Fundraising Attracts Less Than 10 Cents on the Dollar Targeted, CoStar Analysis Shows
By Mark Heschmeyer
The wave of commercial real estate capital that investment managers expected to flow into federally designated opportunity zones hasn’t come close to materializing.
Qualified opportunity funds set up to invest in real estate in economically distressed U.S. areas say they are raising less than 10 cents on the dollar of their targeted goal so far this year, a new CoStar analysis found. Moreover, investment in opportunity zones has tapered off after the initial gusto of 2018.
Sales of properties located in opportunity zones surged last year on the promise of increasing values following enactment of the program. However, investment sales in the first half of this year in those areas are down from a year ago.
Investments so far in opportunity zones show the program is benefiting some property owners but not the communities as a whole, an issue that has become a growing point of contention among the law’s sponsor and activist groups.
“Some of the sizzle, some of the initial excitement and enthusiasm has waned,” said Craig Bernstein, principal of OPZ Bernstein, a Washington, D.C.-based opportunity fund seeking to raise $500 million. “That being said, there are still a number of large investors that have substantial capital gains that remain optimistic about the potential benefits of the program.”
The Tax Cuts and Jobs Act of 2017 created the opportunity zone program. The initiative provides tax breaks to investors who transfer recently realized capital gains into qualified investment funds. These funds then invest that capital in projects and businesses within zones with the goal of boosting jobs and housing.
The federal government estimated the program could pump upwards of $100 billion into the more than 8,700 designated zones. Such funds find the fundraising efforts are moving slower than expected.
CoStar has identified more than 160 qualified opportunity funds targeting commercial real estate that have registered or amended their registrations with the Securities & Exchange Commission this year.
About 130 of those funds have reported a targeted amount to be raised of about $15.46 billion combined. Another 30-plus funds have not set a target goal but are actively raising money.
All the funds combined have reported external fundraising of just $1.59 billion. Given the total to be raised could well be more than $15.46 billion, the amount reported raised would be less than 10%. Some funds have told CoStar that they have yet to get even a bite from potential investors.
The reasons for the slow start are numerous: the newness of the program, delayed clarity from the Department of the Treasury, and the lack of properties worthy of investment consideration in many of the zones, according to fund organizers.
“Fundraising has been interesting and frankly a bit slower than expected,” said Chase Watson, vice president at Maxus Properties in Kansas City, Missouri. “I think the fundraising has been slower due to the level of education that funds have to impart on potential investors. Seems that my first couple meetings with potential investors is more about educating them of the powerful tax advantages that the opportunity zone funds provide.”
Fewer Potential Investors
The pool of potential investors is also smaller, Watson said.
“We had not raised money in years, and typically do not expand outside of our ‘friends and family’ network to do so,” he said. “Because our funds are only accepting capital gain dollars, we have had to reach outside our normal network.”
The funds with the most success meeting their targets are smaller funds focused on single-property investments, according to the reports. Funds targeting capital raising of less than $10 million reported being halfway to their goals.
Primior Management in Diamond Bar, California, has set up its opportunity zone funds for single deals.
“The vast majority of opportunity zone funds are ‘blind pools’ that raise money first and hope to identify projects later,” said Johnney Zhang, chief executive of Primior. The best way to make sure the firm meets Internal Revenue Service requirements and “our investors’ expectations is to create a fund for each development project individually. With fully entitled, single-asset funds, our clients can be confident their investment will provide the targeted returns they are seeking,” he said.
Zhang also added that opportunity funds are up against other more well-known tax investment vehicles in which individuals can swap investments without any tax consequences.
In real estate, what’s known as a 1031 exchange defined by IRS code allows investors to defer paying capital gains taxes on an investment property when it is sold, as long as another “like-kind” property is purchased with the profit gained by the sale of the first property.
“Some individuals in these situations may see more value in that type of exchange than in opportunity zone funds,” Zhang said.
Some Investors Hesitant
Multifamily and office investors, as well as ultra-high-net-worth individuals, have been hesitant to allocate capital, fund managers report. Larger investors want to see the deal before allocating capital, and deals in many low-income areas do not match their investment criteria.
“The general feedback that we’ve been receiving from large-scale investors is that they want to have an opportunity to evaluate each deal on a case-by-case basis versus allocating capital blindly,” said Craig Bernstein of OPZ Bernstein. “They’re also very sensitive about fees.”
Despite the slow start to fundraising, opportunity fund managers remain optimistic that a larger flow is coming. Data also backs up the optimism.
A federal government shutdown early this year delayed the Treasury’s release of a second round of clarifications for investing in opportunity zones. The clarifications that finally came out in April offered greater flexibility for investing in businesses and properties. It produced a surge in new fund filings, including those from major institutional investors, including Brookfield Asset Management, Caliber Cos., Cantor Fitzgerald, Starwood Capital Group and Arden Group.
“A significant number of larger investors are still interested in taking advantage of this once-in-a-lifetime opportunity,” Bernstein said. “The reality is there is still billions to be harvested, and there is still plenty of time to get it in.”
To take full advantage of the opportunity zone tax incentives available in the program through 2026, investors would have to invest their capital gains by the end of this year. With the stock market running hot, there are still billions that could be raised, as Bernstein said.
“Our belief has been that investments would be slow through the first half of the year and would substantially increase in the second half,” said Michael Walker, managing member of the Pilot and Legacy Opportunity Fund, a joint fund of Pilot Properties and Legacy Opportunity Group, which has raised about 40% of its $12.3 million target. “The Treasury guidelines released in the second quarter, however, has eased investors’ concerns, and we have experienced an increased focus by potential investors on the details of our investment.”
He added that “we continue to believe that we will successfully close our fund before the third quarter and have started the process of purchasing land for apartment development in the Texas Triangle for a second, similar fund.”