Right now, the investment community is paying close attention to qualified opportunity zone funds, anticipating that they could be part of a longer-term investment strategy during volatile market conditions. The opportunity zone program was passed into law as part of the 2017 Tax Cuts and Jobs Acts to fuel an influx of private investment to propel growth in local communities, and there are now hundreds of Funds investing in over 8,700 federally designated opportunity zone. Investment in opportunity funds has ballooned to well over $10 billion dollars, according to professional services and accounting firm Novogradac.
Opportunity zone fund investing offers potential tax benefits to investors experiencing capital gains events for the sale of a business, stock, or real estate. In some cases, like the sale of stock, these potential tax benefits have not been available before and can appear particularly attractive to the investor sitting on a large amount of unrealized gains.
However, potential tax benefits are not a substitute for due diligence and ascertaining the quality of the underlying investment remains critical. I’ve been in this industry a long time. I was raised in a family office my father started in 1964 and worked starting at age 13. I have two decades of experience, 10 of which I’ve spent as a portfolio manager of a real estate trust.
It is important for investors and their advisors to find the opportunity zone fund best suited for their investment objectives. For some, investing in real estate instruments may be all together new, or at least different, from the types of investments they’ve made in the past.
A careful examination of three key areas can help you or your clients make more informed decisions about choosing the right opportunity zone fund. Let’s explore each.
Where Are the Assets Located?
When it comes to real estate, good projects in great locations will typically generate higher demand. When looking at an opportunity zone fund that invests in real estate projects, it’s important to understand clearly the underlying market fundamentals that could make a particular location a good long-term investment. The first goal is to acquire a position in a market where there is high demand and limited supply. Scarcity of particular types of real estate assets, or even the land itself, could present a meaningful opportunity. An important question to ask is whether a location would support long-term demand for any particular product, such as housing, office space, or retail.
San Jose, California is a good example. San Jose is the 10th largest city in the U.S. and lies at the heart of Silicon Valley, the engine behind the long-term economic growth for the entire region. Large technology companies like Google, Apple, Cisco, LinkedIn, and Facebook have a significant presence in the region and continue to attract tech workers from around the world. In fact, Google and Apple are already planning for long-term growth in downtown San Jose. Google plans to build a 6-million square foot campus near downtown San Jose’s Diridon station, with thousands of apartments, shops, and community spaces.
Over the past three years, developers, investors, and tech companies have spent over $3 billion buying downtown San Jose properties.The combination of more available space and more affordable housing make San Jose a natural choice for the multitude of companies that continue to compete for employees that prefer housing close to their jobs or near mass transit hubs.
It is also important to understand the relative ease of the development process in a particular area because it is a key factor when determining the strength of the underlying assets in a fund’s portfolio. Local government policies and sentiment toward new development are crucial considerations as funds for opportunity zone projects must be deployed within stated opportunity zone timeframes.
What About the Fund’s Portfolio of Properties?
Investors should look closely at the fund’s projects and ask hard questions to make a more informed assessment about potential upside and risk. Has the fund already acquired properties, or just identified some? If the fund has assets, what are the projects? And at what stage are the projects? Have they been approved and permitted? Is it a blind pool fund—one without specifically defined projects—as that time of fund may present investors with more risk?
A diversified portfolio of projects and property types can lead to better outcomes for investors while benefiting the surrounding communities. A portfolio that presents diversity among asset classes may also help to reduce risk. For example, a fund with a single, larger project may have inherently more risk associated with finding a tenant and competing with other projects in the area.
Ultimately, investors should have a clear understanding of the different properties and asset classes in the fund, why the fund managers chose them, how they tie together, and whether competitors are developing projects nearby.
Who is the Team Behind the Fund?
Besides the location and the projects, there is a common denominator for success when it comes to real estate investments: a team with deep expertise and first-hand real estate development experience in the local market.
Savvy commercial real estate investors look for experienced developers with a consistent track record of building projects with a reasonable risk-adjusted rate of return. Fund managers who are also developers have a distinct advantage, and local experience is often a determinative factor for success.
Funds that are managed by experienced local commercial real estate developers don’t have to worry about finding experienced local commercial real estate developers to complete their projects on time and on budget, which is also one less thing investors have to worry about.
Also, funds that partner with outside developers may charge extra fees or may have a double promote-structure for the developer’s benefit, something investors should be careful to investigate. A team that serves the fund as both developers and fund managers may be in a unique position to better control costs and curate projects that are truly transformational for the community while generating prospective returns for their investors.
In this regard, it is important to ask whether the management team has completed prior projects in the particular opportunity zone. Experienced local developers may be better able to acquire properties at the right price and understand the myriad of variables that go into what projects can be financed, permitted, and built on a particular site. They often have first-hand knowledge of the market and regional economic trends, including local demand for different types of properties, what is appropriate for the site, and what the city will allow to be built. Each locale has its own politics, regulatory governance, and processes, and having the right relationships with key community leaders really matters.
Good questions to ask the team may include the following: How deep are their ties to the community? Do they have relationships with key local constituents and the experience in overcoming hurdles involved in ground-up development projects? Have they worked with neighborhood leaders and other stakeholders, from local elected officials to business leaders to community activists?
Don’t Forget Partnership Structure
Opportunity zone rules are complicated, and a solid understanding the rules will help maximize potential tax advantages. But for those new to investing in real estate, understanding the real estate development investment cycle should not be overlooked.
With real estate, much of the returns in the standard development deal may be generated within the first five years. However, opportunity zone rules require an investor to hold their money in a qualified opportunity zone fund for a minimum of ten years to qualify for the federal capital gains tax benefits associated with the appreciation of that investment. The question then becomes how to structure the fund in a way that allows the investor to maximize the tax benefits for potential returns within that initial five-year period.
Some funds, like Urban Catalyst, are structured to provide potential benefits for qualified opportunity zone investments while simultaneously increasing their ability to pass through potentially tax-free distributions within the first five years of development. Many others in this space, however, are not similarly structured. Anyone seriously considering investing in opportunity zone funds should dig deeper to understand their structure.
Not all opportunity zone funds are equal, but for savvy individuals who do their homework, these novel investments can represent a once in a lifetime opportunity for investors and communities most in need of capital infusion.
Sean Raft is chief administrative officer and partner at Urban Catalyst. A seasoned professional with substantial experience in real estate, law, and securities, Sean provides senior fund management through supervision, analysis, and advice on company structure, compliance, accounting, finance, and legal strategies and oversight of relationships with Urban Catalyst’s outside third-party consultants specializing in those practice areas.
Prior to joining Urban Catalyst, he served as portfolio manager of a real estate trust with more than $100 million in assets. Sean earned his juris doctorate after graduating summa cum laude from Santa Clara University of Law and holds a bachelor’s degree in Biology from Georgetown University. He was recently admitted as a member of The Opportunity Zones Working Group, which advises the U.S. Department of the Treasury, Internal Revenue Service, the Community Development Financial Institutions (CDFI) Fund, members of Congress and other federal and state agencies on best practices and practical applications for the opportunity zone program.
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The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.