual taxes you are required to pay on your real estate investments, and contributing to the regeneration of lower income areas at the same time, you have come to the right place. Joining us on the show today is Jeff Feinstein, previously a technology executive who is now a managing partner at Pinnacle Partners. He is here to share the numerous compelling reasons why real estate investors should be looking at opportunity zones. Jeff explains what an opportunity zone is, why he decided to become involved in projects of this type, and the requirements for investing in them. He and his team have seen a great deal of success by focusing on affordable housing developments in opportunity zones, utilizing a single entity deal model, and Jeff believes that the future of these zones is looking bright (even with the recent change in oval office).
Key Points From This Episode:
- Jeff’s reasoning for getting into real estate while he was working as a technology executive.
- The real estate fund that Jeff and his partner started in 2007, and how it kickstarted his career in real estate.
- A piece of reform legislation that was introduced in 2017 which Jeff became particularly interested in.
- What Jeff’s company, Pinnacle Partners, does, and where it operates.
- An explanation of what an opportunity zone is, and why it is so beneficial to invest in real estate within them.
- Positive social impacts that are intended to be realized through the creation of opportunity zones.
- Three requirements that need to be adhered to if you purchase real estate in an opportunity zone.
- The types of developments that Pinnacle Partners has chosen to invest in within opportunity zones.
- Single entity deals; what these are and why Jeff and his team choose to do them.
- Tax benefits of opportunity zones should only be considered after the deal has been properly evaluated.
- Why Pinnacle Partners does not deal with brokers.
- Investor types that are generally interested in opportunity zones.
- Slight changes that have occurred in the opportunity zone program since Biden came into power.
- Jeff’s thoughts about potential inflationary spikes.
- Typical loan to value ratios of the projects Jeff and his team work on.
[0:00:18.5] JM: Hi, I’m Jenny Merchant, co-founder of PitchBoard and welcome to The Pitch Podcast. We’re here to have thoughtful discussions with forward thinking managers who are taking unique approaches to professionally investing capital. Through these conversations, we hope to introduce you to new ideas and strategies that will help you better manage your own portfolios.
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[0:01:04.9] AH: Hi, this is Andrew from PitchBoard. I had a great chat with Jeff Feinstein of Pinnacle Partners. He explained why opportunity zone real estate investing is so compelling and how increasing capital gains taxes would make it even more attractive. I think you’ll enjoy our conversation.
Hi, this is Andrew from PitchBoard. Today, I have the pleasure of speaking with Jeff Feinstein, managing partner of Pinnacle Partners, a real estate firm focused on opportunity zone investing. In addition to real estate, his experience includes over 30 years as a technology executive. Jeff, welcome to The Pitch Podcast, it’s great to have you on the show.
[0:01:40.0] JF: Hello Andrew, thank you for having me, glad to be here.
[0:01:43.0] AH: How did you come to be involved in real estate investing? As I just mentioned in the intro there, you spent over 30 years in tech. How has that been to move over into a totally different industry?
[0:01:55.5] JF: I got involved with real estate investing passively as a means to diversify from my concentrated position in technology, right? I was investing my time, pursuing my career as an operating executive at technology companies and then either public or private, generally had equity stakes that were either appreciating or had the potential through liquidity event IPO or trade sale to have significant appreciation. In terms of just diversification strategies, I sought to begin investing systematically in real estate.
Upon exit of the second company I was a part of that we built, grew and sold in 2007, I joined with an old friend of mine but also a very well-known and emerging developer in Seattle. We started one of the first private equity real estate funds in Seattle dedicated to investing in Seattle. At the time, you may recall ‘07, the start of the great recession, it was really considered to be a distress fund. We were successful in raising a substantial amount of capital and we deployed that. The extraordinary growth at Amazon, almost simultaneous with that, and the transformation of Seattle.
That proved to be lucky timing and an incredible reward and that accelerated my transition from technology to real estate investing. Very focused on investing in real estate.
