GettyGetty
As the frenzy about Opportunity Zones continues, one trend has emerged that is hard to deny as investors scramble to determine all the nuances of the new program. The main question we keep hearing within the investment community is, “Where are all the deals?” Once the initial novelty of what sounds like a game-changing tax deferral vehicle has worn off, investors want to know where they can turn to get actively involved and gain consistent access to quality deal flow. It turns out the answer to that question is not as simple as one might hope.
The main issue that we continue to see as we evaluate potential Opportunity Zones (OZs, or OZones) is, “Do the deals make sense on their own merit, independent of the potential tax advantages an investor might realize?” If a deal doesn’t pencil out on its own over the 10-year hold period required to meet the OZ, an investor could end up losing money even though they are able to offset some significant capital gains on the front end. This reality seems counterintuitive to why the program was created in the first place.
Like any new program, the early adopters tend to rush in in search of low-hanging fruit. This means they are not necessarily targeting lower-income areas in need of economic stimulus like the program was originally created to try and revitalize. Instead, groups are targeting designated areas that tend to be adjacent to stable submarkets or those that have already experienced significant development growth in recent years where they can benefit from an existing tailwind of economic activity. For example, almost the entire downtown area of Portland, Oregon is a designated Opportunity Zone, despite being one of the fastest-growth markets in the country.
The result of this flight to safety is that many of the areas that need the development activity the least are the ones getting the most attention. In my observation, many of the lower-income areas that the program originally targeted are not getting the same level of attention because most groups are afraid to be the “first one in” to a market that may or may not actually become revitalized. It seems much more preferable to look for loopholes in the designated OZ areas within a given state and find a way to mitigate their risk as much as possible, while ensuring that the deals do in fact pencil out on their merit.
This reality has led to what I see as a scarcity in quality OZone investment deals with solid underlying fundamentals, while creating a level of restricted access to any kind of meaningful deal flow. There is no shortage of qualified capital chasing the deals that actually make sense right now, so access to those opportunities for the average investor becomes very challenging. In turn, the market is starting to become more saturated with deals that simply don’t stand up on their own merit and investors are pursuing them given their restricted access. Looking down the road, I predict that many of these deals will end up going sideways based on the underwriting we are seeing. That will not only result in a loss of all capital gains advantages but could also lead to an investor actually owing money when it is all said and done.
My stance is to strongly encourage investors to view OZone deals through the following lens: Would you do the deal as-is if there were no tax incentives included whatsoever? If the answer is no, move on and wait for an opportunity where you feel more comfortable with that being the case. Any tax-deferred gains should be considered gravy after the 10-year hold period is up and the bulk of your proceeds should be coming from the actual operations of the real estate asset itself. If you are going into a high-risk submarket where there has been limited economic development to date, your return should be risk-adjusted accordingly. It could be a while before this starts to happen, however, as I predict a continued flight to safety as investors flock to lower risk, infill markets.
The key here is to not become blinded by the potential tax-deferred benefits of Opportunity Zone investing and really look for deals that you would want to invest in regardless of their designation. These deals may be slow to come to market in the initial stages of the program being rolled out, and they will most likely be controlled by groups with limited access. Over time, however, the hope is that the more attractive deals will become available to the average investor and they, too, will get to realize the benefits of this new and exciting program. It does appear, at least in the early days, that patience is going to be key in order to achieve that goal.