The congressional intent and hype surrounding the income tax benefits of qualified opportunity-zone funds (QOFs) is well known within the nontraded investment-program universe, and for good reason. The underlying law was intended to motivate taxpayers holding $3.8 trillion in unrealized capital gains to redeploy their resources in several neglected areas of the United States in an effort to create jobs and businesses, redevelop properties, and stimulate economic growth. To accomplish the aforementioned purpose, Congress adopted Internal Revenue Code Section 1400Z, a close cousin of the code’s like-kind exchange provisions.
While Section 1400Z does not allow for an indefinite deferral of capital gains, it provides a compelling set of financial and tax-related advantages, including the ability to: (i) redeploy unrealized capital gains into strategic investments, while deferring the pre-existing gains underlying the redeployed capital through Dec. 31, 2026; (ii) realize partial tax forgiveness of 10 percent to 15 percent on pre-existing gains after five- and seven-year holding periods in the new investment are reached; and (iii) achieve complete forgiveness of the capital gains tax on future asset-related growth generated from the new investment. On its face, one could argue the advantages of Section 1400Z are more compelling than those of its cousin.
This article will focus on the economics and structures of the first generation of QOFs that are being syndicated to accredited investors. It is our hope readers will come to appreciate the risks the initial generation of products present, in an effort to improve the products going forward.
STRUCTURE AND STRATEGIES
While QOFs can be either corporations or pass-through entities, pass-throughs such as limited partnerships and limited liability companies are the entities of choice for the programs reviewed thus far. The predominant domicile state for the QOFs marketed to date within the retail channel has been Delaware.
The retail-syndicated QOFs to date have been structured so the funds endeavor to pool capital from several accredited investors, enabling the QOFs to acquire equity in pass-throughs that hold real estate alongside a co-owning sponsor affiliate and/or development partner. The size of the offerings varies greatly, from as low as $3 million involving an identified single asset, to as much as $300 million for a diversified portfolio of properties (with $25 million to $35 million being a median target raise). Minimum subscriptions likewise vary greatly, with some funds accepting $50,000 investments, whereas others require $100,000 to $250,000 to invest in the fund.
The interests sold to investors at the QOF level are almost always preferred equity interests designed to provide investors with a 6 percent to 8 percent annual preferred return on capital from operational cash flow, and a return of capital and 50 percent to 80 percent split of remaining sales proceeds from capital transactions. In cases where the sponsor must bring in a development partner to manage the construction and stabilization of the underlying real estate, there may be two levels of carried interests and distribution waterfalls intended to compensate the sponsor at the fund level and the development partner at the property level for management-related services. Where two levels of promote are involved, the same could limit the QOF investor’s ability to achieve an economic return beyond the 6 percent to 8 percent preferred return target. As such, those programs where the sponsor can internally source, develop and manage the assets would arguably provide better opportunities for competitive returns by eliminating the proverbial “second cook in the kitchen.”
While QOFs can own their qualified opportunity-zone properties directly, the “partnership interest” is the key asset held within the first-generation funds (i.e., necessitating a 70 percent test at the holding-entity level). The development strategies we have seen thus far involve real estate–centric assets that focus on development of land in cities or urban areas, and redevelopment of improved real estate in such areas. Multifaceted developments situated within historically significant metropolitan areas, multifamily projects, condos, office space, retail space, and hospitality are all strategies being used within the retail-syndicated QOFs we have reviewed, with other classes of real estate, such as industrial/warehousing and storage naturally also being potential strategies for future funds.
Although real estate has dominated the first-generation QOFs offered in the retail channel, private equity–related investments in new or existing businesses could present possible opportunities, provided new equipment is deployed or real estate is substantially improved within the opportunity-zone census tract of interest. Opportunities involving oil-lease development and/or pipelines may also fit into the realm of potential investments, assuming the project has a bona fide growth component to it (e.g., working interests in wells and related leaseholds, or establishing pipelines and gathering systems in areas with upstream growth potential).
Despite the hype surrounding QOF tax benefits, the threat for an investor to “suffer a death from a thousand cuts” must be taken seriously when reviewing the various fees associated with the first generation of QOFs. While certain of these fees are also charged in programs outside of the QOF arena, almost all of these fees appear to be making their way into the structures of the QOFs we have seen, in one form or another.
The offering costs and fees that are paid to sponsors and their affiliates include:
- Syndication costs and offering costs: 10 percent to 12 percent of gross offering proceeds
- Fund/asset management fee: 1 percent to 2 percent of capital raised or fund asset fair values
- Acquisition fee: 1 percent to 2 percent property purchase price or project costs
- Development/construction management fee: 4 percent to 6 percent of project costs
- Loan placement fee: 1 percent to 2 percent of loan amount
- Loan guarantee fee: 1 percent of guaranteed loan amount
- Property management: market rates
- Loan restructuring fee: 1 percent to 2 percent of loan amount
- Disposition fee: 1 percent to 2 percent of sales price
- Other fees: Interest charged on capital advanced for start-up costs
In view of the offering loads (i.e., 10 percent to 12 percent of gross capital raised), various levels of management carries, and fees charged within the QOFs, cautious underwriting of the underlying asset under offering-adjusted conditions is strongly recommended. The underwriting should consider prevailing economic conditions, occupancies, rents and construction costs within the markets the assets are located, as well as whether future events may work to the disadvantage of the asset held. The underwriting should also consider that market cap rates could turn for the worse over time. Independent valuation experts should also be consulted to assess whether the sponsor’s pro formas are achievable under conservative market conditions. Although our independently underwritten investor-level returns have ranged from a 9 percent to 15 percent internal rate of return on some projects with identified assets (with an additional 150 to 200 basis points of IRR possible based upon the potential tax advantages), returns can vary greatly from program to program depending upon the fees and levels of promote involved.
