Opportunity zones (OZs) are a hot news topic right now: Part of the new tax law, they’re intended to draw $6.1 trillion in unrealized capital gains into furthering economic development in 8,700 designated low-income areas around the country via investment in real estate and business.
But they’re also drawing controversy, specifically the critique that they will benefit the 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 the OZ regulation can actually lead to measurable economic development and social impact. There is a reason we can experience both the promise of OZs along with skepticism about their impact. This is because the OZ life cycle consists of three distinct “waves.”
Wave One: The Land Rush
When the first tranche of OZ regulations was released last October, 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 opportunity zones went up an average of 20%, fueling 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 opportunity zones were originally designated, some of the initial investments were in zones that didn’t need to be designated as OZs in order to attract investment.
However, wave one is perhaps 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 three or more years to rehab or build properties, 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.
Wave Two: The Business Boom
OZ businesses (OZB) are the sweet spot of the OZ program, both for investors and for communities and 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, typically 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 enterprises 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 a 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 daycare, 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 are 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 the 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 become 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 its 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.
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.