The 9 Biggest Misconceptions About the QOZ Program

Topic:  • By Michael Episcope • November 14, 2019 Views

The 9 Biggest Misconceptions About the QOZ Program

Qualified Opportunity Zone real estate investing has been in the press nonstop this year. The excitement around this program and our QOZ Fund has resulted in hundreds of phone calls to our investor relations team. Some investors are excited to invest immediately, others are curious and want to learn more about how the program may or may not be of value to them, and others are skeptical and have decided not to invest based on what little information they know.

Steering clear of Opportunity Zone investing without a thorough understanding of what the program offers is a mistake. We’ve crunched the numbers and found that a QOZ investment has the potential to generate 75% more in after-tax returns than another investment with a similar risk profile.* Considering how hard high risk-adjusted returns are hard to find in today’s market, QOZ investments are worth trying to better understand.

Over the last several months, we’ve heard every question and assumption about QOZ investing from investors, experts and journalists. We’ve summarized these conversations into the nine biggest misconceptions about the QOZ program. If qualified Opportunity Zone investing is new to you, please read this article for a primer.

Misconception #1: A QOZ site is not where I would want to invest.

I would agree that 95% of Qualified Opportunity Zones are not ideal places for real estate investment. However, there is a fine line between the Census Bureau’s definition of a “distressed economic area” and what we view as areas with high investment potential. By our estimate, only around 5% of QOZ areas fit both definitions and it’s these areas where real estate investors should be investing. After all, transitioning areas on the fringe of development is where the greatest potential for investment returns can be found.

If you’ve invested in real estate long enough, chances are that you’ve invested in a QOZ area without knowing it, and certainly without receiving a tax benefit. Several properties in our last fund, Origin Fund III, are in opportunity zones but they were acquired well before the program existed. Even today, many properties in Qualified Opportunity Zones are being acquired by non-QOZ investors because they deliver great risk-adjusted returns.

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For Origin, investing in transitioning markets with high growth potential has been our real estate investing strategy for the last decade, which is why we refer to QOZ investing as “business as usual.”

One Origin property in Phoenix, Union @ Roosevelt, is a great example of what we look for in an Opportunity Zone deal. The project happens to be on the edge of an Opportunity Zone boundary and across the street from luxury high rise apartment buildings. The property is walking distance to public transportation and the central business district, and the neighborhood is teeming with retail and restaurants.

The acquisition includes a vacant parcel of land and a Class A mid-rise multifamily building that was delivered to market less than two years ago. The plan under our ownership is to develop the vacant land and connect a new building with the existing building. The existing apartment building provides immediate cash flow to our QOZ Fund and the new building will add an additional 105 units to the property, plus incorporate new amenities such as a pool, leasing office and fitness center that will benefit all residents.

All the QOZ deals in our Fund’s pipeline stand on their own merits just like Union @ Roosevelt, which is why my partner and I have already invested $7 million of our personal capital into the Origin QOZ Fund.  We do not evaluate QOZ deals differently from how we evaluate any other real estate deals. These are deals we’d be considering even if the Qualified Opportunity Zone program didn’t exist.

Misconception #2: People will overpay for QOZ deals.

Some investors are concerned that the potential avalanche of QOZ capital will cause real estate prices to rise to the point where the opportunity to make a return on investment ceases to exist. Yes, there will always be someone who overpays for a real estate asset, but that doesn’t mean everyone will. One of the main reasons that investors hire Origin as a real estate investment manager is because we exercise discipline when buying deals, meaning that we’re extremely selective about the price we pay for the asset. To us, buying right is one of the most important things you can get right because you only get one chance. We’ve walked away from many more deals than we’ve acquired because we understand the difference between price and value and our approach with Qualified Opportunity Zone investing is no different.

There are many QOZ funds that have been announced in the press, but very few have actually been successful in raising capital. The competition that we see for QOZ properties comes more from non-QOZ dollars rather than QOZ funds competing with one another. Over the last year, we have underwritten more than one hundred QOZ deals, bid on dozens, and have been awarded five deals. During every bid scenario, we competed with multiple buyers and, in most cases, we were the only bidder using QOZ money.

The takeaway here is – don’t rule out QOZ investing because you are concerned prices will be inflated. Just make sure that whomever you decide to invest with is meticulously evaluating QOZ opportunities like they would any other deal. Look for professional managers who were already expert real estate investors prior to the QOZ program announcement. Don’t trust just anyone starting a QOZ fund to save money on taxes.

Misconception #3: The program will disappear.

The program was enacted via the Tax Cuts and Jobs Act of 2017 and had bipartisan support from both Republicans and Democrats. There is the possibility, but an unlikely one, that this legislation is reversed. The tax benefits provided by the QOZ program should not change the way you or your real estate investment manager evaluates a potential investment. The QOZ tax benefits need to be viewed as a bonus on a deal you would pursue regardless of taxes. If the legislation were to be unexpectedly reversed, you would still be left with an investment that offers the same benefits of private real estate – tax efficiency, income generation, and high returns. The QOZ tax benefits are truly an add on to an already great asset class.

Misconception #4: After-tax cash qualifies for the tax benefits of a QOZ investment.

Only capital gains receive all three of the QOZ program’s key tax benefits of deferral, reduction and elimination. Non-QOZ money can be invested into a QOZ fund but it does not receive any of the tax benefits.

Misconception #5: QOZ will transform once-blighted areas.