While we have yet to see an energy-related QOF, a number of sponsors have indicated plans are under way to present such opportunities in the future. Where leasehold-related energy assets are involved, engineering experts should be retained to provide independent reserve analysis and to assess whether enough reserves can be established to help support a capital gain on the capital invested in leasehold, facilities and drilling.
OTHER SPECIAL RISKS
In addition, we have observed a number of other considerations within the first generation of QOFs that present special investment risks. While we believe retail QOFs have much potential to deliver value, improvements need to be considered in some areas.
First, although most QOFs we reviewed had identified projects in which to deploy capital, none of the reviewed QOFs had established a minimum offering requirement. On a better note, a couple of sponsors did provide a backup plan by making short-term loans to the QOFs to help them fund their capital contributions at the property level, pending equity funding during the offerings. In the other cases, however, no contingency plans were articulated within the offering materials to explain the sponsor’s plan if the QOF were to raise a substantially lower amount of capital than the target offering amount.
The risk of raising a much lower level of capital is the sponsor, its affiliates or its development partners may be required to either procure more project debt than anticipated or to offer more favorable equity investment terms to other parties. Alternatively, the project may need to be scaled down or abandoned. All of these could have an adverse impact on the ability of the QOF to achieve an economic return. As such, it might arguably be preferable to work with sponsors with track records of raising significant investor capital for real estate, energy or private equity projects.
Although most of the QOFs we have reviewed to date have identified projects, some have been organized as blind-pool funds. In addition to the standard risks of investing in a blind-pool fund (i.e., lack of underwriting of assets, no investor control over acquisition decisions, etc.), there is a risk these funds may not be able to source enough acceptable investments in a timely fashion to comply with the 30-month capital deployment requirements of the QOF regulations.
Second, one should consider whether the sponsor is playing the role of a capital raiser and promoter as opposed to that of a developer/asset manager. While this observation is one that is not always fatal to success, the consequence of bringing in a joint-venture partner can pose management and control problems and, as state above, multiple levels of carried interests imposed at the fund and property levels.
Where outside development guidance is needed, the sponsor may be inclined to allow for a recalibration of the development partner’s interest. This would allow the development partner’s carried interest, that otherwise would kick in after a QOF preferred return, to be converted at project stabilization into a fixed interest that does not subordinate to the QOF’s preferred return (i.e., based upon the project’s fair value and the percent of the distributions the development manager would get in a hypothetical sale of the project). While these circumstances are understandable and sometimes needed to engage an appropriate level of expertise, the deals whereby the sponsor can source and manage its own projects may present better opportunities for competitive returns.
Third, and in cases where specific projects had been identified within the reviewed QOFs, we observed varying levels of targeted project leverage, which broadly range from 50 percent to 75 percent of the project costs. In a couple of cases, the sponsor’s loan terms originated from loan commitments, whereas in most of the others, the terms originated from the sponsor’s internal objectives and expectations, and loan commitments had not been secured.
Not surprising to us, the sponsor’s financial projections in many cases assumed the construction financing and permanent loans would be financed with interest-only payments. We remind you, however, of the risks involved in failing to amortize debt, which may involve investment losses if cap rates were to increase from today through an investment hold period of 10 years or more (we of course concede interest-only construction/mini-perm debt through development and value stabilization is appropriate).
Fourth, and on a better note, a majority of the QOFs reviewed made a commitment within the organizational documents of the fund to provide investors with annual audits and quarterly financials. In a couple of instances, however, the sponsor’s commitment to investor transparency was either limited or nonexistent, with the sponsor not required by fund agreement to provide any level of financial statements to investor partners. We would remind you a common theme within prior fund investment fraud cases involved the absence of sound investor-related financial transparency practices.
Fifth, and unlike the prevailing practice we often see in nontraded investment programs, none of the QOFs we reviewed provided the investor group with an at-will manager removal right. In most cases, either a majority or supermajority of the investors were given a for-cause manager removal right, for circumstances relating to fraud and misconduct, and in some cases, for a breach of the QOF’s organizational agreements and sponsor/manager bankruptcy. Although we normally encourage at-will manager removal rights, at a minimum we would encourage the QOF sector to (i) subject a for-cause manager removal to a voting threshold lower than a supermajority; and (ii) to include a breach of the fund agreement, and sponsor/manager insolvency, bankruptcy or receivership, as for-cause removal conditions.
Consistent with the pending status of the next round of QOF income tax regulations, the structures and features of QOFs marketed within the retail investment channel appear to be very much a work in progress and, in many cases, in search of an identity. As perhaps several billions in potential investor capital come up for grabs in 2019 and 2020, we encourage the unfound identity of the QOF sector to be established sooner than later.
As the opportunity for the financial services sector to deliver tremendous service and value to the investor community develops before us, we also encourage broker dealers and investment advisors alike to be diligent in their evaluations of QOFs, and to look beyond the hype of the tax benefits in an effort to competently evaluate the economic return potential of the assets and the retained rights for the investors that decide to place their confidence and dollars in the QOF sector.
Brad Updike is a shareholder and director of Mick Law, and Kyla Ehrisman is an associate with the firm.