December 31 is the first significant deadline for the qualified opportunity zone program, an ambitious federal initiative offering tax breaks to investments in distressed US neighborhoods. While the concept has piqued interest among real estate investors and managers alike, fundraising activity relating to the program has not lived up to expectations.
The Economic Innovation Group, a lobbying firm that championed the program, estimated that more than $6 trillion of unrealized gains in the US would be eligible for reinvestment through qualified opportunity funds. In response, managers have launched more than 366 funds since the program went into effect in late 2017, but only 184 have raised capital, according to a survey conducted by California-based service provider Novogradac. Respondents reported raising $4.46 billion against a total target of nearly $66 billion.
Among those blamed for the shortfall are the federal government, which has yet to finalize regulations for the program, and starry-eyed managers that overestimated the appeal of the funds and their ability to raise capital, PERE has learned through interviews with 10 lawyers, accountants, service providers and fund managers that are active in the space.
“It’s still good for the economy because it’s putting money into underserved areas, but there were a lot of people that thought it would be easier to qualify for these benefits than it has been,” Jeffrey Bowden, a partner at the New York-based accounting firm Anchin, Block & Anchin, told PERE.
Among the most bedeviling details, Bowden said, were the stipulations for properties to qualify as original use and how much capital had to be invested to satisfy the substantial improvement requirement applied to existing buildings. “As they started educating themselves, as guidance came out, people realized it wasn’t a free home run.”
However, deadlines for new investment, fund deployment and capital gain calculation converge on the final day of this month – a confluence that is expected to set off a flurry of activity, especially if the Treasury Department finalizes regulations by then. “In December, we could see $500 million to $1 billion of capital flows being both deployed and funded into opportunity zone funds across the country,” Craig Bernstein, principal of Washington, DC-based fund manager OPZ Bernstein, told PERE.
The opportunity zone program allows investors to defer taxes on capital gains by rolling them into investments in designated areas. If they hold their capital in these funds for seven years, they can get a 15 percent step up in basis for their original gain, but only if they invest by December 31. After that, the maximum step up falls to 10 percent. Investors that keep their gains in a qualified opportunity fund for at least a decade pay no tax when they exit their funds.
Bowden said he and his team have spoken to dozens of would-be fund sponsors during the past 18 months and only about 10 percent of the groups that initially expressed interest in the program were able to launch funds. Many were deterred by the nuances of the initiative and some were simply unable to source capital. The success rate has climbed over time, Bowden noted, but it has skewed toward experienced asset managers.
A handful of firms in the PERE 100 have launched opportunity zone funds, including CIM Group, which is targeting $5 billion for its fund, according to OpportunityDB, an online database of opportunity zone funds. Starwood Capital Partners, which targeted $500 million, closed a vehicle in June, PERE understands. The Florida-based manager declined to comment for this article. Brookfield Asset Management and Bridge Investment Group hope to raise $1 billion apiece around the strategy, although PERE’s sister publication Buyouts Insider has reported that Bridge has changed its fundraising approach and now seeks smaller pools of capital that will be easier to deploy between the program’s deadlines. Bridge, Brookfield and CIM Group did not respond to requests for comment.
Among smaller managers, there is a variety of investment philosophies. Some are raising blind-pool funds, similar to traditional private equity real estate vehicles, while others offer more customized structures.
Bernstein, who works with high-net-worth individuals and family offices, told PERE that OPZ Bernstein sees more than 200 potential deals a month. Rather than raising multi-asset funds, the firm matches investors with individual properties that align with their interests. “While we initially had plans to raise a blind-pool fund, our investor base has preferred to see deals on a one-off basis,” he said.
Other models have found success through the multi-asset fund model. The Cresset-Diversified Qualified Opportunity Zone – a partnership between two Chicago-based firms, Cresset Partners and Diversified Real Estate Capital – has raised $390 million for a seven-property vehicle. Investors can invest in each project individually, but most have opted for the fund, said Nick Parrish, a managing director at Cresset.
Cresset-Diversified’s investor base is primarily family offices, but the firm has also secured direct commitments from more than a dozen billionaires. Roughly 30 percent of the capital has come from wire houses. The partnership is targeting $460 million, a mark Parrish expects to hit in early 2020. “The pace at which capital is being raised is increasing materially as people get more confident,” he told PERE. “This is harder than people thought. No one has ever raised a fund off capital gains and there are a lot of timing considerations to get capital to line up with projects. People are realizing this is not so simple and the market is bifurcated into those who have been successful in raising capital and those who have not.”
Along with being the cutoff from the maximum step up in basis, December 31 is also when certain gains are calculated, such as net income for partnership structures or sales of trade or business properties, commonly known as 1231 assets, which can be offset by losses. That surge of realizations is likely to result in a rash of reinvestment, PERE understands. Also, many gains realized at the end of 2018 were rolled into funds mid-2019 and must be deployed by year-end.
Some service providers have established products to cater specifically to the year-end needs of these vehicles. NES Financial, a California-based service provider that administers more than 50 opportunity zone funds, has devised an escrow account to collect gains so they can be quickly reinvested on the 31st. “Investors don’t know their exact gain until it’s netted against business losses at the end of the year,” Reid Thomas, NES’s general manager of specialty financial administration, said. “We’ve created this specialized solution to allow the investor to get everything lined up so on that very last day it can go into a fund.”
Managers and consultants alike are quick to caution against committing capital to funds simply to meet the first cutoff. Investors still have two years to qualify for a 10 percent step up in basis and the biggest prize, PERE understands, is the full tax exemption on opportunity zone investments after 10 years. Still, an influx of fresh gains and the convergence of key deadlines will make the closing days of 2019 a pivotal time for the opportunity zone program.