After the devastating 2005 hurricane season, the U.S. government passed the Gulf Opportunity Zone Act (GO Zone) to encourage economic growth and rebuilding in damaged areas. The Katrina GO Zone, which includes parts of Louisiana, Mississippi and southwestern Alabama, offers particularly intriguing investment opportunities.
Incentives include a possible 50 percent first-year accelerated depreciation and tax free bonds that can finance projects at rates up to 2 percent lower than conventional financing.
Normally, depreciation is spread out over 27.5 years for residential rental properties and 39 years for commercial properties.
In the Katrina GO Zone, qualified investors can take a 50 percent depreciation on new rental properties in the first year, along with the normal depreciation on the other half, Kim Smith, a tax attorney with Butler Snow in Jackson, Miss., said.
To qualify, property must be placed in service after Katrina and before the end of 2008, although an extension through 2010 was granted for severely damaged counties, Smith said.
Properties must be “new to the GO Zone,” so purchase of a building that existed before Katrina hit would not qualify, but the cost of substantial renovations would, Ralph Stephens, a CPA with Postlethwaite & Netterville in Baton Rouge, La., said.
For new construction, the investor must be the one to construct the property within the timeframe, but properties constructed by developers for investors are allowed, Wade Ogletree, a realtor with Coldwell Banker, JME Realty in Baldwin County, Ala., said.
Certain properties will not qualify even if new. This includes casinos, liquor stores, golf courses, massage parlors, hot tub facilities, suntan facilities and racetracks, Stephens said.
Passive investors can usually only take the loss against passive income, but real estate professionals can offset other income such as wages, salaries, dividends and interest, Kelly Hayes, a tax attorney, CPA and GO Zone specialist from Southfield, Mich., said.
“The only way, when you’re talking about rental property, for it not to be a passive loss is if you’re a real estate professional,” Smith said. “The definition is that you spend more than 750 hours a year in a real property trade or business and more than half your time in a real property trade or business.”
Smith recommended that investors consult a tax advisor to determine whether they qualify and whether the depreciation would be beneficial.
If the property is sold, the investor must take a recapture of the incentive, Damion Flynn, broker/owner of Viking Realty in Gulfport, Miss., said. Many people don’t believe the incentive must be recaptured as ordinary income, but Smith’s firm takes “a strong position” that it does.
Investors can potentially delay or even avoid recapture through 1031 exchanges, which also allow investors to delay or avoid capital gains taxes on the sale of investment property when the proceeds are used to purchase other investment property and certain requirements are met. Investors should consult with a tax advisor before making a GO Zone investment.
Developers with larger projects can receive low cost financing by issuing special tax exempt GO Zone bonds. Because the bonds are tax exempt, the interest rates paid on them are substantially reduced.
By issuing and selling these bonds, developers in the GO Zone can finance large-scale projects at low rates. The bond financing can be a good fit for projects of $2.5 million and up, Michael Russ, a bond attorney with Butler Snow in Jackson, Miss., said. Bonds can generate savings of 150 to 200 points, or about 2 percent, he said.
The larger the project, the more attractive bond financing becomes. “The bonds are a good deal on a bigger investment…because of the costs of issuing the bonds,” Stephens said. Costs of issuance include attorney, bank and other administrative fees.
Haley Barbour, Mississippi’s governor, recently signed legislation allowing fees for issues $4 million and under to be pooled among four or five smaller projects, Russ said.
Bonds can be used to fund acquisition, construction and renovation of any commercial properties except condos, casinos and the other types of properties which are also disallowed from the depreciation, Smith said. Bonds can’t be used for a residential rental property unless it is low income, she said.
The bond incentive “has a lot longer of a life” than the accelerated depreciation, Smith said. Bonds can be issued until December 31, 2010.
Tax free bond financing provides “consistent savings throughout the project,” Russ said. He has seen projects that finance anywhere from 10 to 30 years. Investors may not finance construction with the bonds and take the accelerated depreciation, Russ said. “You have to choose one or the other.”
Almost two thirds of Mississippi, half of Louisiana and a small strip of Alabama lie in the GO Zone. Because the area is so vast, “there’s no such thing as a GO Zone market,” Ogletree said. Opportunities and economics differ from town to town.
Devastated coastal areas have the greatest need and the greatest risk of future hurricane damage. As a result, insurance rates have risen dramatically along the coast. For many coastal properties, rates have tripled, quadrupled or more, Scott Britton, a full-time Mississippi investor and author of www.realestatesuccess.com, said.
Investors can move inland to avoid hurricane dangers and insurance issues, Britton said. “There’s plenty of room to come inland with the GO Zone, get away from those fears and do a similar type of thing.”
Some areas were “touched very little by Katrina,” Ogletree said. “It’s a way to invest in a healthy economy and get the benefits at the same time.”
Many GO Zone areas are experiencing a housing shortage. Displaced populations moved to areas with less damage, eating up the small supply that was available.
“The supply is low, the demand is high, and those with the money are buying what they need while those that can’t afford it or do not have the credit are forced to rent,” Flynn said.
Single family homes, duplexes and four-plexes rent “almost as soon as you can put an ad in the paper—if it even makes it to the paper,” Flynn said. “The last numbers I heard were over 75,000 people still living in FEMA trailers on the Gulf Coast, so it is not hard to find renters.”
“Apartment complexes are renting very, very well—100 percent occupancy type levels. They’re getting premium rates right now,” Britton said.
Investors should investigate whether the source of demand is sustainable; some “exorbitant rental rates” in severely damaged areas were caused by people temporarily coming in to repair the area, Ogletree said.
In spite of increases, “property values are still below the national average,” Flynn said.
