Opportunity Zone Investing is Hard -- If You Are Doing It Right (Part 1 - Investors)

The 2017 Tax Cuts and Jobs Act (also known as the Investing in Opportunities Act) introduced what is being heralded as the greatest investment opportunity in a generation. Depending on your sources, the news about the program takes everything form from uninformed Op-eds just looking to use the attention as a bully pulpit to advocate their political position to sensationalized hype pieces that make it sound like the only investments worth considering are in the 0.1% of zones which are featured in the headlines. As with most things, the truth is somewhere in the middle, but while the Federal government has not been able to define every permutation of investment, it has really done a fantastic job of creating a framework and aligning Federal resources to make the tax law work and passing more than 150 legislative changes to add the support of other federal programs. 

Whatever your starting position, one thing is clear – there is a current and ongoing need for information, tracking, transparency and reporting to be compliant with both the spirit and letter of the law. 

In this series, we will address the various sources that each stakeholder should analyze to get a complete picture, both at the entry into the investment and along the 10+ year hold period that is required maintain compliance and maximize the value of these investments. This may sound ominous, but almost every new investment opportunity in our country’s history has come with some set of requirements and in the case of Opportunity Zone investments, the additional returns in both ROI and social impact will make this work seem minuscule. 

For property, an increased return of 3-6%/year, and for businesses, a potential multiple with no forward gains tax – among many other benefits -- make the return easily worth the added overhead, so don’t let it deter you. Savvy investors certainly aren’t.

Many of the opportunity zone investments we have seen are seeking capital through a "spray and pray" method. These are business owners or developers who are simply looking to capitalize on the OZ frenzy. This is much akin to how technology startups have been (ab)using "AI, "blockchain", "social", "mobile" and a slew of other buzzwords in an attempt to attract investors. This may work for a short period, but in the Opportunity Zone investing space, this time has just about passed. So, now what?

More mature investments and investors are already emerging. Deals must pencil out. Fundamentals must make sense. Communities and municipalities are now heavily engaged and are flexing the tools at their disposal – including permitting and zoning – to ensure that investments have the right kind of support, well beyond the initial onset. 

The market was slow, initially, while the noise level skyrocketed and savvy investors pulled back to the sidelines waiting for clarity -- investments were largely focused on Real Estate. This isn't about to change. It already has. In the coming months, investments will be closing representing shift from being largely focused on $5-50MM RE investments (which are already long in their cycle) to $100MM - $1B+ investments in industrial and infrastructure and a larger move toward business investments. The 400+ pages of the final set of Regulations that are due out before year-end will build on the clarity, but the momentum is already building.

The OZ investment market is already topping $70B annually in declared funds, on its way to an estimated $700B. If that pace continues, that means the market will have accomplished in 12-18 months what has taken the private equity market 3 decades. So, approximately…"BIG". 

This is great news for quality investments, savvy investors, organized communities and municipalities, alike. All stakeholders now realize that they need to do their homework. Below are a few of the resources that each of these stakeholders have at their disposal to ensure that these decisions fit the bill. While many of these are applicable to all stakeholder groups, this first part of this series will focus on the needs of the Investor .For Investors, this means either doing the research and ongoing tracking or requiring their investments to do it on their behalf. 

These can be summarized as follows:

1. Understand the investment and the context that it is going into, both now and over the long term. Communities, municipalities, the environment and other investments all factor into these equations.
2. Layer incentives and use information to forecast, reduce risk, and compound returns. Policies, municipal drivers and consumer/customer insights all play important roles.
3. Structure the investment properly to avoid surprises and ensure proper exit options. Investors often have unique requirements ranging from investment structure to QOF structure to the types of impact that they want to ensure and track over time. This is easy if done correctly, costly if not.

Here are a few of the information sources that investors should include in their analyses to get a complete picture and the importance/use cases of each:

