With every passing year, conversations around Qualified Opportunity Zones (“QOZ”) become more textured, especially as the composition of fund operators in the space evolve. This should come as no surprise, as many early entrants have now vacated the space, due to a combination of the lack of experience operating in economically challenged markets, ongoing shifts in investor sentiment, macroeconomic and capital markets related headwinds, and the highly structured and regulated nature of the program.
Originally created to promote investment in businesses and real estate located in economically underserved areas (both rural and urban), the QOZ program provides investors opportunities to defer and reduce their tax liabilities associated with capital gains in exchange for making long-term investments in projects located in areas designated by the US Treasury. At the IMN’s 2024 Winter Forum on Real Estate Opportunity & Private Investing Conference, several of the most successful and respected market participants shared their views on the QOZ landscape.
Whereas the initial investors generally comprised a mix of family offices, asset management, and high-net worth individuals that had generated substantial gains either via stock market sales, venture capital, or private equity transactions, the panel unanimously agreed that the investor landscape has thinned significantly in the face of recent market volatility. Louis Dubin, Managing Partner of Redbrick LMD, a DC-based developer and asset manager and one of the largest OZ focused developers in the country, explained that high-net worth capital flows had recently seen sharp declines. “We are probably at 20-30% of what we were during a more normalized time before rates came up. For most of our contemporaries, I’m hearing, it’s more like 10-15%. Gains came down quite a bit.” Despite the staggering decrease, Dubin explained that it wasn’t all doom in gloom because larger families had largely picked up the slack. “The one bright spot in 2023 was lumpiness of ultra-high net worth families. So, what made up for a deficiency in capital fundraising from our wealth management channels, like UBS and Raymond James, was the big lumpy billion-dollar family offices that had a gain and sold a business. We started getting calls on bespoke structures around those kinds of deals. That made up entirely for the normalized fundraising we were doing before that.”
Alex Bhathal, Founder and CEO of Raj Capital, echoed Dubin’s sentiments. “The half million-dollar investors who were allocating gains from their stock market portfolios has pretty much dried up. It’s the large liquidity event from a family taking a company public or private equity that has created one-time meaningful gains and the OZ structure offers several tax mitigation strategies. So, we’ve had some really big chunky money come into the space, but it is concentrated.” The broad shift in demand has clearly prompted other fund operators to follow suit, making family offices the newest belle of the ball. Liam Krahe, Managing Partner of SF QOZ Fund concurred. “Our original investor base was doctors, dentists, individuals that were buying and selling practices. We also had a lot of private equity investors. That has definitely shifted. There is focus on working with single and multi-family offices.”
When asked if this shift has forced a fundamentally different approach to fundraising, responses were mixed. Krahe predicted that the slow-down amongst high-net-worth individuals would be temporary. “According to S&P Global Insight total volume is down 32% YOY, according to CBRE real estate volume is even lower. But I think when you look at the S&P 500 and it’s up 25% in 2023. I believe now, more than ever, the OZ program is attractive to investors that have highly appreciated equity portfolios.” For Dubin, the priority is ensuring that RedBrick remains flexibly positioned to benefit from capital flows multiple constituents. “We’re still going with the strategy of sitting on wealth management platforms. That was anemic production in 2023. I think that will pick up as people are harvesting gains. And some very major family offices now have become somewhat experts in OZ as a tax planning tool. I think a barbel approach is the way to go.”
Bhathal emphasized that investor behavior was not only driven by the idiosyncratic performance of their portfolios, but key deadlines associated with the program itself. For instance, under the current legislation an investor in a QOZ can defer paying capital gains taxes associated with funds invested until December 31st, 2026. Given the shrinking window, investing in a QOZ is less attractive for investors who prioritize the deferral versus other benefits like depreciation recapture. “We are coming closer to the 2026 tax deferral date, so that is mitigating some of the motivation for investors to invest in OZ funds. The main benefit of the program is the benefit of step up to market value in year ten, so you avoid capital gains tax and depreciation recapture. But for any one investor who is making that decision to invest in an OZ, some of the motivation is driven by the immediate tax deferral, and as we get closer to that date there is less of a window to invest in a project, have it refinanced, and distribute back in time to pay the taxes.” This, in Bhathal’s view, not only shrinks the pools of QOZ investors in the short-term, but also means that those that do invest are generally focused on more straightforward projects that can quickly. He elaborated. “There has been more focus to find projects that have a more stable cash profile, so industrial, simple build multifamily, build to rent, where you can invest the capital, get the project built and leased up relatively quickly, so you can refinance and distribute proceeds. The big mega projects that take years and years and years to build, they are probably out of the money in the OZ space because there just isn’t the time necessary to get them completed.” For this reason, both Liu and Dubin observed that pre-service new construction multifamily projects could be a particularly interesting investment segment, if not for the wide bid ask spreads between buyers and sellers.