Single family and condo properties can be found in the GO Zone for $150,000 to $220,000, Glenn Plantone, a full-time real estate investor and founder of National New Builds, LLC, said.
“Apartment complexes, single family houses, I think are where the average guy can get in and make some good money. Maybe even some low income housing off the coast…out of the way of the hurricanes a little bit more,” Britton said.
GO Zone incentives have spurred growth in Mississippi, Flynn said. “There have been an astounding number of new businesses opening and being built along the Mississippi coast.”
Biloxi and Gulfport, major centers on the Mississippi coast, are doing well, Flynn said. Their employment is “coming back nicely” and drawing more residents, which increases rental demand, Plantone said.
Biloxi offers immediate cash flow, Hayes said. “They are building a ton of single family homes in the $120,000 to $175,000 range.”
In Mississippi, a $100,000 house would rent for about 1 percent a month, or $1,000, Britton said. As in many areas, there is a “sliding scale”; a $150,000 house is likely to rent for $1,200 or $1,300, he said.
“Right now, the area that seems to be the hottest is the Biloxi, Mississippi, area,” Ron Costa of RE/MAX Millennium Commercial Properties in Las Vegas, and author of www.gozoneprojects.com, said.
Many people are investing in Biloxi now and intending to move their money toward New Orleans in about two years, Costa said. “They figure that New Orleans is still about two years away.”
Baton Rouge, which is “up the way about an hour” from New Orleans, was not hit directly by Katrina, and its economy has grown “tremendously” because of the influx of people from New Orleans, Plantone said.
Plantone said he believes Baton Rouge has a solid future of growth. The rental market there is strong, with rents at almost a dollar per square foot, he said. Baton Rouge is home to Louisiana State University, so it has a stable demand for housing.
Areas struggling to recover are less attractive for investing. Louisiana as a whole and New Orleans in particular are struggling more than Mississippi and Alabama, Britton said. Some of that is because of local politics, he said.
Many residents left New Orleans and may never return, Plantone said. “I don’t see New Orleans as a real strong economic force.” The damage to the city’s convention business was a big economic blow, he said.
“If you wanted to make an investment in New Orleans, you would definitely be looking really long term,” Costa said. He said he expects that market to pick up in two to five years.
Gulf Shores, Foley and Baldwin County in general have strong rental demand. “We have been short of rental property in this market for some time, and the hurricanes have just made it worse,” Robert Ingram, president and CEO of the Baldwin County Economic Development Alliance, said.
The area has an excellent job market with a “very low unemployment rate,” Hayes said.
Rapid growth has led to "a severe worker shortage," Ingram said.
The construction boom, which is creating jobs, includes reconstruction of hurricane damaged properties, “but a big part of it’s just a natural growth,” Ingram said. “This is one of the fastest growing areas, job-wise, in the United States.”
Unlike areas that were hit hard by Katrina, “the impact has been mostly psychological” in Baldwin County, Ogletree said. The hurricanes shifted the national attitude of investors and homebuyers toward the area, he said.
“In two years, I really look for this market to be booming again and for folks that have invested now when things have settled down to be very happy with their investments a couple years out,” Ingram said.
The town of Bayou La Batre was heavily damaged by Katrina and has since made efforts to reinvent itself as an ecotourism destination.
However, some of its “fundamentals were questionable before the storm,” Ogletree said. He expressed concern that the town’s recovery may be impaired by its rejection of development opportunities in favor of a “green” route.
Construction is a big source of GO Zone employment, and that is not likely to lessen anytime soon, Britton said. Rebuilding will probably take a minimum of five years, and it will probably be 10 years before the area fully recovers, he said.
Shortages in labor and materials have increased construction costs, and creative alternatives are arising.
Modular homes are becoming popular, Britton said. These well-built homes have strong wind ratings to withstand future storms and can be “up and running very, very quickly,” he said.
Modular homes are glued, nailed, prewired and preplumbed in a factory, and they result in “a great looking product that’s better built than a stick built house,” Britton said. Costs are typically in the range of $85 to $90 per square foot, he said.
Small, well-designed “Katrina cottages” to replace FEMA trailers are another growing trend, Britton said. “There’s some opportunity there with building these tiny houses for people.”
“You can go into somebody’s lot, build them a Katrina cottage, they can live there while they’re building their main house back and…they can keep the Katrina cottage as a guest house or…it can become a part of their new structure,” he said.
Rely on fundamentals
Word about the GO Zone incentives is spreading, and some real estate professionals are promoting it to stimulate business. This is drawing investors “to buy anything from preconstruction to new houses, just to get the GO Zone incentives,” Britton said.
“I see a lot of them paying too much and thinking their properties will rent for way more than they really will,” he said.
“New condo construction is one of the main things naïve investors are buying,” Flynn said. “When they realize they can’t rent them for what they were told at a seminar, they try to sell them….The worst part is that they may have already taken a GO Zone credit on them and have to recapture that credit when (if) they sell.”
“Be careful of who you talk to…there are a lot of companies (and real estate professionals) preaching ‘GO Zone’ who have no clue about anything other than what to tell you to get you sold on it,” Flynn said.
“My greatest fears have been with fellow realtors and my concern over whether we’re going to see professionals get themselves into trouble” by pushing properties as qualifying, Ogletree said.
Flipped properties and condos are particularly uncertain areas. Some companies promote condos as GO Zone properties, while others forbid the mention of the GO Zone in relation to condos, Ogletree said.
Ultimately, investors need to consider the numbers and underlying fundamentals, rather than rushing in to invest solely based on incentives.
“Don’t invest in these areas just for the tax incentives,” Britton said. “Make sure the deal makes sense financially.”
“Do a transaction because of the economics and not because of the tax incentives. Let that be icing on the cake,” Smith said.