I recently participated in a video Q&A with Eric Nghiem, founder of the accounting company The Cashflow Doctor, to answer several questions from him on what opportunity zones are and how opportunity zone funds work. Although the opportunity zone program has been around for five years, I still come across people in the alternative investment space who’ve only vaguely heard of it.
Part of my job is to provide prospective investors with a clear overview of the opportunity zone program. That way, they know enough to discuss it with an investment adviser before investing with us. My 12-minute conversation with Eric, which you can watch in full here, allowed me to provide an overview of the program and sprinkle in some nuggets of information I don’t typically discuss with tax professionals.
Some of what we discussed sounded familiar to those who keep up with our blog or have heard me speak at one of our past webinars. For example, you may have already heard me say that we’re fund managers and real estate developers. Our leadership team has collectively built more than $5 billion in ground-up development projects in Silicon Valley alone.
Rather than reiterating those talking points, I’m focusing for this blog on information on opportunity zone funds I haven’t discussed with tax professionals in a while. Below are some that Eric and I touched upon:
Cashflow Doctor: What are some caveats of being an opportunity zone fund? If I recall, it must significantly improve or repair specific properties, and those properties also must be in particular zip codes to be considered part of an opportunity zone.
In general, the opportunity zone requirements are pretty easy to meet. The biggest one is “substantial improvement.” That means you have to put money into a project of greater value than the existing structures built on that property, not including the property itself.
Here at Urban Catalyst, we get an appraisal when we seek to acquire a property. The appraisal says how much the land and any structures atop it are worth. As a result, we must spend more on the project than the existing structures’ value.
Cashflow Doctor: Let’s say we have a client that’s allocating $7 million of capital gains from the sale of stock. They have identified that they want to invest in real estate but don’t want to do any property management. What would happen next if they were going to wire that money to a fund such as Urban Catalyst?
Most opportunity zone funds are private entities, and so they generally send out what’s known as a “private placement memorandum.” This document explains the business plan of the company and all the risk factors associated with an investment. Really, it’s to protect the investor to ensure they understand what they’re investing into.
An investor should see the private placement memorandum before investing and read it entirely. You could see 40 to 45 pages explaining the risk factors of investing in one. For example, ours mentions the potential for a volcano to blow up in Downtown San Jose, the site of our opportunity zone development projects. When reading through those risk factors, you should take them with a grain of salt.
Understanding the private placement memorandum is key. Once an investor does, they’ll sign a subscription agreement, which makes them a limited partner in the limited liability company that is the fund. They then wire money to the opportunity zone fund’s bank account.
Investors in opportunity zone funds can expect quarterly updates from these LLCs. Usually, there’s an online portal where they can log in and see a company’s audited financial statements. In addition, they can get their K-1s and all of their tax documents from there. Over time, they can expect to see returns come in, either from refinance events or income from stabilized assets. And then, eventually, there is a disposition — when a fund sells one of its projects.
Cashflow Doctor: Is there any rating system — Morningstar as its Analyst Rating, for example — that a client can check for opportunity zone funds, or is it more of just doing due diligence and finding the right fund manager based on their experience and history?
Almost all opportunity zone funds are private; in fact, there’s only one publicly traded opportunity zone fund out there. Because of that, they don’t typically have ratings. So instead, it’s up to the investor or that investor’s advisor to do due diligence on different opportunity zone funds to understand a sponsor’s track record, financial capabilities, and business plan.
Important Disclosures
The contents of this communication: (i) do not constitute an offer of securities or a solicitation of an offer to buy securities, (ii) offers can be made only by the confidential Private Placement Memorandum (the “PPM”) which is available upon request, (iii) do not and cannot replace the PPM and is qualified in its entirety by the PPM, and (iv) may not be relied upon in making an investment decision related to any investment offering by an issuer, or any affiliate, or partner thereof ("Issuer").
All potential investors must read the PPM and no person may invest without acknowledging receipt and complete review of the PPM.
With respect to any performance levels outlined herein, these do not constitute a promise of performance, nor is there any assurance that the investment objectives of any program will be attained. All investments carry the risk of loss of some or all of the principal invested. Assumptions are more fully outlined in the Offering Documents/ PPM for the respective offering. Consult the PPM for investment conditions, risk factors, minimum requirements, fees and expenses and other pertinent information with respect to any investment.
These investment opportunities have not been registered under the Securities Act of 1933 and are being offered pursuant to an exemption therefrom and from applicable state securities laws. All offerings are intended only for accredited investors unless otherwise specified.
Past performance are no guarantee of future results. All information is subject to change. You should always consult a tax professional prior to investing. Investment offerings and investment decisions may only be made on the basis of a confidential private placement memorandum issued by Issuer, or one of its partner/issuers. Issuer does not warrant the accuracy or completeness of the information contained herein. Thank you for your cooperation.
Real Estate Risk Disclosure:
- There is no guarantee that any strategy will be successful or achieve investment objectives including, among other things, profits, distributions, tax benefits, exit strategy, etc.;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
- Illiquidity – These assets are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits
- Stated tax benefits – Any stated tax benefits are not guaranteed and are subject to changes in the tax code. Speak to your tax professional prior to investing.
Opportunity Zone Disclosures
- Investing in opportunity zones is speculative. Opportunity zones are newly formed entities with no operating history. There is no assurance of investment return, property appreciation, or profits. The ability to resell the fund’s underlying investment properties or businesses is not guaranteed. Investing in opportunity zone funds may involve a higher level of risk than investing in other established real estate offerings.
- Long-term investment. Opportunity zone funds have illiquid underlying investments that may not be easy to sell and the return of capital and realization of gains, if any, from an investment will generally occur only upon the partial or complete disposition or refinancing of such investments.
- Limited secondary market for redemption. Although secondary markets may provide a liquidity option in limited circumstances, the amount you will receive typically is discounted to current valuations.
- Difficult valuation assessment. The portfolio holdings in opportunity zone funds may be difficult to value because financial markets or exchanges do not usually quote or trade the holdings. As such, market prices for most of a fund’s holdings will not be readily available.
- Capital call default consequences. Meeting capital calls to provide managers with the pledged capital is a contractual obligation of each investor. Failure to meet this requirement in a timely manner could elicit significant adverse consequences, including, without limitation, the forfeiture of your interest in the fund.
- Opportunity zone funds may use leverage in connection with certain investments or participate in investments with highly leveraged capital structures. Leverage involves a high degree of financial risk and may increase the exposure of such investments to factors such as rising interest rates, downturns in the economy or deterioration in the condition of the assets underlying such investments.
- Unregistered investment. As with other unregistered investments, the regulatory protections of the Investment Company Act of 1940 are not available with unregistered securities.
- It is possible, due to tax, regulatory, or investment decisions, that a fund, or its investors, are unable realize any tax benefits. You should evaluate the merits of the underlying investment and not solely invest in an opportunity zone fund for any potential tax advantage.
The above material cannot be altered, revised, and/or modified without the express written consent of Urban Catalyst.
