To date, a majority of Qualified Opportunity Zone directed funds have been committed to real estate related projects including affordable housing, commercial or residential real estate, and mixed-use developments.
We expect the investment mix in QOZ to change in the near future to include direct investment into companies in QOZs. We believe many current QOZ investors are seeking to diversify their QOZ allocation and venture investors are just now beginning to catch on to the benefits of QOZ investing directly into small businesses. Currently, less than 1% of QOZ funds are exclusively reserved for investments into small businesses (less than 500 employees) after excluding for construction and real estate firms. We believe as funding pours into QOZs and the number of both residential and commercial developments surge, the risk/reward profile for real estate investing versus direct investing in companies will shift in favor of direct investment in companies located in QOZs.
Opportunity Zones contain over 24 million jobs and 1.6 million businesses. Over six thousand businesses located in opportunity zones are categorized as “prime growth businesses” and are accepting funding for expansion and growth. Despite such strong economic activity within Opportunity Zones, an average of 31% of prime-aged adults are not working, compared to the national average of 22%.
The expansion of small businesses located within Opportunity Zones is vital to the direction and mission-driven initiative of Opportunity Zones. Small businesses have generated 64% of net new jobs created over the past 15 years, according to the U.S. Small Business Administration (SBA) Office of Advocacy. Small businesses also account for 47.5% of total US employment. Certainly, the recent effect of COVID 19 on small businesses cannot be overstated. Capital allocation to small businesses located in QOZs at this moment is critical to their survival.
Despite the outsized share of QOZ investment in real estate, small businesses operating in the Construction and Real Estate (Rental and Leasing) Industries only account for 6.5% of total employment within small businesses. Which begs the question – If the majority of QOZ directed funds end up in the real estate, are QOZ directed funds too concentrated in these sectors to make the idealized and desired effects of the Jobs Act of 2017?
“There have been lots of QOZ properties retrofitted and ready to go here in the Erie, Pennsylvania, area for example. Still, it can be quite difficult to get small businesses in the door of these facilities if these companies can’t find access to funding. QOZ investment can be critical to the success of a small business in an Opportunity Zone,” said Duane Clement, CEO of Erie-based Data Inventions, a company that specializes in IoT software and analytics for the discrete manufacturing sector. “I think the real estate investors are realizing this too because the value of their real estate will only increase if the businesses in their building can thrive and the whole ecosystem can thrive.”
Mr. Clement is in the process of closing a Series A investment round for his business and is expecting nearly half of the round to come from QOZ investors dedicated to the Erie business ecosystem. For some of Mr. Clement’s investors, this will mark their first QOZ investment that is not real estate related.
“For the real benefits of the Opportunity Zone program to be realized (including job creation and increased business opportunities) money has to funnel into businesses that will substantially increase employment in QOZs,” said Pandwe Gibson, CEO of Ecotech Visions, outsourced manufacturing, and maker space company strategically placed within opportunity zones. She believes investments to date in QOZs have yet to have a material benefit for the communities they are intended to serve.
“Until Opportunity Zone investors as a whole begin investing in small businesses to fill those real estate spaces, job creation is not going to happen,” said Dr. Gibson.
Ecotech has a mission of supporting businesses located in Opportunity Zones with green manufacturing, situating the company directly at the convergence of a national debate on social justice and climate change. Ecotech has committed to buy the facility spaces they plan to build out nationwide in order to serve its customers in Opportunity Zones, making the company an attractive hybrid investment opportunity for real estate and venture investors alike.
“Now more than ever there has to be a concentrated effort to bring opportunities and growth to low-income areas. Funding small businesses not only in centers that have access to capital but those that don’t is how we make a more equitable society,” said Dr. Gibson. Investors are taking notice. Ecotech has recently received a commitment from a venture fund interested in leading an equity financing round through an Opportunity Zone vehicle.
The passing of the Tax Cuts and Jobs Act passed in 2017 introduced Qualified Opportunity Zones that entice investment into distressed parts of the country by offering long term tax benefits on realized capital gains. The program allows investors who have tax liabilities on incurred capital gains to delay taxation until December 31st, 2026, or when the Qualified Opportunity Fund sells. If the fund is held for:
- 5 years, 10% of capital gains deferred is eliminated
- 7 years, 15% of capital gains deferred is eliminated
- 10 years, there is the elimination of the gain on the QOF investment from any increase in value over the term of the investors holding period
While the program was never implemented solely for real estate investors, it makes sense that investors in this asset class were first to take advantage of its benefits. Capital gains are needed in a given tax year that is eligible to roll into a new investment in order to claim the tax benefits of a QOZ investment. This means capital by an investor was already “at-risk” and turned a nice profit. The tendency for many investors once a profit is made is to seek to “park” their gains somewhere safe with the least tax impact as possible. Real estate as an asset class can be an attractive fit for this kind of investor.
How then do we get investors excited about investing directly into small businesses in underserved communities? The answer may lie within the venture community. Venture capital firms for the most part have not yet been creative about structuring QOZ venture funds. Many have recently made pledges or constructed specific vehicles to invest in women and minority-owned businesses. It is not a stretch to encourage them to make those investments in communities that need it most, particularly when there are tax benefits to be had.
“We find most corporate, institutional, and high net worth individual investors get excited about QOZ investing once they understand the benefits and the rules around the program. We find the greatest resistance comes from a fear of unintentionally doing something wrong that ends up generating a tax burden,” said Steve Smith, Head of Growth Equity Investing at CapZone Impact Investments, a firm that advises and structures QOZ vehicles for its clients as well as provides due diligence on QOZ investment opportunities. “The investor clarity and breadth of opportunity within QOZ has been greatly improved even within the last 12 months. We see this as good things to come for QOZ investors and the businesses their capital can support.”
“Opportunity Zone Fund Directory.” NCSHA, 28 Aug. 2020, www.ncsha.org/resource/opportunity-zone-fund-directory/?pagenum=2.
“Small Business or Big Business – Which Creates More Jobs?” Factor Finders, 5 Mar. 2020, www.factorfinders.com/small-business-job-creation-vs-big.
“Investors.” Opportunity Zones – Investors, opportunityzones.hud.gov/investors.
“Opportunity Zones Facts and Figures.” Economic Innovation Group, eig.org/opportunityzones/facts-and-figures.