I recently wrote about the calls we get from people wanting to start Opportunity Funds. We also hear from people who have projects in hand, located in Opportunity Zones, and they are looking for Opportunity Fund money. This post is for them.
If you have a project in an Opportunity Zone that you think can be funded with Opportunity Fund money, consider the following:
1. Do you have an Original Use or Substantial Improvement Project? Opportunity Funds may invest only in projects that satisfy the Original Use Test or the Substantial Improvement Test.
“Original Use Test”. To satisfy the Original Use Test, the original use of the property in the Opportunity Zone must commence with the Opportunity Fund. For example, the Opportunity Fund purchases raw land and constructs a hotel. There was no economic use of the land or the building materials until the Opportunity Fund built the hotel, and so the hotel satisfies the Original Use Test.
“Substantial Improvement Test”. To satisfy the Substantial Improvement Test, the Opportunity Fund must invest (within 30 months after acquisition) an amount equal to the Opportunity Fund’s basis in the property on the date of acquisition. For example, the Opportunity Fund acquires an old hotel building for $3.0m, and invests an additional $3.1 m (bringing total invested amount to $6.1m) to renovate the building and re-open it as a hotel. The Opportunity Fund’s basis on acquisition was $3.0m, and it invested an additional sum in excess of it’s acquisition basis, and so the renovated hotel satisfies Substantial Improvement Test.
An error I commonly see is the belief that an existing operating business located in an Opportunity Zone will make a good Opportunity Fund investment. For example, I received a call from the owner of an excellent light manufacturing business in an Opportunity Zone, who was wondering if a sale to an Opportunity Fund might be a viable exit to allow his retirement. I explained to the caller that his business probably would not satisfy the Original Use Test or the Substantial Improvement test, and so it was unlikely an Opportunity Fund would be interested in it. The drafters of the Opportunity Fund/Zone law had their heads screwed on right. The law allows for tax advantages only if the money invested in the Opportunity Zone creates positive change – either by creating a new business, or by substantially improving an existing one. Just investing money in an existing business in the Opportunity Zone doesn’t cut it.
2. Is Your Project a Good Economic Investment? Opportunity Funds will be evaluating projects in Opportunity Zones with the same risk-reward glasses that any investor uses to evaluate investment opportunities. Yes, the Opportunity Funds are captive investors which must put the money they have into an Opportunity Zone. But the Opportunity Funds still will be shopping hard for good investments, and with some 3000+ Opportunity Zones, there are going to be a heck of a lot of viable projects to look at. So if you want Opportunity Fund money, your project will need to have economic fundamentals that compete well with the rest of the Opportunity Zone projects across the country.
Are the Opportunity Funds going to favor low-risk/low-return projects? Or will they take on more risk in exchange for higher return? Ultimately history will answer this question; but my theory is that there will be demand for investments along the entirety of the spectrum, from low-risk/low-return to high-risk/high-return. There will be taxpayers with gain who want to invest in high-risk/high-return Opportunity Funds. And there will be taxpayers who want to invest in low-risk/low-return Opportunity Funds. Opportunity Funds will be created to meet all of this demand, along the entirety of the risk-premium spectrum,
3. Is Your Project Packaged Well? Everything sells better when packaged well, and this goes equally for Opportunity Zone projects. Each type of project will require different packaging, but in all cases the goal is to explain what the project is, why it is a good idea, and how the financial model works. Opportunity Funds will care little how the project helps the community, so don’t spend much ink on that. Opportunity Funds are going to look at Opportunity Zone projects the same way investors look at all other investments – information, risk and reward. The only difference is going to be that Opportunity Funds will pick their projects from a more limited pool – i.e. projects located within Opportunity Zones that satisfy the Original Use or Substantial Improvement Test.
At this point I foresee two key differentiating characteristics between Opportunity Fund projects and non-Opportunity Fund projects. First, Opportunity Funds will favor projects with lifespans in excess of 10 years, due to the 10-year hold requirement for tax avoidance. Second, Opportunity Funds will have a disproportionately strong preference for projects that have experienced and proven local teams, because professionals local to, and knowledgeable about, Opportunity Zone projects will be in short supply by the very nature of most Opportunity Zones.
Opportunity Funds will be shopping for your Opportunity Zone project soon. If you have an Opportunity Zone project to pitch, use this down time as the IRS develops its regulations, to prepare and package your project for sale to an Opportunity Fund.
Questions? Contact us by email to info@Opportunity-Funds.com.