Qualified Opportunity Zone (QOZ) investments are among the highest risk opportunities available for real estate investment. It is essentially ground-up development in unproven locations. There are a few apparent major risks, such as development completion and lack of liquidity, but investors should also consider the more hidden risks that these opportunities may contain before making their investments.
QOZ regulations started off quite vague. The meaning of QOZ was unclear in a number of situations. The second round of regulations, released in April of 2019, provided some much-needed clarification. These were followed by the final round in December 2019. However, QOZ qualification still depends on strict compliance with the new, and sometimes ambiguous, regulations.
QOZ Regulations are a work in progress, which can make them a moving target. They do not always provide a cut and dry answer to every possible outcome.
There’s another consideration, while not about regulations, is also along the lines of rules. QOZ accounting is very complicated with multi-tier setups, joint-ventures, financing, etc. You’ll likely need an accountant familiar with this kind of complexity to ensure you get everything right and don’t fall outside of the QOZ qualifications.
There are many moving parts when going from deal introduction to closing. Both the deal and capital pipelines are dynamic. Anything can change at any time, which makes receiving updates critical. You need a team that is on top of changes and will bring them to light so that important decisions can be made in a timely manner.
Some of the above issues can be mitigated in a couple of ways:
- There is a 31-month working capital safe harbor that allows a Qualified Opportunity Zone business to hold cash or cash equivalents before needing to put them to work.
- If the fund is multi-asset, the sponsor has discretion over the allocation of funds. To better deal with multiple timelines, as funds come in, the sponsor can allocate funds to different projects.
There is some concern among investors that a mass exit may occur in year 10 (2028/2029 for most funds). 2026 marks the point when the QOZ tax deferral ends. Once the benefit is over, investors may not have much incentive to remain invested in the QOZ program. They may instead decide to sell out, creating a rush for the exits, and driving down QOZ property values in the process. This risk is likely to be overstated as the top 50 global investors acquired more than $150 billion of commercial real estate in 2019 per Real Capital Analytics, compared to the $6.7 billion in equity raised to date in opportunity zones according to Novogradac.
Some states do not fully conform to the federal QOZ tax benefits. These are called non-conforming states. Currently, these states include California, Mississippi, and North Carolina. It’s important to note that non-conformity is at the state level only, federal tax benefits still apply. So if you’re a resident in one of the above states, that doesn’t mean you can’t invest in a QOZ fund; it just means you will have to factor in your state’s capital gains tax.
Rising Land Values
Investor interest in QOZs has begun to impact the price of available land within a QOZ-eligible census tract. For smaller operators, this can be a hindrance or even a detriment to finding valuable properties. This is one area where larger operators have an advantage. The percentage increase in land values is small compared to the total costs for large-scale (institutional) grade projects. With land at 10% of the total project cost, for example, even a 20% spike in land price is only a 2.0% increase in total project cost. If the price of the land gets too high to make the numbers work, it probably wasn’t a very good investment opportunity in the first place!
Sponsor Fee Structure/Economic Alignment
Many variables go into fee structures. Understanding the agreement between you and the sponsor can help to ensure the fee structure is fair. Here are a few things to look out for with fees:
- Are the return calculations accurate and reasonable?
- Which type of interest is being used — simple or compound?
- Are fees gross or net-based?
- Is the sponsor using any double promotion?
- Are the fees competitive?
In addition to fees, for the project to be a financial success, there needs to be economic alignment. For example, if your development is long-term, but the neighborhood is transitioning, there can be a higher risk as the end product may not be suitable for the neighborhood down the road.
Some funds might have tax benefits. Is there a fund available that might be trying to secure tax incentive financing or a project that will receive tax credits? Such funds can reduce taxes for investors as well.
Qualified Opportunity Zones provide investors will special tax benefits, but they come with risks. We’ve looked at six such risks and some ways to mitigate them. It’s important to compare multiple funds to properly evaluate investment opportunities. That’s why Realized has created a QOZ fund marketplace, where you can compare and evaluate properties, build a customized real estate portfolio, and keep track of your investments moving forward.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
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