[0:03:31.4] AH: Sort of came about as a – almost a diversification sort of an approach, right? That you – there’s industries where – I think financial services is a good example, where someone – that’s where they earn their money from it but then they’re also, most of their investments are in the stock of that company,or in the industry and then it’s really doubling up on the bets. I think what you did there was quite wise.
What can you tell us about Pinnacle? Can you give us an overview of the firm?
[0:04:03.7] JF: Certainly. As I mentioned we created this private equity fund in ‘07 and that was ultimately a 10-year fund that began dispositioning or selling the assets systematically to fully exit from the portfolio around 2017, 2018 when we thought we had top ticked the market. Didn’t prove to be the case but nonetheless again, very rewarding experience.
I was without real estate exposure and became keenly interested in the tax reform act that was introduced under the Trump administration in 2017 and there are a great many moving parts within that reform legislation, corporate tax rates and individual tax rates and yet, there was this very ambiguous piece of legislation called opportunity zones. We dug into that and it was still quite vague but I seized upon it along with some other like minded, sophisticated investors and we thought this was a unique opportunity.
If we could execute on the opportunity zone real estate investing, we could really take full advantage of the tax incentives that were provided, which we thought were once in a generation and extremely compelling, and continue to invest in real estate.
We set out, we formed Pinnacle once we better understood the legislation and could execute on it. We formed Pinnacle Partners to participate in these OZ real estate projects in attractive, urban locations. We are participating generally through JB Equity Partnerships with well-known developers in attractive opportunity zones, heretofore it has been in and around the western US, so California, Washington and we continue to look throughout Utah, Boise, many other states in the western area.
[0:05:53.0] AH: Can you describe for us what exactly opportunity zones are, why does the opportunity exist and why should investors have it on their radar screens?
[0:06:04.0] JF: Just to put the headline out, it is a significant tax shield that one can obtain through participation in the program, and given that it’s possible that capital gains tax rates will increase, this becomes extraordinarily compelling now. I’ll come back, I’ll leave that there, let’s come back to the program definition.
What the legislation was intended to do was to unlock trillions of dollars of really passive, unrealized gains, principally in stock market, and provide incentives for reallocating those – monetizing those gains and realizing those gains and then reallocating those gains into 8,700 designated economic zones or opportunity zones.
If you are to invest in these zones in real estate as an example, you’re then entitled to a series of tax benefits I can describe in a moment. Again, in the macro, the objective was to move these passive gains out into these zones and create economic activity. Principally, what they’re requiring and what they’re providing is the following:
If you realize a capital gain, so the sale of real estate business, stocks, bonds, RSUs, even collectibles, you invest the capital gain into a designated real estate opportunity zone real estate project, you begin to accumulate tax benefits to include the deferral of the tax, you don’t have to pay the tax on the original gain through 2026 and then ultimately, what we think is the most compelling wealth building driver is you qualify for tax elimination.
All the appreciation on the real estate, after a 10-year hold period, qualifies their tax exemption. In other words, you paid no tax on the appreciation of the real estate asset. That’s the program as it was intended. We’ve been executing on the program, we’ve been identifying real estate projects, investing, a syndication of investors using capital gains to then qualify and derive the tax benefits while participating in very high-quality real estate.
[0:08:15.8] AH: Is there a social benefit to these investments and is that – I guess that’s both from your perspective as the investor but also the way that the governments have to program up?
[0:08:27.9] JF: That is correct, yeah. It was intended to – these zones were nominated and ultimately submitted by the governors of each state and they said, “This is where we’d like to stimulate investment.” Generally speaking, they were using 2010 census data. These were zones that had lower income, higher unemployment and we’re in need of economic activity.
So yes, indeed. Our focus has been on community impact wherever possible. We’ve been very focused on supporting workforce housing or affordable housing projects. Although the legislation doesn’t require you to build anything specifically, I think the spirit of the program was to deliver, you know, we’ve seized upon this and executed on it, affordable housing in these designated communities.
[0:09:15.8] AH: Are there any rules about the sorts of improvements that have to be made to what you’re buying? I’m guessing it’s not enough to just buy an empty plot of land for example.