The purpose of the QOZ program was to unlock the trillions of dollars of capital gains held by wealthy individuals and incentivize them to invest in QOZ funds that would eventually invest in economically distressed areas. Unfortunately, I don’t believe this will be the case. Real estate investment opportunities need to be economically viable and produce returns to investors and low-income areas don’t support the rents required to build new product. This law will most likely help to accelerate development in already transitioning areas, but it is unlikely to bring capital into the neighborhoods that truly need it the most.

Misconception #6: The QOZ program will end in disaster.

I’ve heard expert panelists at nearly every QOZ event say “the QOZ program will end in disaster” and that sentiment has certainly been echoed by the media. The so-called experts who spread these fears generally have no true insight or actual knowledge in this area to base this claim on and the journalists are simply out to capture clicks and views because they know nothing sells more than fear.

However, the immediate attachment to this sentiment by many investors is not a surprise when you consider the historical impact of government tax programs to real estate. We can trace back the real estate meltdown of the late ’80s and early ’90s to government tax legislation of the previous decade. In the 1980s, investors flocked to real estate for a depreciation benefit, so they could avoid paying income taxes at the highest federal rate of 70%. This meant investors became far more interested in the losses generated by real estate than any potential gain. This isn’t the case with QOZ program today as investors will only receive a tax break on the profits. This program doesn’t enable us to pay more for land or accept a lower rate of return on our investment dollars. If there are no profits, there is no tax break.

Many people are also concerned about what will happen after the government-required ten-year hold period and how this process may negatively affect the broader real estate market. However, QOZ properties and capital represent only a small fraction of the entire real estate market. We heard a similar sentiment ten years ago when people expected the market to crash due to hundreds of billions of dollars of loans issued pre-crisis came due. That time came and went with no crash, and cash sitting on the sidelines missed out one of the greatest bull markets of our time. Additionally, nearly all QOZ managers have some discretion to sell or hold assets and some managers can hold properties well beyond 2040 if it makes the most sense for investors. The liquidation of QOZ assets is likely to take place over time and simply isn’t big enough to create pricing or liquidity issues in the overall real estate market.

Misconception #7: It’s not a good time to invest in a QOZ fund because real estate values are at an all-time high.

Real estate values have increased over the last nine years and expected returns have declined. However, this is true of all risk-based assets today. Returns over the next ten years are not likely to match the returns over the previous ten years, but this doesn’t necessarily mean you will lose money.

The key to preventing a loss is to make sure you invest in high-quality assets at a good basis, that you are geographically diversified in markets with population and job growth, and invest with a manager that is experienced and uses leverage responsibly. Real estate produces a healthy amount of income and if there is a recession, you should want to be holding cash flowing assets with a stable income stream. Cyclicality is a part of every investment across all asset classes and investors must do what they can to protect themselves. As bad as the great real estate recession was, prices paid at the height of the market look like a bargain today. When you consider that institutional real estate has never lost money over any ten-year period and QOZ investors must be invested for 10 years to receive the full benefits, the odds of making money are very much in your favor. Nothing is certain in investing, but the smart approach is to compare investment opportunities on an after-tax risk-adjusted basis, and nothing comes close to beating the risk-adjusted returns of a QOZ investment.

Further, many investors believe that spreading capital across multiple sponsors diversifies their risk, but it actually increases risk exponentially. In the private real estate business, you bet on the people behind the deal and spreading capital around simply increases your odds of investing with a bad manager. Take the time to get to know a real estate investment manager as well as you can, because that’s where the risk lies. A QOZ investment is a 10 plus year commitment, so make sure the manager you invest with is highly qualified to maximize your investment from the day you invest to the day you take your money out.

Misconception #8: I get the QOZ tax benefits once I sign the documents.

In order to receive the tax benefits, the QOZ fund must actually take your money. Signing the documents is not enough to satisfy the QOZ program’s requirements. The money also has to be invested within 180 days of the gain being realized so make sure you fully understand the tax laws or you may miss your window.

Misconception #9: My tax deferral rate is locked in.

One of the risks of the tax deferral is that tax rates may be much higher in 2026 than what they are today. The way this works is that an investor gets a “step-up in basis” rather than an actual tax reduction. If tax rates stay the same, the effective outcome is a tax reduction, but if they go up, the investor might be paying more in 2027. For example, if $1 million of capital gains is invested in a QOZ fund in 2019, the tax payment of approximately $220,000 will be deferred until 2026 and payable in 2027. Because the investment was made in 2019, the investor is eligible to receive a step-up in basis of 15% which means they will only be taxed on $850,000. However, if the capital gains rate goes up to 35% in 2026, the investor would actually owe roughly $300,000 in taxes, more than what their tax liability would be this year.

This is one of the many risks of QOZ investing and the question is, is it worth it? In this case, yes. The profit generated from investing the tax deferral money for the period from 2019 to 2027 is estimated to be worth between $300,000 and $500,000, depending on how the QOZ fund actually performs. The ability to invest the tax-deferred money for seven years more than offsets any potential increase in tax rates and the step-up in basis further mitigates this risk. And, cash flow from refinancing assets and general operations should be more than sufficient to pay this liability when its due.

*Assumes 2.5x equity multiple return over 10 year period. Assumes deferred taxes on original capital gains with 15% step-up in basis return. Assumes same investment basis as equivalent taxable investment ($762,000). For the full analysis in greater detail, download the Fund Overview.

The views expressed herein are exclusively those of Michael Episcope, are not meant as investment advice and are subject to change. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recommended in this article.

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Posted By

Michael Episcope
Principal

Michael is 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.