Five Criteria for Investors to Evaluate a QOZ Fund

Qualified Opportunity Zones (QOZ) were first introduced in 2017 by the Tax Cuts & Jobs Act. This allowed investors the ability to invest their realized capital gains from prior investments into economically distressed areas.

There are great tax benefits for individual investors who decide to invest in QOZ Funds. However just like any other private investment, investors need to make sure that they don’t abandon their business and investment acumen when choosing a manager to invest within a QOZ Fund.

QOZ investments are long-term investments, usually mandating a 10+ year holding period. It’s important to conduct due diligence on many levels and be particularly comfortable with the fund manager, strategy and projects(s).

Here are five criteria to consider.

1. Sponsorship Experience in Development

Past experience may not be indicative of future results however, a manager’s previous real estate development track record can be a good indicator of their future success.

There are a number of inexperienced managers that will be making unfamiliar investments solely to capitalize on QOZ tax incentives and fees they can generate from their investors.

Development involves a slew of complexities that could be very challenging for inexperienced manager such as complex finance, construction and operational plans. This inexperience could ultimately lead to an unsuccessful QOZ investment.

Investors should start by visiting the firm’s website and searching online for press releases about the manager and their previous investments. If the manager has no track record, or negative press on past deals, run.

QOF investors are relying on the manager’s ability to navigate underwriting and due diligence challenges on a timely basis so that it that meets federal tax incentive requirements. Experienced managers with previous real estate development success are better position to win projects and execute at a high level and expeditious manner.

Additionally, it’s important to look for real estate managers that have a previous development track record with the same types of properties they’ll be focusing on in their QOF. Each property that is developed carries their own nuances. Having experience with these differences can be the difference between a profitable or unsuccessful investment.

2. Market Selection & Strategy

A successful manager will have a clear-cut market selection strategy along with a detailed investment criteria that can be measured.

Investors should get a better understanding and ask the QOF manager how they arrive at selecting specific markets to invest in. With more than 8,700 opportunity zone tracts to choose from, managers should have a structured selection plan with a supporting thesis to invest in those selected markets.

Examples of key characteristics that most promising markets possess are strong population and job growth, a diverse economy, higher forecasted demand than supply for the property type, attractive cost of living rates and a business-friendly environment.

3. Strategy

Finding quality QOZ deals is much harder than a standard development given the finite number of tracts available for selection. Additionally, a good amount of the “quality” QOZ tracts may have already been awarded to previous QOF Managers for development, leaving a lesser amount to choose from for future development. However, there is still plenty of opportunities to choose from.

Most of the QOZ tracts that were designated may not be able to support the rents, costs and economics of a QOZ development. One key differentiating factor to be aware of are select neighborhoods in a market where there is transition for prime development.

One interesting fact is that the QOZ definition is based on the 2010 census data, which many cities may have significantly changed by then. Today, there could be QOZ tracts that are located in thriving neighborhoods but are still deemed “economically distressed” per the QOZ definition.

Look for managers who have been successful in identifying in up-and-coming neighborhoods. Investing in these transition areas towards the path of development may create the greatest opportunity for a QOZ investment. These managers more than likely invested in neighborhoods that were once considered “distressed” but eventually turned to a thriving neighborhood.

Lastly, consider the expected liquidity to investors in a QOF Investment. Investors’ capital gain tax liabilities are still due by the end of 2026. Where will that capital come from? Some managers plan to refinance developed and stabilized assets and return back a portion to its investor base. However, that’s never a guarantee as the debt markets could be considerably change in the coming years. It’s always a good idea to have a back up plan to cover your tax liability.

4. Manager Compliance

Unlike other conventional real estate investment funds, there are more compliance requirements to meet QOZ standards. This responsibility falls directly onto the manager.

If not compliant, the manager could inadvertently trigger a taxable event for its investor base and eliminate the QOZ benefits.

QOZ managers who receive investor capital need to act quickly in deploying those funds into a potential deal. Typically, if a manager does not have a pending deal, it must invest it within six months and 31 months if there is one.

Additionally, property improvements must satisfy QOZ requirements, which need to meet “substantial improvements” per the definition. Lesser improvements may disqualify a deal from the program, and the investor base’s capital gain proceeds invested in the fund will not receive any of the QOZ benefits (i.e., light rehab on an apartment building). In these cases, investors may be faced with an unwanted and unanticipated tax burden. In order to help mitigate this issue, it’s important that managers have great legal counsel on their side to provide the proper guidance.

5. Alignment of Interest

Having proper alignment of interest between manager its investor base is a key item to consider when reviewing a QOZ fund manager. Proper alignment suits all parties in the long run and can help mitigate improper activities, increasing the likelihood of a successful investment.

At the outset, managers should have skin in the game and allocate a portion of their funds or net worth alongside its investor base. It’s typically a red flag if a manager’s principals do not have any capital in their deals. The more capital they can put forth, typically the better for investors as it demonstrates their commitment to the upcoming projects.

In addition, distribution of proceeds that are sent to investors, whether during or at the end of the QOZ holding period is another important item that needs to be reviewed.  There are manager fees and charges that are associated with these types of activities. For example, if a manager is planning to send back a portion of its investor base’s principal from a refinancing scenario, a manager could have the right to take in a percentage of the new loan amount. Lastly, a manager’s carried interest over a certain preferred return should be closely examined. The higher the preferred return to the investors, typically the better.

Conclusion

Investors should be comfortable investing alongside a QOZ manager. After all, this type of investment is at a minimum a 10-year plus hold and requires both investors and the manager to establish a long-term relationship.

It’s important to know that the manager’s principals are fully committed to this endeavor and do not have on foot out the door. A manager’s entire team from, acquisition, financing, legal and leasing should be in place before an investment is made. In addition, the team’s experience, operations and contingency plans all need to be in place in order to navigate a 10-year plus time horizon.

A tax incentive shouldn’t be the sole reason to invest in these types of funds. Investors must first be comfortable with the investment strategy and manager, which will play the key role of delivering exceptional returns.

General Disclosure

This material is provided for informational and educational purposes only and is based on information from sources we believe to be reliable. However, its accuracy is not guaranteed, and it is not intended to be the sole basis for investment decisions or to meet specific investment needs.

Wealthstone Group does not offer tax or legal advice. This content should not replace professional advice tailored to your individual situation.

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only. Securities offered through Arkadios Capital, member FINRA/SIPC. Advisory Services offered through Arkadios Wealth. Wealthstone Group and Arkadios are not affiliated through any ownership.