[0:09:28.7] JF: There’s a few stipulations, requirements that you need to adhere to and we use the term compliance and the first is that, one, you have to invest in capital gain, we discussed that already. Two, you must substantially improve the asset you purchased to your point.
You just can’t own it passively, you’ve got to do something to improve upon it and generally speaking a substantial improvement passes is generally doubling the basis. You invest equal to what you acquired the land or the building for.
We’ve been pursuing ground up development where we acquire land, get it permitted and then go vertical on it. Or we’ve been looking at historical assets that need to be modernized so we could invest substantial amounts of money to reposition an existing asset.
Number one, you need to invest capital gains, number two, you need to substantially improve the asset. Number three, you can’t flip it. You gotta hold the asset for 10 years to qualify for that tax exemption status I spoke of earlier. That really encourages patient capital, long term investment horizon, and so that has proven, I think there’s close to one hundred billion of capital gains now, invested in the program nationwide. And there’s a big multiplier effect on the economic activity that it’s created, probably measured in hundreds of billions of dollars. And these are lasting investments that will go for 10 years plus. Those are the requirements to participate.
[0:11:08.5] AH: So far, most of the investments, pursuant to this program, have they been in multi-family residential, have they been in commercial or industrial? Has there been a noticeable breakdown in how things have shaken out?
[0:11:25.3] JF: For our part, we’ve invested in and supported projects equaling about 400 plus million in total construction and 85% of that has been in multi-family. I’m speaking for ourselves. I think the program has seen predominantly multi-family investment but we’ve seen a lot, I’ve seen other regions and other funds investing in industrial hospitality, commercial properties, office included.
Again, you’re not limited to any particular product type but I think the large proportion has been in multi-family.
[0:12:02.5] AH: When you’re looking for, no pun intended, opportunities here, you know what the tax incentives will be, what are you looking for from a real estate perspective? What says to you, this worth investing in versus, “We’ll take a pass on this one”.
[0:12:17.7] JF: That’s a great question and you know, we have seen hundreds of deals, we’ve pursued eight, only eight projects, so we disqualified many. I would tell you that what we do is we set aside all the tax benefits. As you say, they’re understood. We set them aside and we vet and evaluate these real estate projects on a standalone basis and we look to ensure this is a high quality real estate project.
We look at all the things you’d normally evaluate such as its location, the developer and their ability to execute, and ultimately the type of product, and then you do these comparable analysis and determine, “Yeah, there’s a need, we can perform, we can deliver an attractive return to our investors, those that are participating.” And then we add in the tax benefits. That is only a sweetener.
[0:13:12.2] AH: Right.
[0:13:13.0] JF: The other thing we do differently than some other funds is we evaluate what we call single entity deals. We go very deep into one project, we perform an extensive amount of due diligence and then we offer that to our investors and we share our conclusions with them so that they can get full disclosure on all the attributes of the investment and take a point of view on it. We think that’s good for investor stewardship.
Generally speaking, we look at it straight ahead like anyone would evaluate a real estate deal. We’ve been focused on the urban core and the western US, as I described earlier, and we’ve got reasons for that. And then we add on the tax benefits as an incremental benefit. I think what you should not do is take the tax benefits layer in your analysis and say, “Well, this is an okay deal and it gets better with the tax benefits.” We look for great deals that get even better with the tax benefits. It’s gotta be sitting on its own first.
[0:14:10.1] AH: There are some people who will – they won’t sell a stock because they have a huge capital gain and they think of the tax implications first, right? You sort of have to put the tax implications to the side and if they’re positive that’s great as an add-on but it shouldn’t really be your driving force behind the analysis, right?
[0:14:31.6] JF: Right, exactly. Just a little bit of a note on the anecdote you raised, I think that the opportunity zone for tech investors has provided a gateway, or maybe additional rationale, to encourage them to sell or realize the capital gain. Of course, we’ve seen significant volatility in the stock market and we’ve seen technology stocks in particular appreciate at very rapid ways and so yeah, most people including myself would say, “Oh, I don’t want to sell because I am going to have a big tax bill,” but there’s good fundamental reasons to sell when you’ve enjoyed a significant gain.