• Municipal focal points - these can be either through listed interests or through direct research with municipal development leaders. These sources vary in their level of maturity, but understanding where focused efforts like Houston's "Complete Communities" or Cleveland's wide-ranging "Corridors" provide information about community needs and municipal incentives can increase returns (both from added incentives and through the compounding of investments within a limited area), reduce performance and community risk (a la Amazon HQ2) and even provide a series of liquidity options along the path, if needed.
• Property and Real Estate trends - understanding both what is already there and what is needed by the community are a good start, but to improve longer-term returns, investors should also know what other investments are incoming into the same area. The establishment of the zones has already increased property values, since they limit the space in which these investments can be made. While the short-term pop might be related to speculation, the longer-term scarcity is inevitable. For example, one property that we used for our analytical models was located at the boundary of an opportunity zone. Neighboring tracts all showed tectonic trends in which AMI, crime (included in walkability scoring) and a series of indicators of prosperity all improved by 50-100% and even resisted the recession a decade ago. The investment memorandum already demonstrated a 14-15% IRR, not including state incentives, which could be layered on top of federal OZ benefits. Add OZ benefits and state incentives and the property would perform closer to 18-20%. Now, add the compounding factors of incoming businesses, neighboring lots available and the focus of the municipality on permitting and it would perform in the low 20s with a lot of resiliency. CoStar, REIS, Reonomy, Ten-X and even Zillow can all be helpful in understanding and evaluating these properties, but may not provide easy contextual analysis.
• Labor Trends- Labor trends are extremely important to understand, but BLS can only get investors so far. With additional access from BLS, Analysts can get closer to worker-level detail, but additional data sets through companies like ADP help provide more insights into employment trends and spending.
• Spending Habits - Services like Orbital Insights provide tool sets that make it easy for Analysts to understand how people within and that commute into a Zone spend their money and how that changes, over time. This can inform investment analyses, especially for commercial and retail properties and for business investments. MasterCard also has a data platform that can be used to gain insights, but it is limited to transactions conducted over the MasterCard network. No Visa, Amex, store cards or cash, included.
• Environmental Insights - There are several sources for environmental data, including USGS and FEMA, but both are focused on broad trends and impacts. Investors should also look for sources like EDR to find existing environmental issues that could cause delays or have cost implications (or both) before investing.
• Current and Planned Infrastructure Investments - Services like Inframation can provide additional insights into where investments are needed or occurring in everything from roads and bridges to water treatment and power delivery. These can have dramatic effects on the viability of other investments into these same areas.
• Community Insights - While some communities have the focus of groups like the Kinder Institute at Rice University with a deep Urban Data Platform, many others are more aggregated or focused on specific use cases, like JUST Capital or i360. Most of the services that set out to do community analytics, like Passenger, Satmetrix and NetworkedInsights have all either pivoted or have been acquired.
• Developer / Business Owner Reputation - There are several data sources that can help investors understand whom they are working with, many of these sources are not as objective as D&B or background search services and are left to self-submission. LinkedIn is a great service for background information, but the business model is not very objective for getting information about the principals. Web searches can be good, as well, but the more sophisticated the individual, the more likely they are to be steering searches or self-submissions to what they want investors to see.
• Policy and Incentive Layering - The Advanced Energy Economy and PolicyMap both provide great information that can be used to understand more of the context and the applicable policies that can benefit -- or hinder -- the viability of these investments.
• Best Practices for Structuring - While it is essential to do the proper research to ensure the long-term viability of the investment, it can all break down if not structured properly. Firms like Kirkland & Ellis and Akin Gump have made investments in understanding these investments and have been essential in the formation of the law and regulations. Accounting agencies like Novogradac or EY have also been involved since early in the evolution and are plugged into the structures that take the most advantage of the incentives. Most importantly, having the right structure for the investment will be critical and understanding the obligations of the underlying investment for the long term isn't something that every financial services firm will know how to do. For OZ investments, Kipling Jones & Co is probably best positioned to ensure that these are done according to both the spirit and letter of the law, while allowing the maximum flexibility and exit optionality. While it is tempting to go with the lawyers, accountants or structuring teams that investors are already familiar with, if the firms don't have real depth and experience in the OZ investment space, it may be best to work with the experts…at least for this part of the portfolio. 
• How Much of Their Capital Gains to Deploy - One of the most frequent mistakes that interested investors make -- especially for those that have the scars of the financial crisis -- is not knowing how much of their gains to trigger, and when. Platforms like Straterix can help take the guesswork and emotion out of the decision by helping to run statistical models which make these decisions far more intelligent and informed. A structured approach can dramatically change the investor's ROA calculation and manage downside risk, simultaneously.

There are many other sources, including trends in POI (Points of Interest), consumer preferences and behavior and other factors to consider -- each with varying degrees of importance and correlation to investment performance and risk, but the list above provides a fairly comprehensive start. In some cases, more than one source may be needed. For example, if an investor uses Google Maps and Open Street Map to provide POI data, both are crowd-sourced and can exhibit the same errors. Cross-referencing with paid sources like Pitney Bowes can often reveal information that adds to confidence levels in the analysis.

On-the-ground networks can also play an essential role, but intelligent investments with an eye on the future and alignment to municipal and community needs will likely outperform anecdotal predictions. Bring the two together and the likelihood for a broad "win" skyrockets.