The Opportunity Zone program is an exciting opportunity for both investors and the under-served urban and rural communities the program was designed to lift.
Central to the program are significant tax savings and incentives. These are offered to potential investors to place their capital with Qualified Opportunity Funds (“QOFs”) for investment in Opportunity Zones to boost business and real estate development in these communities.
Investors interested in Opportunity Zones have many tax incentives to be excited about. Along with being able to defer current capital gains for up to 10 years, investors also have the chance to realize zero capital gains on any new appreciation from investment in a QOF and also be able to reduce their final deferred capital gains liability by up to 15%.
With a deadline of December 31, 2019, to invest in a QOF to take advantage of the tax incentives, investors are in a rush to find a QOF in which to place their capital.
If you’re one of these investors, buyer beware. Just like not all private investments are created equal, not all QOFs are created equal. It’s essential to evaluate the tax as well as the non-tax factors. What use are the tax incentives if you place them in a fund that’s going to lose all your money anyway?
When evaluating a potential QOF, there are a few critical points to remember in order to invest in the right fund:
1. Fund Vision and Strategy.
Does the QOF have a clear, defined strategy in a proven business segment or real estate asset class? Does management communicate this strategy?
Investors should avoid vague, unfocused, and speculative strategies. Funds that should be avoided are those that take a scatter-shot approach. This means that they have no asset class, geographic area or the management delves into asset classes in which it’s unfamiliar or lacks experience in.
An example of an unfocused strategy is a QOF that plans to invest anywhere and everywhere throughout the U.S. and in any property type even though management has only had experience with single-family fix and flips.
Different property types have different risk-return profiles with multifamily, industrial, affordable housing and self-storage, generally providing the best risk-adjusted returns with ground-up developments and restaurants considered high risk.
QOFs are designed by regulation to encourage long-term investment of at least ten years. Investors should, therefore, ask themselves if the proposed strategy is sustainable in the long-term.
For example, 60% of restaurants fail within the first year and 80% before their fifth anniversary. Given that fact, one should avoid restaurant-related QOFs and focus on one of the many other opportunities that are out there.
A clear and proven strategy will contain specific details, such as clear-cut:
- Asset class
- Geographic focus
- Company and market data
- Development or renovation plan
- Financial projections
- Exit strategy
An example of a clear-cut strategy is investing in a ground-up affordable multifamily development in Charlotte and/or Raleigh.
2. Track Record.
Going hand in hand with a clear and detailed strategy is a management track record. Management with a track record of success will typically have clear, concise strategies.
Because private investments like the investment in a QOF are passive, meaning investors have no hand in management, it is imperative to scrutinize the track record of the managers.
Do they have the requisite experience and knowledge in the asset class and locales in which they are proposing to invest? In other words, is this particular investment in the manager’s “wheelhouse” or is this new territory?
Be leery of managers undertaking a real estate class they’ve never invested in before. Due diligence is, and transparency is key. Do the managers make themselves available to answer questions?
3. Investor Returns.
Ensure that the payout and distribution structure of the opportunity aligns with your investment goals.
Are you more interested in a long-term return and payoff from appreciation or are you more interested in cash flow with a consistent return? Or are you interested in a mix of both? Make sure the QOF’s business strategy aligns with your financial goals.
4. Diversification.
Diversification hedges risk and can be accomplished in a variety of ways, including compiling a portfolio of single-tenant properties various geographical markets or investing in a multi-tenant property or across multiple property types in one geographic market.
Investors should pay attention to a QOF’s diversification strategy. Any QOF with all eggs in one basket approach should be avoided.
5. Use of Leverage.
Investors evaluating risk should look at the QOF’s proposed use of debt and their willingness to leverage with conventional as well as non-conventional sources. Look to QOFs with a conservative approach to debt.
Here is an example of an aggressive approach to debt:
As a general rule, sticking to a maximum loan-to-value ratio of 75% for the purchase of existing real estate is a conservative rule of thumb.
However, most bank lenders will cap LTV at 65% of the total development cost for ground-up development.
However, QOFs can get around this 65% cap through non-conventional financing sources such as mezzanine financing and the offering of preferred equity with fixed payouts.
These non-conventional types of financing contain higher interest and payout rates than typical bank financing and have higher payback priorities.
QOFs using an aggressive approach to debt by piling non-conventional funding on top of a conventional fund may be in considerably more trouble if the development goes south, and the property doesn’t generate enough cash to service the debt. Investment returns shouldn’t be swallowed up by debt.
6. Fees.
In an ideal world, a QOF shouldn’t have any upfront or management fees. Ideally, management should only be paid if the fund is successful. Since we don’t live in a perfect world, management fees are unavoidable.
In those cases, a QOF should have fee structures that are first transparent and second, fair. The fees shouldn’t be buried in the fine print. Acquisition and other fees that are linked to individual deals or properties are the fees most commonly buried in footnotes.
Competent QOFs don’t bury their fees. They’re upfront with them. As a rule of thumb, a sponsorship fee (i.e., fundraising commission) higher than 5% or a performance-based fee higher than 25% (absent the infusion of management’s own capital) are considered unreasonable, as well as an annual asset management fee over 2.0%.
A manager that makes more from annual management fees than they expect to achieve from performance payouts over the expected 10-year course of the investment is no better than the hedge fund manager who makes money while his clients lose it.
7. Timing.
Investors have 180 days from the date of sale of their capital gains property to invest in a QOF in order to qualify for deferral. That means funds must be invested and accepted by the QOF in order to qualify. If 180 days lapses without the investor having their capital called by the QOF, investors lose the tax advantages. So timing is critical.
A QOF needs to establish set dates for capital calls so that investors can have reasonable expectations of making their investment within the 180-day window. That means QOFs need to be organized and have deals under contract or in the pipeline that will close within the deadline. Make sure the QOF has deals under contract and far down the due diligence road to ensure this 180-day window is met.
Conclusion. The Opportunity Zones program gives investors a tremendous opportunity to lift up depressed communities while being able to take advantage of considerable tax benefits. However, to take full advantage of the program, don’t get suckered into just any deal. A bad deal will defeat the purpose of the program.
In considering investments in Qualified Opportunity Funds, don’t forget the fundamentals and separate the non-tax factors from the tax benefits.
Keeping a few key factors in mind when evaluating opportunities will save you time and potentially money.
Recognizing red flags will help you to avoid bad investments and allow you to truly maximize the benefits of investing in a potential financial and socially rewarding Opportunity Zone program.
To learn more about the Opportunity Zone program, please feel free to contact us.
Investing for growth,
Michael Foley