These challenges, coupled with the current interest rate environment, make identifying attractive opportunities much harder. “All of the dislocation that is happening in the larger macro real estate world is impacting the ability for (QOZ) projects to pencil. Product is a little bit of an issue,” said Canyon Real Estate’s Frank Liu. As a result, fund managers not only have to become nimbler in selecting sites and projects, but also pursue creative financing structures to complete new deals. For the Menkiti Group, which specializes in ground-up, adaptive re-use, and affordable housing development in transitioning urban markets, both activities are par for the course, since it’s always been difficult to transact in deeply underserved communities. Founder Bo Menkiti explained his rationale for focusing on such areas, despite the difficulties. “If you think about proverbial idea of the other side of the tracks, where you can see macroeconomic growth moving across a region or city, if you can find those oftentimes arbitrary dividing lines that retard growth and create dislocation pricing it creates an opportunity. One approach the firm has adopted has been to layer multiple incentive programs onto the same project. “We’ve been able to leverage the historic tax credit program and, in some cases, the new market tax credit program,” he explained.
For Menkiti, the value in the QOZ program is creating a structural mechanism to drive more patient capital into economically depressed areas, where shorter term investment horizons are incompatible with jumpstarting renewal. That structural mechanism is that in order to maximize their tax benefits, QOZ investors must invest over a ten-year period. “What has always been a challenge is to bring real capital to an area on a longer-term basis with a much longer-term view to it. There is a lot of (QOZ) fund capital that went to operators that actually weren’t experienced in the actual communities that this work is being done in. We were doing this work before. The question was always from a capital standpoint if I’m on a 3 to 5-year cycle to capitalize my fund, a lot of these long-term benefits to a community don’t actually affect my investors. So doing well and doing good are actually at odds with one another. The longer the investment time frame the closer those two things come into alignment.” Liu concurred. “The ten-year requirement really makes you think differently in terms of not only where you invest but how you invest, how you operate. It brings a different level of performance.”
It’s an important point, since many real estate operators are so focused on the underlying tax benefits of QOZ that they forget why the program was created in the first place. Regardless of how much tax savings accrue to investors, it’s clear Menkiti believes QOZ cannot be viewed as a success unless the communities impacted are more prosperous as a result. He explained. “One of the questions is what impact does this actually have? Is the program achieving its stated outcome? In communities where are working in, there’s an education audit that looks at performance in the local schools, workforce audit that tracks participation in the workforce, etc. What you see if you look over time is very important outcomes that are not just in the sticks and bricks that are in the way people interact around those communities and the impact those dollars have.”
Dubin shared a real-time story illustrating impact in motion. “This summer we cut the ribbon on the first wood mass timber commercial building in DC. Who did we tenant it with? 15 black owned businesses. We went to faith based and civic leaders. We said we’re going to give you key money, we’re going to give you space. We put the applications together. 35 local businesses applied. Everyone from the great cupcake person to the fashion designer and everything in between. We let the community select them, key money, lawyers, accountants, business coaches all free of charge. If you make it here, in our permanent town center you going to get a space and pay us market rent for it. We did that. We cut the ribbon. We were expecting 400 people. We had 1200 people. Tears. Elders. Little kids. The entire community out. Protected like you can’t imagine. With free floating furniture. No one would dare touch it. It was so beautiful. These are important things you can do if you’ve got long-term dollars. You wouldn’t do it otherwise. How could you justify in a 3-to-5-year merchant flip and do an intervention like this? You couldn’t.”
Dubin emphasized the importance of measuring impact and warned the lack of robust tracking would have practical consequences for QOZ operators. “We track our metrics and because of that we have very significant impact investors. Some of the biggest surprises are bank holding companies. We have quite a few that are investors. Why? 6% yield on tax credits or 12-14% with all the tax benefits, and the regulator nods “yes,” and you get Community Re-investment Act credits as well. I think the industry as a whole that hasn’t been doing a good job in industry tracking. That’s been one of the big pushbacks. I think it’s very important that new legislation is proposed that we all embrace these reporting metrics. It’s more defensible of a program.” Bhathal echoed the sentiment. “We work with the Urban Institute to develop a community reporting tool to track all the metrics and we established a social impact council that is bi-partisan, former Mayor Baltimore, former Mayor of Oklahoma City, former professional athletes, etc. not on a concessionary basis but making sure when we are investing capital, we are doing it the right way and the types of projects that have a multiplier effect. And it is extremely rewarding seeing these projects come out of the ground. It’s not just the financial returns that we see from the building. We are helping to truly transform areas where we are making investments.”
One of the more interesting aspects of the discussion centered around how the collective efforts of disparate ZOQ fund managers are critical to magnifying the economic development of any given submarket as well as the firm’s individual success. In a traditional context, such firms would consider themselves solely as competitors. But in historically depressed areas, in the same way the failure to attract a critical mass of capital can stagnate the local economic ecosystem, a surplus of capital can also allow it to flourish. Menkiti used the combined efforts of his firm and Redbrick in the Anacostia section of Washington DC as an example. “There is a piece of this I’m not sure we’ve fully captured. You heard what Louis (Dubin) is doing. Just down the street we were able to build MLK Gateway I, which brought the first urban café to the area, four new restaurants to a food desert, and the largest private employer to move east of the Anacostia River in 50 years. When you see that bucket, and then you’ve got their (Redbrick’s) large projects down the street, we’re doing another project across the street, these things start to play off each other. So, one of the opportunities, some people are doing it but not as much as you’d think, that could really be looked at is really looking at these OZ as zones, and the synergies between different investments in them because when you start to think long-term, we’re way better off because of what they (Redbrick) are doing down the street.”