Qualified Opportunity Zone investments are designed to be long-term. But thanks to the tax reform act that created them, they’re on a fast track because of the program’s timeline. To qualify for the full tax break that QOZ investments offer, participants must harvest their capital gains and reinvest them in a Qualified Opportunity Zone Fund by the last day of 2019. Though the savings on capital gains will diminish slightly after this deadline, investors can still reap considerable tax benefits from the program going forward but must invest capital gains in a QOF within 180 days of realizing it.
As a result, this new law has spurred the creation of scores of Qualified Opportunity Funds that are focused on raising capital for commercial real estate investments in Qualified Opportunity Zones. Investors must make an expedient decision about whether the program is right for them, then choose to participate in one (or several) QOFs. But given the speed and competition the program has incited, fund managers are competing to find deals with excellent fundamentals.
Making the task more complicated, asset managers, broker-dealers and investment advisers can all market funds that invest in QOZs. And the QOZ funds can be organized as direct investments in real estate, or as real estate businesses such as private equity real estate partnerships or real estate investment trusts (REITs)—all investments that have different advantages in a portfolio.
So, how does an investor identify the most promising QOZ funds?
An opportunity zone database founded last year, aptly named OpportunityDb, is a growing Opportunity Zone Fund Directory that currently lists 108 QOFs. Another database with 147 listings to date was founded by the National Council of State Housing Agencies, a nonprofit that focuses on affordable housing advocacy. Both feature basic information on each fund’s size, investment strategy and geographic market focus—and are likely to grow. Search engines will turn up even more options, many of them paid ads.
But for investors, finding Qualified Opportunity Funds is only the start of the process. All have their own unique characteristics due to the nature of the federal opportunity zone tax rules and requirements regarding eligible properties. Narrowing the field comes down to the investor conducting a prudent due diligence process on the QOFs.
Consider these five factors when evaluating QOFs to add to your investment portfolio:
1. Fund Strategy. Investors should look for QOFs that have clear-cut and proven strategies that are easily communicated by the manager. Funds that have vague or unfocused strategies may end up making investments that take on outsized risks, such as investing in property types and markets where they have little familiarity or prior experience. Given that these investments can last 10 or more years, understanding the strategy behind a QOF will help minimize any potential surprises for QOZ investors.
An example of a vague or unfocused strategy is a QOF that plans to invest anywhere throughout the U.S. and in any property type. Certain property types have inherently different risk and return profiles. Generally, multifamily housing, industrial, and creative office space are some of the stronger property types today. Run from a fund banking on building hotels from the ground-up in the Arizona desert. Ground-up development is risky to begin with and should be balanced with less risky types of development.
Be mindful of funds that may engage in recycling investment capital. Recycling capital is developing properties, selling them at completion, and then reinvesting the proceeds into new QOZ developments. This strategy contains reinvestment risk that would not be present in a “build-to-core” strategy, which is building properties and then continuing to hold the stabilized, cash-flow-generating properties for several years after construction is complete.
Clear-cut and proven strategies contain specific and tangible details such as how long the QOF will hold the assets, the types of properties that will be targeted and the specific markets that the QOF is targeting to invest in. These strategies have details, data and stories to back them. An example of a clear-cut strategy is investing in ground-up development of multifamily properties in Atlanta, Austin, Charlotte, Dallas, Denver, Houston, Nashville, Orlando, Phoenix and Raleigh, with intent to build-to-core.
2. Diversification. QOF strategies can range from investing in the development of a single property to compiling a portfolio of investments in 10 or more separate properties in different geographical markets. Generally, diversification hedges risk, so investors should pay special consideration to the level of diversification that the QOF intends to achieve across different investments and geographical markets.
The roughly 8,700 federal qualified opportunity zones represent areas in great need of investor capital, so by intention they carry greater risk than other types of investment. Additionally, not all opportunity zones have the best investment opportunities. For example, Georgia, Texas and other large states encompass economic opportunity zones in urban markets like Atlanta and Houston, which are growing faster than small rural areas.
Similarly, some markets start with less overall income disparity. Charlotte, North Carolina and Phoenix, Arizona are on a broad growth trajectory, with low-income tracts next to middle-income neighborhoods. Managers with boots on the ground in markets with qualified opportunity zones poised for ready growth will be in the best position to fund the limited number of available projects and build QOFs with promising projects.
Investors seeking to maximize diversification in their QOZ investment(s) should look for QOFs that plan to invest in, or are already invested in, at least five different properties that are spread across diverse neighborhoods, opportunity zones and geographical markets.
3. Risk Appetite. A QOF needs more than just a clear-cut strategy and diversified portfolio to limit risk. Investors trying to minimize QOZ investment risk should also look for the conservative use of debt at the property level.
As a general rule, conservative use of debt would entail a maximum loan-to-value ratio of 75% for the purchase of existing real estate. However, most bank lenders will cap the amount they are willing to lend for ground-up developments at 65% of the total development cost. In many cases, QOFs can only get ground-up development debt in excess of 65% by layering on mezzanine financing and preferred equity. Both types of “debt” contain higher interest rates than typical bank financing and have higher payback priority than an investor’s equity investment in the development.
QOFs that use debt conservatively may have relatively lower target returns than those that don’t, but those using more debt would be in considerably more trouble if any aspect of the development goes south and the property doesn’t generate enough cash to service the debt. Investment returns should be generated primarily from the performance of the real estate – not through excessive use of debt.
4. Fees. Funds should have fee structures that are fair and transparent, not buried in the fine print. Acquisition and other fees that are linked to individual deals instead of being linked to the overall QOF are some examples of fees that are most commonly buried from investor’s plain sight. Passive investors shouldn’t have to dig for hidden fees.
A fundraising commission north of 5% or a performance fee higher than 20-25% is egregious. So is an annual asset management fee over 2.0%. Over a decade or longer, an asset manager shouldn’t make more from annual management fees than they expect to achieve from performance payouts.
5. Funding Mechanism. The 180-day deadline to shelter capital gains applies to invested capital, not commitments. If 180 days elapse without the investor having their capital called by the QOF, investors lose the QOZ tax advantages. So timing is critical.
A QOF needs to accept the full investment on a single date or have set dates and amounts planned for capital calls so that investors can make certain they will be able to make their QOZ investment within their 180-day window. That means QOFs need to maintain deals in the pipeline that will close within the deadline. Look for QOFs that have deals under contract and in due diligence review, or proof of manager relationships that can bring a steady deal flow to the fund.
U.S. Securities and Exchange Commission guidance makes QOZ funds subject to federal and state securities laws. This means all the information required to test these five factors should be available in offering documents. Vetting the finalists also requires taking a close look at how funds will be managed, which I cover in this article.