25 Feb Opportunity Zones Explained: Not All Are Risk-Free
There’s a frenzy of interest around Opportunity Zones (OZ) brought about by 2017 US tax law changes. Investors like you are interested in the prospect of having this very enticing investment model explained. Most people want to understand the massive tax incentive. If you’re smart, you’ll think about Opportunity Zone risks and be prepared to resist the hype.
“Finding the right Opportunity Zones,” explained Tim Shoultz, President of SMARTCAP Group, “is like searching in the fog for a specific tree. It’s hard to discover a qualified investment and the risks are not that obvious.”
People Who Explain Opportunity Zones Don’t Talk Much About Risk
SMARTCAP has studied the new regulations in depth. We’ve researched the tax code, identified the legal gray area as yet undefined around OZs and we’ve scouted investment ideas and properties. In our search, we have seen and heard a lot of hype.
“It is such a good opportunity, no one actually cares about the actual deal.”
“We are going to raise one hundred million dollars or more. Then we’ll find the deals to invest in.”
“You just can’t lose within an Opportunity Zone investment!”
“In 10 years, there will be enough growth that even if the deal does not make sense today, it will be profitable by the time we sell.”
Don’t Let Just Anyone Explain Opportunity Zones to You
We have heard myths, pitches, exaggeration, and hyperbole. Sometimes all at the same time. In fact, we’ve seen very few actual investments that make real sense inside an Opportunity Zone.
It is especially critical to understand the risk profile within Opportunity Zones. As we explained in December, All Opportunity Zones are Not Created Equal. Neither are all deals created equal.
Opportunity Zones Require Extra Scrutiny
However, when you do find a good investment with a good sponsor, you should take advantage of the offering quickly. We are seeing quality deals fill up very fast because more money is available than there are low risk, value-add deals.
Before SMARTCAP will consider an OZ investment, there are key questions and issues we think about. We ask all our investors to go through this thought process before considering any SMARTCAP offering.
Make Apples-to-Apples Comparisons: Don’t Mix After-Tax with Pre-Tax Returns
First off, consider that an OZ investment generates about a 300-basis point increase in net return to the investor, depending on the projected total Internal Rate of Return (IRR) of the investment. As an example, a 12% IRR in an Opportunity Zone is equivalent to approximately a 15% IRR in a taxable account after accounting for the payment of tax.
Look at the Returns Over Ten Years
Not all IRR’s are created equal. A 12% – 13% IRR is much more difficult to achieve over a 10-year hold than a 15% IRR is to achieve over a 3-year hold. This is due to the fact that the long-term IRR stabilizes around the cash flow distribution made to investors.Look at the chart below to see how this affects an investment over time.
Risk Increases if You Let Short-Term IRR Drive Decisions
Being short-term IRR driven significantly increases risk over the long run. You are continuously “doubling down” on your investment. You are also taking new risk on a new asset and/or strategy each time. Finally, you have downtime between when you sell Asset A and acquire Asset B. By investing in a high-quality, long-term investment that generates cash flow along the way, you are able to reduce your risk profile and achieve a strong equity multiplier (3x – 4x profit over a 10-year horizon). Utilizing this strategy can be an excellent way to diversify your portfolio risk as well as your investment time frames.
Understand Opportunity Zone Investments Versus Funds
There are major differences between investing in a specific deal vs. investing in a blind fund. A blind fund offers Opportunity Zone investments aggregated by a sponsor. The SMARTCAP Seattle Industrial Opportunity Zone Fund launched in December of 2018 was based on a single asset deal, not multiple assets.
Investors evaluating Opportunity Zone Funds should understand if the investment is placed in already identified OZ assets or if the assets have yet to be identified. If you are investing gains into a fund and there is no deal readily available, several bad things could happen:
- Every six months, according to IRS Code section 140OZ-2, a qualified OZ Fund must register proof that it has invested 90% of its funds into a Qualified Opportunity Zone Business. If the Fund does not meet that standard, the fund could be charged a 6% penalty for not having funds invested (penalties are subject to change quarterly). This could reduce operating capital. It will require a fund manager to raise additional funds, diluting the original investors. So, as in all commercial real estate investment, it behooves the investor to know who and what you are buying.
- If the OZ Fund doesn’t meet the IRS requirements, the funds you invested may be returned by the sponsor to avoid penalties. This means you could pay gain on an investment you sold. Outside of the pain of paying gain for an investment you might not otherwise have sold. you will also suffer opportunity cost. You may lose the chance to defer your gain and receive the long-term tax benefits you were seeking, if the fund you’ve selected does not qualify the investment in time and has to return capital to investors.
- Lastly, there is no clarity on what happens in the event your OZ Fund continually fails the test to allocate 90% of funds into a Qualified Opportunity Zone Business. This outstanding issue is not yet addressed in the regulations at the time of this writing.
Needless to say, any sponsor or operator will feel pressure to raise funds within bonafide Opportunity Zones. They could feel tremendous pressure to invest capital quickly. In our experience, anxiety + pressure often = lower quality investments or outsized risks.
Quick Tips for Evaluating a Solid Opportunity Zone Investment
Since we’re an early mover in the Opportunity Zone space (the Seattle OZ Fund was the first offering on the West coast), Joe and I get calls daily on how investors can ensure that the specific investment they’re looking at is a good investment. What people are really asking is how to analyze the risk of such a new and untried investment.
- The first thing you should do is take taxes out of the picture entirely. Ask yourself, “Would I invest in this Opportunity Zone Investment if there were no tax incentives?” If not, you should likely not invest even with the tax incentive. If the deal doesn’t pass the smell test when you run the basic numbers, you can’t bet that the tax advantage will save it.
- Ask yourself what the timing and the business plan is for the investment. Will it be capitalized to hold the project for 10 years and ensure the project costs and maintenance will be covered? Or is it meant for a shorter-term hold, and if so, what changes to the financial equation will result?
- What is the exit plan in 10 years? Is there a reasonable sales strategy? How will this investment differ from other OZ investments made near the same time?
- What does the sponsor’s track record look like? Have they completed similar projects in the past including development or redevelopment? Are they an expert in the area or is this a first time effort at developing a project in a low-income area? One of the reasons SMARTCAP believes that Seattle area Opportunity Zones are strong investments is because of the region’s surging economy and robust market. We asked ourselves, “Are the fundamentals strong?” When the answer was yes, we knew we had a good, value-driven product.
Joe and I believe that Opportunity Zones are likely a “once in a lifetime opportunity” for investors to receive incredible tax incentives, provide a way to diversify your investment strategy over a long-term horizon, as well as diversify your tax strategy.
We are also inspired when we think about how Opportunity Zone investments will fulfill the promise of the 2017 Tax Reform Act. These tax incentives will help grow the nation’s communities where they most need help; they’ll build jobs; and they’ll provide good financial opportunities for all. That’s exactly why we decided to devote our time and energy into figuring out the ins-and-outs of the Opportunity Zone program early.
It is, however, imperative that you complete detailed analysis of the deals you are investing in and believe in the strategy being offered.
Feel free to reach out to us directly if you have questions or comments. Click here to see our active offerings.