The Three Waves OZ Model: How OZB + OZRE Can Work Together for Optimal Returns and Impact
Opportunity Zones are a hot news topic right now: part of the new tax law, they’re intended to draw some of the $6.1 trillion in unrealized capital gains into furthering economic development in 8700 designated low-income areas around the country via investment in real estate and business.
Most recently, there is more news coverage of OZ Business (i.e. OZB), as the media and the investment community begin to look beyond real estate (i.e. OZRE) in exploring the full potential of OZ.
Opportunity Zones have drawn controversy, specifically the critique that they will benefit the very rich through an unprecedented tax break, while investment goes to real estate development that would have happened anyway, and that furthers gentrification while doing little to benefit the communities residing in the zones. Skeptics ask: How can the OZ regulation actually lead to measurable economic development and social impact?
There is a reason why we can be experiencing both the promise of OZ along with skepticism about its impact. In my view, that is because the OZ lifecycle consists of three waves. Many of the issues and concerns about OZ are linked to wave 1, while waves 2 and 3 bring progressively greater economic and social impact. The good news is that these waves do not have to be sequential in time, but with the right kinds of smart investment can build on each other simultaneously, lifting the tide. This is what I call the Three Waves OZ Model.
Wave 1: The Land Rush
When the first tranche of OZ regulations was released on October 19, 2018, it focused primarily on real estate, and the result was that real estate funds that have existed for decades needed to make very few changes in order to make the jump into real estate investment in Opportunity Zones. Large real estate projects are also a quick way to soak up large amounts of capital gains looking for tax shelter. An estimated $20 billion flowed into OZ real estate (OZRE) in the first six months after the regulations were released, and land values in OZ zones went up an average of 20%, fueling charges of speculation and concern that money was going to development projects that were already underway. These first investments cherry-picked many of the projects with the most promising returns. Because of the way OZ zones were originally designated (chosen by governors, some politically motivated, some in census tracks that would no longer qualify as OZ zones today), some of the initial investments were in zones that didn’t need to be designated as OZ in order to attract investment. All of this led to justified criticism and calls for regulation reform as well as rigorous impact tracking.
However, wave 1 is in a sense the least representative of the legislative intent behind OZ. (Lawmakers made this clear in the letter they sent to the Treasury following the release of first tranche regulations.) And the cherry-picking rush with which it kicked off is not sustainable. Soon all the low-hanging fruit will be taken, and OZRE will slow. Finding and developing additional projects that can generate returns will be much more challenging: it will take 3+ years to rehab or build properties, and then there is the issue of finding tenants to occupy these spaces at rates that justify the initial investment plus rehab. OZ regulations specify that the basis of the real estate (minus the land value) must be doubled in order to qualify for the tax break, which puts tremendous pressure on rent rates. There is a real potential for OZRE to be overbuilt and to stall out under this pressure in the next few years.
Wave 2: The Business Boom
That is, unless there is concurrent investment in building up the businesses resident in OZ zones. OZ businesses (OZB) are the sweet spot of the OZ program, both for investors and for communities / social impact.
OZB investing, i.e. OZ venture capital, has the strong potential to generate much better investor returns than OZRE. As with venture investing in general, the target returns for OZB investing should be at least 10X; the holy grail is to fund the next Apple or Google in an OZ. By comparison, typical real estate investments target returns of 2-3X. Additionally, the requirement to double the base value of an OZRE investment means in all practicality that 2-5 years of the 10-year OZ window will be consumed with investment prior to seeing cash flow. By contrast, OZ businesses generally will be operational (ideally, doubling in value every year) even while investment is flowing in to speed their growth.
OZB is truly exciting from a social impact perspective. A study shows that investment in rapidly scaling small-to-medium enterprise is the most effective way to drive economic development. (I saw this first hand in the decade I spent mentoring and advising entrepreneurs around the world. Notably, there is proven benefit to investing in diverse and women entrepreneurs, a finding that should also be applied to OZ community development in the US.) Fast-growing companies create jobs. More jobs mean more people who need better housing near their workplaces, and who also need more local services such as day care, dry cleaning, auto repair, and places to eat and shop. This is the cycle of wealth creation and community revitalization that legislators intended to spur with OZ.
So why is OZB wave 2? Simply because it is getting a slower start than OZRE. A business-friendly update to OZ regulations was released on April 17, six months after the regulations that opened the gates for wave 1 OZRE investment and 15 months after the law was passed. Complying with OZ regulations is more complex for OZB than for OZRE, there are fewer experienced OZB fund managers than OZRE and the initial setup costs are high.
But that’s changing, and an OZ Movement is starting. In fact, despite the slower start, OZB investment and development is expected to scale quickly due to the higher potential for both returns and impact.
Further, an ecosystem around OZB funds is starting to develop. They can work together collegially rather than competitively because they are geographically dispersed and/or target different types of businesses. It’s also beneficial for OZB funds to co-invest in follow on venture rounds of companies launched and nurtured by other OZB funds.
Wave 3: The End Zone
Wave 3 is where we can see the full potential of Opportunity Zone investment and impact realized. In this wave, with the right foresight, the potential shortcomings and challenges of both OZRE and OZB will each solve the other’s problems, and in so doing create something greater. In my view, this will likely occur 3-5 years into the OZ program.
At that point, OZRE will have slowed and be possibly overbuilt. OZRE construction projects will be coming ready for occupancy. OZRE will need tenants who can pay rents/leases that justify the increase in basis. The best source of such tenants ideally will be successful, fast-growing companies and the supporting service infrastructure that have scaled up, fueled by OZB fund investment in wave 2.
Meanwhile, OZB will be growing rapidly, outgrowing their current spaces. But, to remain qualified OZB, they are required to keep 70% of their tangible assets and 50% of their workforce in an OZ. Ideally, the wave 1 OZRE development will happen with these companies and their needs in mind, fueling a virtuous cycle of sustainable revitalization.
In summary:
Current frustrations around wave 1 OZRE may be justified but will not be a long-lasting trend. Wave 2 OZB investment will drive measurable impact once fast-growing companies benefit from capital and time to scale. OZRE and OZB need each other to maximize both tax-free investor returns and community / social impact. Ideally, OZRE and OZB funds begin to work together early rather than later with a view to wave 3 and the full ambition and potential of OZ.
Brian Phillips is a serial entrepreneur and the Managing Partner of The Pearl Fund, a pioneering qualified opportunity zone venture capital fund. He is a well-regarded speaker and thought leader on Opportunity Zones. Follow him @thepearlfund. An earlier version of this article appeared in Forbes: http://bit.ly/Forbes-PearlFund
