Yesterday, the New York Times published an article on Opportunity Zones by Jesse Drucker and Eric Lipton: How a Tax Break to Help Poor Communities Became a Bonanza for the Rich. We think the authors correctly point out several real estate developments underway under the auspices of OZ which do not meet the ambitions or aspirations of the OZ program in terms of delivering needed social and economic development to low-income census tracts. The factors described driving the rise of such projects are all spot-on, including investor opportunism, the inclusion of zones that are not currently or strictly low-income, and zoning that encompassed already planned or pet projects. However, we agree with John Lettieri: this “early wave” is not what we should use to judge OZ overall.
In fact, we believe there will be “Three Waves of OZ”: Wave 1, The Land Rush, is the current focus on real estate (OZRE). It is worth noting, this wave is itself in early days, which is why we see the most opportunistic projects happening first. Wave 2, The Business Boom, is venture capital investment in OZ businesses (OZB) and is the sweet spot of the program in terms of community/social impact as well as broader scale investor returns. Cherry-picked projects aside, venture capital has the potential to deliver higher ROI than real estate development over time. Wave 3, The End Zone, is when OZB and OZRE together deliver on the full promise and ambition of OZ. At that point, OZRE will have slowed and be possibly even be overbuilt, OZRE construction projects will be coming ready for occupancy, and they will need tenants who can pay rents/leases that justify the increase in basis required by OZ regulations. The best source of such tenants ideally will be successful, fast-growing companies and the supporting infrastructure (places for employees to live, eat, and shop) that will have been fueled by OZB investment (wave 2).
Fortunately, waves 1 and 2 do not need to be sequential, and wave 2 has already begun. The only reason OZB is wave 2 is because it has had a slower start than real estate investment. When OZ was passed in January 2018, it was essentially seamless for the big money real estate firms and funds to begin OZ development projects. It was also fairly straightforward for Treasury to issue regulations around OZ real estate, in October 2018. Real estate investment in OZ thus could move forward with the momentum of “business as usual” and in large-scale projects.
By contrast, regulatory guidance for OZ business investing was not released until April 2019, and it’s complex. In addition, unlike large real estate funds and developers, the big money players on the business side, the large VC and private equity firms, are not moving swiftly into OZ. Over the past decade, venture capital and private equity have moved away from the kind of early-stage, smaller investments that OZ startups require. They will wait to invest larger amounts in later rounds, when winners have emerged. OZ business growth will be seeded by specialized OZB funds focused on creating winners from the ground up.
We believe the good news is that this “OZ Movement” has started. Funds are being created around the country, many by repeat entrepreneurs who are networked into communities and a range of industries. We personally have been helping a number of great OZB funds prepare for a launch. Examples: a mission-driven, minority-founded impact fund in Baltimore, Maryland; a food hall for first time chefs in Houston, Texas; OZ-incubators™ in Manchester, Connecticut and Los Angeles, Berkley, and Oakland, California; a fund to build 5G towers in OZs across the country; a fund to invest in outdoor/recreational companies in Colorado; a consortium of snack foods companies in Danville, Illinois; a clean-tech HVAC plant in Richmond, Virginia; and a group of housing restoration contractors in Atlanta, Georgia. Hundreds more are out there, not open yet but underway. Some of these are wave 2; some are even the earliest signs of wave 3, thoughtfully developing business and real estate together. As more entrepreneurs, investors, fund managers, and communities realize what is possible to accomplish with OZ, these waves will build. Eventually, they will dwarf the early opportunism of wave 1.
Importantly, there are many good players out there, committed to delivering on the promise of OZ to drive attractive tax-free returns for investors and real, sustainable social and economic impact in low-income communities. It’s up to us not to let OZ become nothing but a tax break.
Brian Phillips is a serial entrepreneur and the Managing Partner of The Pearl Fund, a pioneering qualified opportunity zone venture capital fund. He is a well-regarded speaker and thought leader on Opportunity Zones. Follow him @thepearlfund