You want to obtain diversification whenever possible and the opportunity zone gives you that ability to mute the tax implications, right? Because you defer the tax to be paid and you obtain diversification, so I think your example is quite relevant to the opportunity zone. Many of our investors are tech executives or tech investors.
[0:15:31.2] AH: Well, that’s interesting. Okay. Yeah, I mean I guess that makes a lot of sense too, right? On the west coast. A lot of people are sitting on, as you say, significant unrealized capital gains. Do you find when you are looking at a project and you decide, “Okay, we’re going to bid on this property,” is there much competition from other specialized opportunity zone investors? Is it pretty specialized still at this point? I mean, there’s not many firms that specialize in what you’re doing?
[0:16:03.8] JF: I think it is very specialized yet it is also crowded. We will not pay a premium because a particular project is in an opportunity zone. That’s called [inaudible 0:16:17] that we’re unwilling to pay because that negates, again, your investment thesis and potentially even mutes the tax benefits that we’ve discussed. We try really hard with the boots on the ground strategy to source unique opportunities that don’t have a lot of competition and/or we get alignment with our development partner to not impose this premium or lift, yet to participate with us alongside our investors and to capitalize on the long-term benefits. So we look at trade and sort of short-term incremental gain with long-term alignment.
[0:17:00.3] AH: How do you source your deals? What’s the process like as far as dealing with developers and do you hear most of the deals through them or through brokers or other people in your network?
[0:17:12.3] JF: I don’t think we’ve done a deal that was introduced by a broker. All respect to the brokerage community but those are generally sort of – those are on-market deals. Those are going to be heavily promoted and then you’ll get that crowding effect I spoke about and maybe the seller’s desires of that lift. I also identified that we really don’t participate with the broker community. The reason why we’ve been more centric to the western area and very specifically in Washington State and California is we have a number of durable relationships with well-known developers that have OZ projects.
We’ve got an advantage, or a relationship advantage in that way and our board of advisors, which each member is quite steep in a particular subject matter, they’re very experienced real estate experts, they’ve been assisting us in identifying opportunities through their own network. It’s like a collective approach to sourcing.
[0:18:05.8] AH: Right. Then I guess, switching to the investor’s side, what’s a typical investor like for you and what’s their situation? What are they looking for?
[0:18:15.7] JF: Yeah, there’s a couple of profiles of our investors. Let’s start with where we also discussed, the tech investor. You know, concentrated position, outsize gain, desire as to realizing those gains now and seeking diversification, that’s one type of investor.
Increasingly, we’ve been seeing more real estate investors selling properties and they have sought tax efficiency through something called the 1031 exchange. But the opportunity zone presents more flexible benefits and ultimately tax exemption that the 1031 does not. So we’re getting an increased number of real estate investors coming to us looking to compare 1031, which is trading like assets in exchange for tax deferral with the opportunity zone.
The third type of investor we’ve seen is, and it’s related to Biden’s tax initiatives whereby he has proposed the potential to eliminate the 1031, potentially increase capital gains tax rates to ordinary income and to change the parameters on carrying interest. So what we’ve been seeing, those are all proposed and we don’t know what will ultimately be legislated of course, but we’ve been seeing some people react to that and making moves accelerating the sales of a business, a small business so that they can preserve their position and be as tax efficient as possible. That would be, I’d say, the final category of our investors.
So we’ve got tech investors seeking diversification, we’ve got real estate investors looking at an alternative to 1031, and then we’ve got other sellers of assets locking in gains and looking for that tax shield that the OZ provides in an environment of potentially increased tax rates.
[0:20:07.5] AH: Right, and are they also looking for the income that a property might spin off or are they mostly looking at the ultimate tax benefit?
[0:20:19.6] JF: When we talk about a ten year hold, people might perceive it, “Oh, I see liquid for 10 years,” and that’s not the case. This is a real estate asset that is performing, you assume it’s performing, meaning it’s generating cash and there are other vehicles like refinancing strategies that you can return on your capital during the 10-year hold period. The answer is yes, each one of our deals provide a cash-on-cash return and then a return on capital return and then ultimately after 10 years, if we choose to sell the building, we hope that at the highest possible valuation and then generate that final, what they call terminal sale return, which again is going to be tax exempt.
