In April, we released our reaction to the latest proposed Qualified Opportunity Zone regulations issued by the IRS. We noted that the “New Proposed Regulations” clarified and confirmed several critical points and created additional flexibility for managers to implement a Qualified Opportunity Zone program.
Perhaps unsurprisingly, these news rules, which generally embody a spirit of flexibility, have opened the door to a wider range of Qualified Opportunity Zone managers and offerings in the market. While Cadre welcomes the New Proposed Regulations, we want to highlight a number of potential pitfalls that savvy investors should be wary of.
1. Markup Risk
One of the most common refrains in the Qualified Opportunity Zone space is that deals need to “stand on their own merit” ignoring any potential tax benefits. While perhaps cliche at this point, this message is critical now more than ever, and regrettably the refrain has begun to ring hollow in certain circumstances. For example, in early 2019 we were shown a deal with broker guidance at $26mm. The partner at the time believed that given the Qualified Opportunity Zone designation, it might trade for slightly north of that number. After numerous bidders came to the table, the deal ultimately traded to a different bidder at $34mm — a 33% markup in just a few months!
Added regulatory certainty may continue to accelerate capital flows and push pricing on eligible deals to untenable levels, resulting in an unsustainable number of Qualified Opportunity Zone deals in the market. A recent MIT study discovered that redevelopment properties in designated Opportunity Zones have experienced a 14% price increase, while prices for vacant development sites have increased by 20%.
Overpaying today to eliminate capital gains on potential appreciation above an inflated basis can quickly become an unwise tradeoff. At Cadre, we believe that we’ll continue to find interesting investment opportunities, but have also passed on many deals where the “Qualified Opportunity Zone Markup” seems irrational and unjustified.
2. Deployment Risk
A key challenge for Qualified Opportunity Funds (QOFs)s is managing cash inflows with timely deployment of that capital, since 90% of a QOF’s property must constitute qualifying assets. Given this constraint, one of the most frequently highlighted outcomes from the New Proposed Regulations is that managers have more flexibility to accept capital into a fund and then deploy that capital into unidentified assets over a 12 month period. Working capital that is documented on a schedule can be retained by a “Qualified Opportunity Zone Business” for up to 31 months without impeding a QOF’s status, granting managers further flexibility.
Let’s assume an investor is looking to redeploy capital gains earned through a partnership in 2018, giving them until June 29th, 2019 to redeploy their gains by reinvesting in a QOF. This is perhaps the most common expiration date for capital gains, so let’s also assume a manager targets raising $100mm for Qualified Opportunity Zone deals by June 29th. $50mm of deals are ready to accept capital, but the remaining $50mm are expected to be identified and deployed after closing the fund. Given the known timing difficulties associated with Qualified Opportunity Zones, the New Proposed Regulations allow investors to more easily deploy capital before a fixed deadline than they previously were able.
However, this added flexibility comes at a potentially high cost — fund managers who were previously patient are now under pressure to deploy capital. This time constraint can lead to a number of adverse consequences:
- Managers are unable to be patient and may have to sacrifice on deal quality to meet deployment deadlines.
- Managers may find themselves in an adverse negotiating position. If it becomes clear that a potential buyer has to close by a certain date, sellers may have leverage on other key points.
- Managers may be unable to deploy the capital in time, leading to tax penalties and investor dissatisfaction or missed opportunities.
3. Recycling Risk
Another important component of the New Proposed Regulations is the ability for funds to sell assets and recycle the cash proceeds into a new Opportunity Zone investment within a 12-month period. Critically, this recycling of capital does not affect an investor’s holding period in its QOF interest.
While this rule could allow funds to opportunistically sell certain assets without holding for ten years, it is important to note that any gain recognized on the sale of said asset is required to be recognized and allocated to investors.
For example, let’s assume a QOF has three assets, each of which have a cost basis of $100. After five years, one of the assets is sold for $150 and that $150 is reinvested into a new Qualified Opportunity Zone development. While this outcome is generally positive for the fund, investors are liable for tax on the $50 gain generated by the sale without being able to take any of the sale proceeds to pay that tax liability. This scenario is sometimes referred to as one of phantom income because investors owe taxes on income that never ended up in their pocket. Of course, certain funds may make “tax distributions” to investors to offset this phantom tax liability.
Added clarity on the ability to recycle assets should ultimately be viewed as a positive, but investors should be aware of the possibility that they may need to come out of pocket to satisfy tax liabilities in certain circumstances.
Investing in Opportunity Zones with Cadre
Since the inception of our Opportunity Zones program, Cadre has reviewed over 200 transactions, many of which featured one or more of these potential risks. By adhering to a deal-by-deal approach, Cadre has been able to remain patient and discerning, only pursuing deals we believe offer a compelling risk-adjusted return before accounting for the potential tax benefits. While this has limited the number of Opportunity Zone deals available on Cadre’s platform, we believe this rigorous approach will ultimately lead to a better outcome for investors.
Investors who have questions about Qualified Opportunity Zones or the most recent guidance can email the Cadre team at email@example.com. To become an investor, please request access to the Cadre platform.