Educating Individuals About Real Estate Investing
Michael Episcope is a principal of Origin, co-chairs the Investment Committee, and oversees investor relations, marketing, and company operations. Michael brings 25 years of investment and risk management experience to the company and believes that calculated risk-taking in inefficient markets is the key to building wealth. He has closed over $2.3 billion of transactions and has raised or invested principal funds of over 56 million and averaging a gross IRR of 30%.
He’s been featured on Forbes ValueWalk and HuffPost. He was a Commodities Trader on one of the exchanges. Now, he’s focused on helping others transform the way they invest in commercial real estate.
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Brett:
Our guest is one of the Principals of Origin Investments. He is a co-chair of the Investment Committee and oversees Investor Relations, Marketing, and Company Operations. He brings 25 years of investment and risk management experience to the company and believes that calculated risk-taking in inefficient markets is the key to building wealth. He has an amazing story of being on the Chicago I believe, based hedge fund and trading on the floor of exchanges. And then he brings that expertise and focuses to the commercial real estate world. Please welcome to the show with me, Michael Episcope. Hey, Michael, how are you doing?
Michael:
Great, Brett. Thanks for having me on again. That last conversation once so quickly, I’m glad we could do this again.
Brett:
Absolutely. So, let’s just dive right in. Instead of going to the backstory and the focus info, you can go find that episode. We’re gonna dive right into the main topic, which is opportunity zone ground-up developments. So Michael, what’s the biggest best-kept secret when it comes to different capital gains tax using opportunity zones?
Michael:
Well, I’ll just back up a second. I’m sure there are some people who aren’t familiar with opportunity zones at all. This was a program that was built out of the 2017 tax cuts and JOBS Act. It’s really a way to defer, reduce and eliminate capital gains taxes when you are investing in real estate through an opportunity zone fund. The first benefit is the reduction if you invest in 2021, this year, and you have a million dollars in capital gains, you only have to pay capital gains on $900,000 of that and actually disappear after 12-31 of this year, and it goes down to zero. So the reduction is actually going to be short-lived here, it has been going on for the last three years and sort of stepping down from 15% to 10% until it gets to zero. And then the deferral is actually a nice benefit. Because if you have a capital gains obligation this year, you’ve realized capital gains, you have to pay taxes, if you invest in an opportunity zone fund, you actually don’t have to recognize those gains until the tax year 2026 payable in 2027. So it’s actually like an interest-free loan from the government for six years or so. And then the big kicker to it is that if you are in the opportunity zone fund for 10 years in one day, no matter how much you make, if you invest a million dollars, and it grows to $2 million, $5 million, $10 million, $100 million, whatever it might be, you pay zero taxes when you get out. So it’s one of the best programs for real estate. And you know, for an already efficient asset class. From a tax perspective, it makes it that much better. And you know, when we run the math, and we look at this and look at the after-tax returns of an opportunity zone investment, versus using after-tax dollars, the benefit is about 60% to 70% greater in an opportunity zone. So if you like real estate, and you’re willing to take the ground of development risk, there’s really nothing better than you can invest in at this time, than in opportunity’s own fund.
Brett:
Absolutely love those benefits. So again, the first one is deferring, you can defer your capital gains tax from a previous investment until 2026. And the end of this year, you said it’s the benefit goes down. Would you just clarify that again, one more time to make sure I understood that?
Michael:
Yeah, and I’ll clarify one of the risks too because the deferral means that you don’t have to pay your capital gains this year. So you’ve got a million dollars in capital gains on your tax statement, and you’re gonna have to pay that if you invest that into a qualified opportunity’s own fund that gets kicked out. Now, the risk is that capital gains rates go up during that 2026, 2027 period, if they double the flipside of that is that the forgiveness at 10 years in a day more than equalizes the added tax that you’ll pay in 2026 or ‘27. If those taxes go out, so when you run the math, if taxes if you believe tax They’re going up, there’s actually a greater reason to invest in this fund. And so just taking on that example 100 million dollars this year, you would only recognize $900,000 of capital gains in 2026. So even if cap gate cap, capital gains rates go up slightly, or a lot, some of that is offset by the fact that you won’t be recognizing a million dollars, you’ll only be recognizing $900,000 at that time period. But it’s definitely some calculus that every investor should do. And understanding that during that time period, you’re going to have a huge liability. And one of the ways that we are trying to solve for that within our fund is as we build these ground-up development projects, in about year three or four, once we’ve created value, then we refinance the project and generally send back anywhere between 20 to 30, even 40%, of investors equity to pay those tax obligations, and I should just tell you, like my partner and I are heavily invested in this fund, we have about $10 million between the two of us. So people always ask us questions about this, in reality, we have these large tax obligations that we have to take care of. So it’s in our best interest from both a manager’s perspective and an individual perspective, to refinance these properties, get the money back as quickly as possible because we’re both on an IRR clock, and we have a huge tax liability ourselves to pay.