[0:21:03.8] AH: The final cherry on the top, right?
[0:21:06.1] JF: Exactly.
[0:21:06.7] AH: I’m guessing that you guys keep your eye on Washington fairly closely given the business you’re in. Is there any worry that Biden might in some way repeal or amend the rules surrounding opportunity zones?
[0:21:26.8] JF: What we have learned is that the program is an active and effective economic recovery program that’s in place and that they would like to continue to utilize as we come through this pandemic. What we’ve also heard is that they want to enhance the reporting requirements so that they know exactly how people are investing in opportunity zones. We’ve also heard that they have a strong bias towards affordable housing solutions as a preferred product type.
Now, will they require that? I don’t think so, but that’s clearly their desire. When you couple affordable housing with reporting, our sense is that they’re going to want us to be very much focused the way we have been on making a positive community impact in each and every opportunity zone. That’s what we know of, we think the program continues and it’s been legislated through 2046. We think they’ll probably require enhanced reporting so they understand where the funds are flowing and the type of investments that are being made with a strong focus on affordable solutions. I don’t know if there’s a reward for that but that’s something we’ve been doing and so we feel we’re aligned.
[0:22:42.3] AH: The prospect of interest rates rising, how much did that affect your financing of the various projects and valuation of the real estate?
[0:22:52.0] JF: In a significant way. More recently, we’ve had the 10 year moving upward to I think one seven. Then you also have commodity costs in the specter of inflation, right? We’ve all heard about the cost of copper, lumber, concrete, et cetera, those make a profound impact on your proforma, and we’ve been recasting our proforma assumptions both on material costs and the cost of debt. But, you know, depending on who you listen to and what your point of view is, many people think the inflationary spike is due to, in large part, economic stimulus in the system and it’s transitory in nature and we’ve had a deflationary cycle through over a decade and that will return, or revert to the mean.
So we’re less concerned about inflationary pressures. I think the fed is on side to support low rates for an indeterminate amount of time. So right now we’re trying to get busy with both capitalizing our projects suitably to get to reasonable loan to value ratios and to lock in whatever possible permit financing now and I think that will benefit our projects for sure.
[0:24:07.2] AH: What would be a typical loan to value ratio for your projects?
[0:24:11.5] JF: We’ve been in and around sort of 55 to 65% loan to value. I’d say more recently, it was getting compressed, you know, down to 60 and 55. Whereas you could, in a prior cycle, maybe get to 70. We try to evaluate everything in a very conservative way and in many cases, we like to add more equity into the deal, so you know our loan to value is going to come down. That does kind of mute the returns, the total returns, but we think it’s – you know, we don’t want to have substantial leverage, or overleverage in any way. We work closely with our partners to optimize that loan to value ratio.
[0:24:48.9] AH: Your model, if I understand correctly, is a syndicated model rather than a committed fund, right?
[0:24:56.4] JF: Yeah, we don’t like to use the term syndicated per se but it’s not a multi-asset fund. We go deep, as I described, in our sourcing process and we accumulate all of the due diligence and then we present that to the perspective investor for their own evaluation one deal at a time.
[0:25:14.9] AH: Is there anything else that we haven’t mentioned about Pinnacle or opportunity zone investing that you’d like to chat about today?
[0:25:22.2] JF: No, I think you had a lot of questions, it’s fantastic. Thank you very much, we covered a lot of ground and I’ve enjoyed the conversation.
[0:25:27.8] AH: Okay, great. Well, we’ll wrap it up on that note. Jeff Feinstein of Pinnacle Partners, thanks so much again for sharing your insights and as always, thanks for our listeners. We’ll be back again soon with another episode.
[END OF INTERVIEW]
[0:25:38.5] JM: Thanks for joining us on this episode of The Pitch Podcast. Make sure you check us out online at thepitchboard.com. If you liked our podcast today, please make sure to subscribe to The Pitch Podcast so you don’t miss an episode.