In 2017, the bipartisan legislation creating the qualified opportunity zones (QOZ) program made the investment world giddy with excitement. This was more than just a subsidized lending program, as nearly all previous incentive programs had been. This legislation created the ability to raise qualified opportunity zone private equity funds, where private investment-type returns might possibly be realized, while making use of capital gains tax incentives and other tax deferrals to further boost returns. The goal was to make private investing in economically distressed communities too attractive to pass up, and thus turn these areas into vibrant growth zones where people would want to live, work, play and invest.
So, how have things turned out? Is the program working as planned? Well, “yes,” and “no,” and “sort of.”
SLOW AS SHE GOES
Despite the hype and enthusiasm, the program got off to a slow start. Developers and investors were champing at the bit to dive in, but clarity surrounding the regulations was slow in coming. No one was going to risk millions of dollars without knowing exactly what the incentives, restrictions and timelines were. By the time the program was fleshed out, with guidelines coming in dribs and drabs, many had lost interest and moved on to other opportunities. And those that were still interested were spending hundreds of hours trying to decipher rules that seemed to be devised to give tax attorneys a guarantee of lifetime employment rather than encourage investment in distressed zip codes.
By the end of 2019, however, the program was having an impact. Individual states are allowed to designate up to 25 percent of their low-income tracts, as defined by the 2010 census, as qualified opportunity zones. All 50 states, as well as Washington, D.C., and five territories, have taken advantage of the program, resulting in more than 8,700 designated opportunity zones. Capital was beginning to flow into the QOZ funds, with about $75 billion raised, according to the Council of Economic Advisers.
While that $75 billion looks pretty significant, it isn’t as much as was expected, and there are indications that fundraising is already softening.
“Thirteen qualified opportunity zone funds were added to our private placement coverage in 2020,” says Laura Sexton, senior director, program management at AI Insight, which tracks real estate QOZ funds. “The category is falling well below 2019 levels, with 28 percent fewer funds added and 47 percent less capital being targeted.”
Sexton goes on to note that in addition to fewer funds being launched, those that are already in the market have struggled more than other private placements to reach their capital raise targets. “One large energy-focused QOZ fund closed in April, having raised approximately 22 percent of its $400 million target in 315 days on the market,” she said. “Twelve other QOZ funds in our database have closed offerings in 2020, and reported they raised 60 percent of their target on average. This is below the overall private placement and 1031 exchange capital raise averages of 71 percent and 100 percent of target raised on average, respectively.”
The reason for the fall off is unclear — COVID-19 uncertainties can’t be ruled out — but one of the oft-cited factors is the convolutedness of the guidelines.
“In my opinion, a lot of the complexity that Congress created around the rules in this program are bureaucratic nonsense,” says Jonathan Miller, president and CEO at Parsonex. “For example, they allow investors to defer taxes on the capital gains used to purchase the QOZ investment until December 31, 2026, but then require taxes be paid on that date — from a gain five to 10 years ago at that point — while the fund itself must be held for 10 years, which would take it past that 2026 deadline. It is unnecessarily complicated. Ultimately, the simpler the rules are for developers [sponsors] and investors, the more effective the program can be.”
There is also a lack of understanding surrounding the full breadth of the program. More investors might be interested if they realized how the opportunity zone program can apply proceeds from multiple types of sales.
“There is wider application than what first meets the eye,” says Jay Frank, chief operating officer at Cantor Fitzgerald Investment Management. “The general misconception that a QOF is designed to only house gains recognized from a business sale overlooks the ability to use a QOF for a blown 1031 exchange, addressing concentrated stock concerns, the sale of a primary or secondary home, or simply meeting the tax liability created from portfolio rebalancing, especially given current equity valuations.”
Another factor causing hesitancy on the part of investors is their inability to get their arms around the due diligence required. Program incentives are luring investors to areas they would not have considered without the incentives, and many aren’t sure how to project a risk-adjusted return. Some of the OZ requirements, such as the 10-year hold, add factors to the due diligence that investors might not have included in the past. Investors and fund sponsors are leery of making a mistake because they don’t understand the local dynamics. Tax incentives alone do not make a feasible project.
“Good tax programs will help enhance quality projects, but tax incentives have never made a poor investment into a good one,” says Bill Shopoff, president and CEO at Shopoff Realty Investments. “In many of the most disadvantaged neighborhoods, if the goal is to provide affordable housing, the government, often local, will have to find ways to provide additional incentives, including the use of low-
income housing tax credits. These can, in fact, be layered onto a QOZ project.”
If an investment doesn’t produce enough return, the benefits of an opportunity zone investment become questionable. So, ultimately, the key to a qualified opportunity zone investment is accurately assessing the probability of achieving various outcomes.
