This article was originally published on the Forbes website.
We live in a world where keeping it simple wins. Yet many investors are rushing to participate in Qualified Opportunity Zones, which are not about keeping it simple. Instead, they involve more rules and regulations for investors and fund managers— starting with the fact that QOZ investments can only be made through QOZ Funds. Then there are myriad compliance and timing issues that make QOZ Funds more complicated than traditional real estate funds.
But dismissing one of the greatest investment opportunities of our lifetime because of complexity would be a mistake. However, the proliferation of non-qualified sponsors is a key issue. QOZs are generating a tidal wave of capital, and many new funds are being launched by individuals and companies new to the real estate space. We’ve seen the likes of Hollywood moguls, NFL players and community activists enter this market.
Inexperience combined with complexity is not a recipe for success. Yet finding the right investment vehicle is not impossible. It comes down to performing due diligence as you would with any other private investment. Here are the three most important things to look for when evaluating QOZ Funds.
1. Look for Experienced Sponsors
Sponsors pose the biggest risk to realizing QOZ benefits, so make sure you choose the right one. You can do everything right as an investor, but the tax break could easily turn into a tax write off if you get this wrong.
For example, timing is everything in QOF investing. For the investor, making sure capital gains are invested in the fund prior to their 180-day expiration period is of the utmost importance. And for the manager, complying with the laws and finding good quality deals is a priority. An investor can do everything right on their end, but if the manager violates federal regulations, that investor could lose their tax benefits. Can they put your money to work today or are they taking your money with the expectation they will find a deal in the future?
More often, you’ll find sponsors that have ample real estate experience, but not the type that’s aligned with a QOZ strategy. Requirements state substantial improvements must be made to a property—which means most projects will be developed from the ground up. That makes it critical to check the manager’s track record executing ground-up developments. Ask if they’ve developed properties in transitioning neighborhoods. Vet their reputation in the marketplace. Determine if they’re putting a substantial amount of their own money into the fund.
Beware of sponsors who are looking at deals differently because of the tax breaks. Unlike other tax incentives, QOZ capital can’t be used to supplement the capital structure. For a deal to work, the revenues must be there. Basically, a developer can’t go into a truly depressed neighborhood, spend $50 million, and then rent units for 50% lower than the market rate. The deal must work to receive the tax benefits and QOZ deals shouldn’t be evaluated differently.
There are many highly qualified sponsors who are well-suited to QOZ investment and will deliver the full range of tax benefits. Yet timing issues can lead to quick decision-making. Good enough is not the standard in this industry, especially given the 10-year span QOZ-investing requires.
Take the time to get it right; this is truly a commitment to the manager and long-term investing.
2. Gauge the Strategy
Though there are 8764 opportunity zones, most won’t see a dime. Deals must make money, and most neighborhoods can’t support rents that justify new construction. This makes the task of finding quality deals much harder. However, cities change quickly and some QOZ areas are transitioning and becoming prime for new development.
Also, the QOZ definition is based on the 2010 census data; many cities have changed since then. Some of these “economically distressed” areas are thriving neighborhoods. Investing on the fringes is a higher risk, but transitioning neighborhoods create the greatest opportunities for investment.
Competition will increase pricing, but there’s still plenty of opportunities. Look for managers experienced in investing in up-and-coming neighborhoods. Identifying the transitioning neighborhoods and getting there first are hallmarks of a great real estate investment strategy. Many have likely invested in “economically distressed” areas without even knowing it.
Also, consider liquidity. When does the manager intend to distribute capital? Keep in mind that your deferred taxes will become payable in 2026. Where will that capital come from? Most fund managers plan on refinancing assets and returning capital to investors but have a backup plan just in case.
3. Make Sure the Sponsor Has a Handle on Compliance
Maintaining fund compliance is the responsibility of the manager. But there are many ways a manager can trip up, trigger a taxable event and eliminate the investor’s tax benefits. A manager who takes capital from investors without a deal must invest it quickly in order to maintain QOZ status—within six months if there is no plan and 31 months with a plan.
The manager also must make sure that their property improvements satisfy QOZ requirements. Rehabbing an apartment complex may be a good investment but may not pass the QOZ requirement to make “substantial improvements.” Spending less than anticipated can easily disqualify a deal from the program, and those investment dollars won’t receive a dime of the benefit. Investors may suddenly find themselves with an unanticipated tax burden. And the manager must allow ample liquidity to allow investors to exit. Having great legal counsel and understanding the law is paramount.
For those willing to take the time and dig a little deeper, QOZs offer benefits far-and-above traditional real estate investments. Even if you believe we’re a high point in the cycle, remember that institutional real estate has never lost money over any ten-year period. Properties bought at the height of the recession in 2007 are generally worth far more today. Great real estate wins over time, so make sure you are in high-quality deals, leveraged appropriately and invest with a reputable sponsor that meets the criteria above.