Should a zone deal be allowed to earn a lower return than your non-zone deals?

The way capital I've been reading about handles this is to underwrite pretax only, then compute the after-tax number separately and never let the second one move the first. It's a discipline thing more than a math thing. The math works either way, the discipline is what stops you from paying 11 percent more per door.

11 percent higher per door and 60 basis points worse yield, in a market that got designated because it's distressed. Is anything about the zone site better other than the tax treatment? Location, tenant demand, anything?

I'm mostly here for the notes side and I don't follow the tax part yet, but the sentence that landed for me is that the person willing to accept the thinnest return sets the price. That's true of every market I've read about, zones or not.

From running a service business in what turned out to be a designated tract, the operational side of these areas is real work. Insurance, vacancy between tenants, collections. Whatever your yield assumption is, add friction that doesn't show up in the pretax model. That argues against lowering your hurdle, not for it.

If I'm reading this right, the tax benefit only shows up if you hold ten years and there's appreciation. So you're accepting less income for a decade in exchange for a maybe on appreciation? That would make me nervous.

@marlow that's the shape of it. And on the lending side the ten year hold matters, because your debt almost certainly doesn't have a ten year term at fixed pricing, so you refinance at least once inside the hold and that's a real risk sitting on top of the tax story. Whatever a lender tells you about zone properties, get it in writing, it varies a lot by lender.

The rural component of the new designations is the part I'm watching, since low price points are where I look. If enhanced benefits attach to rural tracts, the pricing pressure @pike is describing shows up there too, just later. I'd rather be early in a market nobody's bid up than debating 60 basis points in one that's already been found.

Land angle: if you buy dirt in a tract that comes off the 2027 map, you're holding an asset whose buyer pool just got smaller for reasons that have nothing to do with the land. @pike, do you know which of your two sites is on the eligible list Treasury put out?

I'd take the non-zone site and I don't think it's close on those numbers. Paying 11 percent more to earn 60 bps less is a real cost you pay in cash every year, against a benefit that requires holding to 2036 and having appreciation to shelter. One of those is certain.

@windlass said what I was going to. The 11 percent shows up on the closing statement. Everything else is a projection.

Question I probably should know the answer to: does the seller of a zone property actually get anything from the designation, or is it purely the buyer's benefit? Because if it's purely the buyer's, sellers pricing it in are just capturing something they didn't create.

@halyard sellers capture it because buyers let them. Same as a seller pricing in a permit they never pulled.

@pike, on scope: same builder and same rough scope in two different neighborhoods is not the same job. Distressed tracts hand you more unknowns behind the walls, more code correction when the inspector shows up, and more time. My last renovation in an older tract ran 19 percent over on the mechanical line alone because nothing had been touched since the 70s. Put a contingency on the zone site that you don't put on the other one and see if it still only costs 11 percent more.

Reading this whole thread as someone who started last month, the thing I'm taking away is that a tax benefit ten years out isn't worth much when the extra cost is due at closing.

@harrow is right about the walls but I'd push back on the conclusion. Construction in a distressed tract can be cheaper on the soft side, fewer neighbors filing complaints, easier staging, sometimes faster on inspections because the jurisdiction wants the project. That's not enough to close an 11 percent gap, though.

@pike, my actual answer to your question: no, a zone deal shouldn't earn less. But it also shouldn't have to earn more, and I think that's where your hole closes. Same hurdle, and if the tax treatment happens after that, fine. What you're describing is being asked to accept less, which is a different thing than the argument your friend made.

Problem in progress on exactly this. I let a zone story talk me into a basis I wouldn't have paid otherwise, on a small mixed use building, and 16 months later I've got the improvement test satisfied and a rent roll 8 percent under my underwriting. The tax treatment is intact and I still don't like the deal. So I've become a hardliner on the same-hurdle thing.

The embarrassing question: if the tax benefit is only on appreciation, and these tracts appreciate less than average because they're distressed, isn't the benefit smaller exactly where the program sends you? Or does the improvement itself create the appreciation?

@compass that's the best question in the thread and I want to know too.

@compass I think the answer is the improvement creates it, which means the benefit tracks how well you build rather than how the neighborhood does. Which puts it back on @pike's builder and scope, not the map.

Thin margins are my whole business and my rule is that I never pay for something that pays off after I'm dead in deal terms. Ten years is dead in deal terms for me. Non-zone site, no hesitation. But I'm not the guy the program is built for.

@compass, the appreciation comes from what you build and how the property is capitalized at exit, so the benefit is largest on a heavy improvement where you create value against a low basis. That's why the program is written around a substantial improvement test rather than just buying and holding.

@pike, your position has a hole because you've conflated two questions. The first is whether the tax treatment changes what a project is worth to you. It does, arithmetically. The second is whether you should bid that difference to the seller. You shouldn't, because bidding it away leaves you holding the risk and the seller holding the value.

On your actual numbers, 11 percent more basis with 60 bps less stabilized yield is a wide gap. Run it as after-tax equity multiple over ten years with a conservative exit cap on both, and then run the zone site again assuming your tract is off the 2027 map and the exit buyer gets nothing. If it survives both, take it. My guess is it survives neither, but that's a guess about your rents and I'd want to see @harrow's contingency in there before I said anything firmer. Anything about the actual tax treatment of your structure goes to a CPA.

@quarry's post is the one that will stay with me. Improvement test satisfied, tax treatment intact, deal you don't like. That's the whole failure mode in one sentence.

Voting same hurdle. What I'd add to @sextant's framing: the tax benefit is a call option on your own execution. You only collect if you hold ten years, if the improvement creates value, and if you don't need to sell. Every one of those is inside your control and none of them is certain. I don't pay cash today for an option I might not exercise.