Opportunity Zones Experts Discuss Qualified Opportunity Fund Trends, Investor Insights at Novogradac Conference
The opportunity zones (OZ) incentive is hitting its stride with a growing number of qualified opportunity funds (QOFs) and increasingly diverse investments in qualified OZ businesses, according to a panel of OZ experts Oct. 21 at the Novogradac 2021 Fall Opportunity Zones Conference in Cleveland. Moderated by Novogradac partner and conference chair John Sciarretti, CPA, the panel explored OZ fundraising trends, fund structures, investor profiles and other observations.
QOF Fundraising Trends
“Opportunity zones are still very popular,” said Sciarretti, citing OZ investment data tracked by Novogradac, which includes 1,243 QOFs, of which 909 QOFs reported an amount of equity raised. Funds raised and reported by QOFs totaled $20.28 billion in cumulative equity, reflecting a 15.8% increase in fundraising between June 30 and Sept. 30. In the same three-month timeframe, the number of QOFs tracked by Novogradac increased by 6%, which Sciarretti called “all good signs for opportunity zones.”
Jeff Drinkwater, regional vice president of business development for JTC Americas (formerly NES Financial), said that many first-time QOF managers have run into fundraising challenges and that institutional funds with existing infrastructure and reporting capabilities typically out-compete first-timers in fundraising.
Julia Shin, vice president and fund manager for Enterprises’ Opportunity Zones Funds at Enterprise Community Partners, said capital raising has been relatively smooth for Enterprise, which has focused its QOF strategy on workforce housing, both new construction and substantial rehabilitation.
When Enterprise launched its QOF in 2019, it primarily drew investment from financial institutions. “We targeted raising $50 million in 2019; we ended up getting commitment for upward of $100 million pretty quickly,” said Shin. “Our challenge has been, with COVID and the delay in regulations coming out, really making sure that the deployment of that commitment is in line with the impact thesis that we articulated as the reason for our fund.”
OZ Fund Structures
Single-asset funds tend to be the preferred model of OZ investors, panelists reported. Joseph Darby, the founder and senior tax attorney with Joseph Darby Law PC, said it is easier for a single QOF to invest in a single qualified OZ business product for key tax reasons, including timing of raising funds that are tied to recognition of capital gains and also the contemporaneous start of the 10-year holding period for the full investor pool in the QOF. He said investors also prefer having a clear idea of what they are in investing in, as opposed to a blind pool.
Drinkwater said that when the OZ incentive launched, there were some funds that announced they would target $1 billion in fundraising for multiple projects, but that those endeavors had limited success and did not do well in the marketplace. “I think it’s just a real challenge to try to sell investors on 10 different investments in one fund structure and the ramifications of disposing of an asset, tax ramifications–it just didn’t fly,” said Drinkwater. “So now you’re seeing funds come out with a single investment, $20 million to $30 million target raise having much more success; it’s a better model.”
OZ Investment by Asset Class
Real estate continues to dominate OZ fundraising activity by asset class, particularly residential housing development. Other OZ investment categories that experienced a slump during the pandemic are showing signs of recovery. Sciarretti said that in the prior three months, fundraising tracked by Novogradac for commercial-only OZ investments increased 49%. In the same period, fundraising for hospitality OZ investments tracked by Novogradac increased by 102% or $200 million.
Sciarretti said a natural next step is increased investment in operating businesses that are heavy in real estate but are scalable, such as vertical farming and maintenance facilities for electric vehicles and aircraft. He said those investments work well with the OZ incentive because they are fixed in those locations and assets stay in the zones, but they also have significant operating activity inside of the assets.
Sciarretti asked panelists for their observations on investor profiles. Shin noted the surprising amount of retail investor appetite and interest in OZs. Shin said that financial advisory-type firms that had not previously worked with Enterprise began approaching her and asking whether Enterprise can deploy a $250 million to $500 million investment in a fund because that was the kind of scale that the financial advisers needed to get on a broker-dealer platform. As a result of this interest, Shin said Enterprise is assessing ways to work with retail investors and ultra-high-net-worth investors.
Drinkwater said JTC Americas surveyed its clients for their primary reasons for investing in the OZ incentive and found that environmental, social and governance (ESG) priorities are becoming increasingly important for OZ participants. While a 36% plurality of survey respondents reported that the tax benefits of the OZ were their primary driver in 2019, social impact took the lead as the reported primary driver of OZ investment in 2021 with 45% of respondents.
“ESG and impact are carrying the day,” said Drinkwater.
The OZ Drives Investment into More Communities
One of the main points discussed during the session was how the OZ incentive is helping previously underinvested areas attract new capital, as was the intention of the incentive. Most OZ investment early in the incentive was concentrated in big cities in coastal states–perhaps because many of those developments were already in the pipeline when the OZ was enacted, said panelists. Since then, OZ investment has started reaching Middle America and smaller communities. In particular, panelists mentioned Alabama as a popular state for the OZ and Erie, Pennsylvania, as an example of an entire city transformed by multiple OZ investments.
Shin said Enterprise has found success investing in secondary and tertiary market OZs. Enterprise’s funds focus on workforce housing and requires that 51% of units be available to households earning up to 80% of the area median income. Shin said Enterprise underwrites feasibility and financial return, even though, as an asset class, the return thresholds for workforce housing are less than where private equity return thresholds tend to be. “The markets where that work are secondary and tertiary markets and we’re seeing very exciting markets where there’s growth or projected growth of market trends from population, demographic and job employment numbers.”
OZ Pitfalls to Avoid
Panelists also discussed common OZ errors to avoid.
Darby said the biggest mistake he sees with first-time OZ participants is not getting good advice early enough in the process. “Once you start a deal down a path going the wrong direction, it’s hard to fix it,” said Darby.
Drinkwater agreed. “This is really specialized, deep-dive knowledge. … You can’t just jump into this and think you can wing it,” said Drinkwater. “You need to have savvy folks that are really experienced and that have done a lot of funds.”
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