Brett:
Excellent. That’s a good summary. And then at the end of the year, he mentioned that, so I imagine it’s 2022. Now, we have a window to get into these deals, if I’m hearing you right, what happens in 2022, to clarify that one more time?
Michael:
So in 2022, not the program is still there, it’s still available, the only benefit that disappears, is the tax deduction if you will, or so the elimination is there, the deferral is there, but the reduction is not there. So in 2022, if you realize capital gains, and you’re going to invest those into a qualified opportunity’s own fund, if you have a million dollars, you’re going to be recognizing a million dollars in capital gains in 2026. So it’s that reduction that goes away, but the program will be here through 2026.
Brett:
So that’s great. So you have the defer, you have the reduction. And then probably the sweetest thing I’ve ever heard of is the elimination. So pay zero capital gains tax earned by the QOZ Fund, if held for more than 10 years in a day. So let’s just say at a million dollars, and it was a million-dollar gain. I’m in California with a pay, let’s say, 400,000 of tax, I roll it into your fund, Michael, and you’re building some projects we’re talking about here in a second, but 10 years from now, that million is turned in, let’s say turns into five. So if I’m hearing you right, or if I’m reading this, are you saying that’s all tax-free that one to five, all that growth?
Michael:
Yes, 100%. And that’s the nice thing about it is that’s the huge kicker is it’s a huge benefit for investors. And then along the way, Brett, we actually get the benefit of depreciation. So any cash flow that’s produced by the properties will be shielded by depreciation, so you actually get the traditional tax benefits of real estate, and you get the QOZ kickers on top of that. So and I do want to be clear, just to temper expectations in our funding, we’re targeting about a two and a half net multiple to investors over that 10 year period. So million dollars is likely to generate around two and a half million dollars from both appreciation and cash flow during that time period. But with most of it practically being a tax-free return. So you’d have to compare the IRR over 10 year period, there’s about 12 or 13%. When you take in the timing of cash flows, and again, looking at it on an after-tax basis. It’s hard to compare to you know, this program is really a gift to real estate investors. I do want to say like one of the things you know, the QOZ, just even the term has become much more popular over the last couple of years. And I think there were a lot of cynics in 2017, ‘18, and ‘19. And one of the requirements of this program is that managers like us have to go into qualified opportunity zone areas which generally follow census tracts that are lower-income if you will or moderate to lower-income. So the thing is, though, when this census tracts when the qualified opportunity zones, there are about 8,700 of them throughout the United States. These are all built on the 2010 census and what got us comfortable with the qualified opportunity zone, investing are two things. Number one, all of our investors are taxable, we deal with high net worth, ultra-high net worth family offices. And so we’re really catering to the group who could who can benefit from this the most. And on top of that, when we were doing the research in the market, what we were finding were the areas that were already investing in infant three were qualified opportunity zone areas, and these are areas that are not blighted, they’re not distressed. These are what are called transitioning areas and a lot of our projects, when you look at our project in Phoenix, and you look at our project in Chicago, we’re actually on the edge of the qualified opportunity zone itself. And I’ll just make this clear that we don’t look at these projects any differently today than we did three, four, or five years ago in any of our funds. Because the benefit happens on the back end, the qualified opportunity zone tax benefits don’t help us, as sponsors, we don’t have a different model for this, we are still looking at the same return on cost metrics, the same margins, the same everything because we have to make sure that we do our job, deliver a great project to the market that builds value and produces a return for investors so that they can get the benefits on the back end.
Brett:
Excellent. That sounds fantastic. So what is the downside of the Opportunity’s Zone Fund or who may not be a good fit for it?
Michael:
There aren’t downsides. I mean, this to us is business as usual, we’re in the same neighborhoods we’re investing in, I suppose if you’re an investor, and you’re not comfortable with ground-up construction risk that might steer you away from this. But I would add that when you think about a 10 year hold period, what we’re doing in our fund, we’ll have about eight to 10 assets, when when we’re done at the end of this year, raising money and deploying it, and about three to four years of your whole period two years is in construction, then you got a year to year and a half and lease-up and stabilization. And after that, then you’re really holding a Class A property for the duration. So, 70%, 80%, 90% of your whole period is going to be in a portfolio of Class A stabilized properties. So you know, this program allows you to be in much longer than 10 years in a day. For somebody, like myself, I’ll be in it for 15, 20 years, 30 years even. And so I’m really investing for the next generation when I look at this, but certainly, some people want to be out in 10 years and a day. And Brett, I’m sorry, I forgot your follow-up question there. I know you had two questions.
Brett:
I think you answered it there. If you’re not comfortable with ground-up development or that longer-term hold period. Take a little while to develop it, lease it up, get the cash flow going, could take a couple of years to get that all down. So you just got to realize you gotta be patient, you got to plant the seeds and water and let it grow. The next question would be the depreciation recapture. So you mentioned, once your cash flow and you’re depreciating, perhaps you did some cost segregation on that, at the end of that 10-year, is that also eliminated? Or is it recaptured?
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