“From my research, many opportunity zone programs paid too much for their land, have underwriting that isn’t supportable, or have return objectives that are too low to make the risk and timing of the investment worthwhile,” continues Shopoff. “It is critical that investors understand how opportunity zones work, and carefully assess the durability and probability of success of the project and its projections.”
Justifying investing in a long-term project can be hard in the current atmosphere, with its low-interest environment being more amenable to shorter-term investments.
“The current good market has actually hurt the OZ program,” says Adam Stifel, executive vice president, development, at Capital Square. “The OZ legislation requires that the fund or asset be held for 10 years in order to get the full tax benefit. However, pretty much every capital metric in today’s market points to selling quickly. Thus, the 10-year hold is a serious detriment. Some projects that could be OZ deals are being done without OZ benefits for a quicker sale and higher IRRs.”
WHO BENEFITS?
As with any new program, the implementation has not been without its critics. One of the more widespread criticisms is that the tax breaks are benefiting rich developers more than distressed communities. Due to the reliance on 2010 Census data to designate the Opportunity zones, there are areas that probably don’t need additional tax incentives to attract investment as they are already transforming. But the use of OZ incentives for a development that would have been completed without them is the exception, not the rule. The CEA has found that most of the $75 billion it cites in its report would not have found its way to OZ areas without the tax incentives. Others agree.
“While you can point to a project here or there that would have been built without any additional tax benefits, as a whole, the qualified opportunity zone program is working,” says Frank. “Most investors we have worked with are investing gains from asset classes outside the realm of real estate — capital that normally wouldn’t have been earmarked for real estate is facilitating new development projects across the country, leading to job creation, business formation and long-term tax revenues for the local economies.”
CHANGES FOR THE BETTER
Three years into the program, ways to encourage more investment are beginning to take shape. Some of the ideas put forth by those who now have experience revolve around aligning the timelines better so the tax deferral period coincides with the dissolution of the fund or sale of asset. It has also been suggested that funds be allowed to dissolve when the objective of the investment has been achieved instead of requiring a 10-year hold. Another tweak often suggested by active investors is reassessing which tracts are truly distressed every few years rather than basing designations on 10-year-old census data.
“These adjustments could potentially fuel a surge in investment dollars into the programs and spur more development,” says Miller. “The government gave these huge advantages but then tried to mandate the ‘how’ of the execution, which no one likes.”
One simple tweak that nearly everyone would like to see would be to simply extend the deadlines. Because the investment must be held in the fund for at least five years to realize a permanent 10 percent tax exclusion on their income returns, and because the tax deferral period ends the last day of 2026, investors must put their capital into an OZ fund this year to take advantage of that incentive. With its slow start, the program could use some additional time.
“The OZ program has had a very slow start due in large part to the complexity of the tax provisions. The program is working — creating jobs and economic activity in distressed neighborhoods. We simply need more time to make the OZ program a greater success,” says Louis Rogers, founder and CEO at Capital Square.
While all of these suggestions would make the program better, there is no real push to drive them through Congress any time soon. However, we might see additional reporting requirements added.
“I expect any changes surrounding increased reporting on the economic impact of opportunity zone investments would be well received,” adds Frank. “Reporting requirements were part of the original legislation and were removed at the last minute. It is critical that Washington gets this right, as lower income communities need investment now more than ever given the disproportionate impact from COVID-19.”
WHAT NOW?
2021 is expected to be a banner year for opportunity zone funds. They also said that about 2020 at the end of 2019, but this time should be different (a phrase that every investor has emblazoned on a plaque on their desk). The uncertainty of COVID should be behind us. Investors have had more than two years to get acquainted with the challenges and benefits of the program. With the deadline to qualify for the permanent 10 percent tax deferral looming, those who have taken a wait-and-see attitude are moving off the sidelines. In addition, frothy asset prices have led to capital gains that investors would like to shelter. All in all, the stars seem to be aligning for a program that entered the scene with much hype and promise, but has struggled to find its bearings.
“The program is still considered to be in early stages, with pros and cons continuing to reveal themselves,” says Max Sharkansky, managing partner at Trion Properties. “The hype and promise surrounding OZs drove immense interest from the start. But it will still take some time to see significant results and a distribution of investment throughout geographies. That said, we believe the program will do what it was intended to — revitalize communities and boost economic development. Especially following the pandemic and civil unrest of 2020, we will likely see a continued push toward incentives for investment in small businesses, in addition to other aspects of the program, and ensuring a more diverse pool of investors and funds.”
And really, who wouldn’t want to be part of a program that promises so much good along with its tax benefits? 2021 should be the year investors find the zone.
Sheila Hopkins is a freelance writer in Auburn, Ala.