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Comparing Opportunity Zone Funds

June 20, 2019
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Investments in certain economically distressed communities, officially designated as Opportunity Zones, may offer multiple tax benefits that could be significant. The benefits include tax on long-term capital gains from other ventures being deferred, the deferred tax bill can be reduced, and any profits from the Opportunity Zone property might avoid tax altogether.

Many hurdles must be cleared to realize all of these tax advantages. Therefore, many investors prefer to participate through Qualified Opportunity Funds (QOFs), relying on the funds’ managers to meet the requirements and also deliver real estate gains. Investing via a QOF though, means weighing many factors that will vary from one QOF to another.

FINDING THE RIGHT FUND

Citrin Cooperman’s real estate specialists recently studied offering materials from nine Opportunity Zone offerings, including seven QOFs that will obtain multiple properties and two single-asset deals where only one Opportunity Zone property will be acquired. We found substantial differences in the minimum initial commitment required, entity structure, maximum size, and the magnitude of total fees.

For investors, choosing the right multiple property QOF or a single-asset deal should go beyond looking for acceptable fees. The manager’s proven expertise in acquiring and managing real estate must be a critical factor.

The makeup of a QOF should also be considered. One that invests in multiple properties may spread the risk in the way that investing in equity mutual funds may spread stock market risk. If the money raised is used to buy and hold a single asset, investors might be accepting the risk of failure in return for the chance of superior returns.

Furthermore, some QOFs are blind pools, meaning that investors don’t know what their money will buy but trust the sponsor’s judgment. Other QOFs specify property they already own or have lined up. One QOF, for example, reports that it has a fully identified portfolio, including residential and retail properties in and around a major metropolitan area.

COMMON COSTS

After reviewing the fee structure of seven multi-asset QOFs and two single-asset deals, some trends emerged:

  • Preferred return. This is the profit first paid out to all investors, including the sponsor if it has contributed capital. Indeed, investors should look for a deal in which the general partner has invested a significant portion of the equity capital. If the sponsor has meaningful “skin in the game,” as the saying goes, the professionals managing the properties are likely to be motivated to produce superior profits.

    Preferred returns in the multi-asset QOFs reviewed are typically 6%, although 5% and 8% returns also appear. Those preferred returns are lower than the 8%-9% preferred returns that can be found in many traditional real estate deals. Thus, it seems that QOF sponsors are using the promised tax benefits to offer lower returns to investors.

    What’s more, the waiting period for tax-free profits is at least 10 years, which is a long lock-up period for a private equity investment. One QOF in our study is targeting 9.5% gross and 7% net returns and another QOF projects returns at 12%-14% (gross) and 8%-10% (net). Some investors might feel such possible returns are low, considering the 10-year lock-up.

  • Promote. Essentially, this is the equivalent of a carried interest in a private equity deal. Among the Opportunity Zone offerings that were observed, most had a 15% or 20% promote. Once the preferred return has been paid to all investors, the sponsor would receive 15% or 20% of any further profits. (Most multi-asset QOFs and single-asset deals are structured as limited partnerships, so it’s the general partner that will receive the promote interest.)

    One single-asset deal reviewed has a 30% promote which is more favorable to the sponsor. This could look concerning; however, for this deal, the sponsor is offering a higher preferred return of 8% (favorable to investors) as mentioned above. Also, the sponsor is motivated to reach the performance goals as they will be rewarded with a higher promote.

    Single-asset deals may have fewer fees because they might be raising much less capital than multi-asset funds. In the deals we reviewed, single-asset deals raised less than $50 million while most of the multi-asset QOFs raised between $500 million to $1.5 billion.

  • Placement fee. Many multi-asset QOFs are raising money through major financial advisory firms. This can lead to placement fees paid to the brokers, ranging from 1% to 2%.

  • Other fees. Most multi-asset QOFs have fund management fees, ranging from 0.375% to 2% of fund assets per year. These fund management fees are in addition to the property management fees charged at the property level.

REITs VERSUS PARTNERSHIPS

REIT investors may face some disadvantages, relative to investors who choose a limited partnership. Additional compliance is required in order to observe the REIT rules and thus avoid corporate income tax; asset sales of REIT shares are more complicated and may have a limited market compared with limited partnership asset sales; and REIT investors get less of a tax benefit from property depreciation.

On the other hand, REIT investors receive a Form 1099 and not a Schedule K-1, which makes handling tax returns easier because investors will not need to file returns in multiple states. REITs also offer increased liquidity by allowing limited semi-annual redemptions.

HOW WE CAN HELP

At Citrin Cooperman, we can review offerings brought to us by interested investors and verify the tax implications of the potential investment in a QOF.

From another point of view, our knowledge of the QOF market has placed Citrin Cooperman’s real estate specialists in an excellent position to assist prospective fund sponsors and their legal counsel to properly structure the fund from a tax perspective.

Opportunity Zone investments, through multi-asset QOFs and single-asset deals, may offer unparalleled tax advantages. The more that’s known about QOFs, the greater the probability of reaping the benefits. Citrin Cooperman’s focus on Opportunity Zones and Qualified Opportunity Funds enables us to provide full service advice in this area, to investors and fund sponsors alike.