Since its introduction in the 2017 Tax Cuts and Jobs Act, the Opportunity Zones (“O-Zones”) program has become one of the most hyped investing opportunities in recent memory. Tracking Google searches for “Opportunity Zones” over the last year illustrates this impressive snowball: After interest grew steadily over the course of 2018, awareness spiked when the IRS released its much anticipated Proposed Regulations on October 19th. More importantly, the content of the IRS release also catalyzed a number of announcements from managers who are setting up funds to capitalize on the program.
After reviewing the Proposed Regulations, we are similarly encouraged that the IRS seems intent on increasing the program’s flexibility for investors and managers. Still, the program presents a number of logistical hurdles and inherent investment-related risks that may be easily overlooked as both managers and investors rush to capitalize on the opportunity.
We began our diligence on the O-Zone concept in April, and took an early view as to the types of opportunities that would fit squarely within the program. Most importantly, we hold the view that the program’s tax benefits alone will not lead to successful outcomes for managers or investors. Over the past several months, we have therefore begun developing a program with a clear view of what success looks like for our investors. Throughout that period, the pillars of our thesis have not changed:
- Investment Strategy: The largest portion of the tax benefit is contingent on the profitability of the underlying investments. A successful program must be grounded in the merits of the real estate and the parties involved. Given O-Zones qualify as O-Zones for a reason, we seek to mitigate risk by proactively identifying the small subset of O-Zones that are poised for outperformance over the long run.
- Diversification: Most investors will be best served by gaining diversified exposure to O-Zones – across multiple assets and markets. We favor a strategy that can efficiently deliver such diversification.
- Structure: Logistics are not to be taken lightly. In order to reliably capture the potential tax benefits, investing through the right structure is critical.
In short, we agree that the mission-orientation and tax benefits are worthy of the buzz the program has generated. But we also believe certain key components of a well-conceived offering have often been overlooked.
Based on selection criteria1, O-Zones are by definition underserved census tracts. Beyond exhibiting lower average incomes, they tend to have higher unemployment, lower density, and lower homeownership rates than “non O-Zones” (see table below). Given these facts, we believe a critical first step is to identify O-Zone locations with outsized future growth potential. While the program’s tax benefits are highly attractive, their full realization requires a positive investment outcome. Put simply: can’t avoid taxes without taxes to pay.
So how does one target O-Zones that have a greater potential for positive outcomes, especially those that may be less obvious today? We believe one thoughtful approach is through predictive demographic data. That means choosing variables that can be forecasted with reasonable accuracy, ranking all 8,700+ O-Zone census tracts based on those variables, and then mapping those tracts to find clusters of higher scoring O-Zones.
While forecasts are available for just about any variable today, the limited accuracy of many of those projections typically results in a predictive model best described as “garbage in, garbage out.” However, income and population growth projections, two key drivers of long-term demand in real estate, have historically been projected with reasonably high accuracy by certain data providers.2 We see these specific variables as ideal candidates for our scoring analysis. Once we rank each O-Zone according to its demographic potential, we then rank metro areas with the largest concentration of high-scoring O-Zones. Finally, we narrow in on a subset of those metro areas where we believe our operating partner network will have actionable investment opportunities.
Prior to ranking markets, the average O-Zone demonstrates below-average growth prospects. But the below chart illustrates the encouraging result of our data-driven effort: a subset of O-Zones that are not only more appealing than the average O-Zone, but are also actually projected to grow faster than the average non O-Zone census tract over time.
Within our target O-Zone markets, we evaluate a broader set of supply & demand variables to assess specific opportunities alongside our operating partners. The result is not a blind reliance on a data scoring system, but a healthy combination of a top-down, data-driven market analysis and bottoms-up, relationship-driven sourcing. Our initial pipeline of qualifying O-Zone investments closely tracks this target market approach.
We don’t claim that ours is the only viable strategy for investing in O-Zones. However, given these are underserved communities and the program mandates a 10+ year investment horizon, we believe a well-defined market selection strategy is critical.
Another important consideration is the ability to mitigate exposure to any one particular O-Zone asset or market. Many of the investors we have spoken with are either sitting on a sizable capital gain built through a diversified portfolio, or have recently realized a large gain through the discrete sale of a business they spent their life building. In any case, concentrating these gains into any one asset, market or operating partner contradicts a foundational investing principle (diversification) that we believe should not be ignored in pursuit of potential tax savings.
While many managers are limited to a small number of projects based on current ownership or a specific regional focus, we value our ability to flexibly allocate across high-growth markets alongside multiple leading operating partners. In total, we expect to commit to 5–10 of these qualifying transactions over the next couple years. And since the O-Zone program requires development or extensive asset repositioning, we stress the need for an active project oversight role in close alignment with investors. In each transaction we pursue, we will serve as ongoing asset manager and fiduciary for both our investors and our own capital.
As should be expected from any program with such a powerful economic incentive, the devil is often in the details. From our standpoint, a successful offering must both ensure compliance with the regulations and ease the logistical burden associated with the timing and mechanics of investors seeking to participate.
Regarding fund structure, we and numerous respected law firms believe that single-asset funds fall squarely within the issued guidelines of the program, while the viability of the traditional commingled fund model remains unclear: “a traditional fund structure with multiple properties is not a straightforward fit for the OZ Program (since then all of the properties would need to be sold at once to a single buyer of the [fund] itself at exit).”3 Instead, fund managers “may wish to create a separate entity (and thus a separate fund) for each property.”4
Since inception, Cadre has focused exclusively on structuring single-asset funds for its portfolio of assets. Importantly, we have also focused on facilitating programmatic access to single-asset funds by offering investors “managed accounts” that provide first-right, priority allocation into those deals. These accounts provide investors diversification and commingled fund-like operational efficiency alongside cleaner compliance with O-Zone guidance.
Further, whether or not a fund is comprised of one or multiple assets, a key challenge for fund managers will be balancing investor timelines against rolling six-month compliance tests for the fund itself. We benefit from a ~$200mm balance sheet that allows us to “backstop” transactions prior to investors committing. This capability has two hugely valuable applications for us: (1) we are able to proactively secure O-Zone investments we find attractive, and (2) investors can manage their realizations and 180-day windows with the comfort that capital can be funded on a more investor-centric timeline.
While the U.S. Joint Committee on Taxation estimates up to $85bn will be invested through the O-Zone program5, we expect investors to act quickly but discerningly. We share the investing community’s excitement. But as with any opportunity we pursue, we believe we differentiate ourselves through a combination of analytical rigor, team experience, operator network, and structure. We hope this commentary helps clarify the outlines of what we believe a compelling approach should look like.
- Note: While nuances exist, census tracts are generally deemed “low-income” if they either have a greater than 20% poverty rate or a median household income below 80% of the metropolitan or state area median.
- Note: While several 3rd-party demographic forecasting options exist, Cadre utilizes Synergos Technologies’ STI PopStats platform due to its superior backtesting results for granular geographic levels compared to other demographic forecasting services.
- Source: Duval & Stachenfeld LLP, October 25, 2018
- Source: Stroock & Stroock & Lavan LLP, August 28, 2018
- Source: CoStar, “New Tax Provisions Open Gates to $250 Billion in Property Investments”, September 19, 2018