When the Qualified Opportunity Zone (QOZ) guidelines were created under Internal Revenue Code sections 1400Z-1 and 1400Z-2, many astute investors took notice of the set of capital gains tax incentives offered exclusively through this new investment vehicle — and the number of Qualified Opportunity Funds (QOFs) that have since cropped up.
But despite the number of investment choices, critical questions remain for investors. What is the ideal manner in which to structure a QOZ investment? What type of QOF should I invest in? Should I start my own QOF, or is it better to rely on the expertise of an outside fund manager? Am I better off investing in a single-asset fund, or a multi-asset fund?
It’s up to each investor to determine for themselves whether setting up their own self-certified fund or investing through an externally-managed fund is most appropriate for them. As an experienced operator, we understand that high barriers to entry due to legal costs, capital commitments, operational experience, and compliance requirements render self-certification a prohibitive avenue for many.
As such we’ll look at a fundamental structural question for those comparing various externally managed funds:
Is it better to invest in a single-asset or multi-asset opportunity fund?
Why We Believe Multi-Asset Funds Reign Supreme
As single-asset fund operators tout, structuring a multi-asset QOF is not an easy task, and in many cases, it’s not straightforward. But despite the added administrative effort required, we believe the unique benefits offered by multi-asset funds can outweigh the administrative burden if managed properly.
To quote the Economic Innovation Group, the independent think tank that spearheaded the initial legislation that effectively made QOZ investing possible:
Multi-asset funds are imperative so that investors can spread risk across multiple zones, investments, and asset classes.
Morrison and Foerster partner Mark Edelstein echoed this sentiment when speaking with Bisnow:
[Investors] are wondering, ‘Who’s managing the fund to comply with all the rules?’ That’s such an important part, and if it’s my money that will either go towards one developer trying to get something built in Jersey City or a massive fund manager with history and expertise, I’m going to gravitate towards that fund, no matter how trustworthy I find that one developer.
But beyond opinions, let’s look at the empirical evidence.
According to NCREIF data, closed-end value-add real estate private equity funds, as tracked by the CEVA index, registered total net returns above 13.8% over the five-year period ended 2018Q2, compared with under 9.8% total returns for direct private real estate investments, as measured by the NPI index, which tracks property-level returns.
Moreover, we believe diversified funds may offer higher risk-adjusted return potential through exposure to numerous property types, markets, and property-level variables.
The Challenge Around Multi-Asset Funds
But while the empirical findings on multi-asset funds are compelling, since the passage of the QOZ legislation, many operators have struggled with how to offer a multi-asset fund under the statute’s unique parameters.
For some time, questions remained around whether there would be viable mechanisms for the disposition of assets within a multi-asset fund, and whether a comingled fund structure would inhibit the ability of diversified offerings to rotate or churn assets into and out of their portfolios without triggering a taxable gain recognition.
On top of this, structuring a QOF to acquire multiple assets may increase compliance complexity due to the biannual 90% qualifying asset test mandated under QOZ regulations. This added complexity may be prohibitively burdensome for fund managers who are lacking the resources and critical reporting experience needed to maintain compliance.
How Fundrise Aims to Outsmart the Smartest (Institutional) Funds
That said, our team at Fundrise found a viable way to implement a fund structure that we believe maximizes tax efficiency and reduces compliance risk without requiring investors to sacrifice diversification.
Unlike many other QOZ funds, we have chosen to structure our QOF as a REIT. Multi-asset funds structured as non-REIT partnerships still face uncertainties surrounding permissible exits. By contrast, the most recent round of proposed regulations released by the IRS provides clear guidance for REITs.
This round of guidance outlined a much clearer exit strategy and mechanism that funds which have elected REIT status can use to distribute disposition proceeds to investors: through capital gain dividends. Moreover, this guidance clearly allows for asset churn, provided that disposition proceeds are redeployed within 12 months. This means that in addition to providing potentially higher returns at a reduced level of risk, multi-asset funds can also put their funds to work repeatedly, redeveloping or constructing numerous properties, and potentially realizing even stronger returns.
It’s important to note that QOFs with a REIT structure may still trigger a taxable gain recognition through the sale of a constituent property. However, it may be possible to avoid that recognition (and the corresponding disbursement) of capital gain within a REIT structure through alternative acquisition routes, such as a 1031 exchange.
Finally, REITs are poised to benefit from the new 20% deduction for Qualified Business Income enacted through the Tax Cuts and Jobs Act. Combined with our ability to leverage accounting tools such as the deduction for depreciable real property, this should enable us to maximize the tax efficiency of our Opportunity Fund, and help investors earn potentially better net returns.
Hence, multi-asset REITs offer a way for Opportunity Zone investors to:
- Lower risk through diversification across a variety of markets, property types, and strategies
- Boost return potential through the gradated and opportunistic disposition of assets
- Avoid double taxation of income and maximize the tax efficiency of their investment
As a manager of nearly a dozen public non-traded REITs, our experience has taught us both the complexities and flexibilities of this structure, an experience set that we intend to leverage for the benefit of our Opportunity Fund investors.
We’ve also created a bilevel model within our Opportunity Fund’s REIT structure. Under this bilevel model, we invest in a Qualified Opportunity Zone Business (QOZB), which is only required to have 70% of its tangible assets be invested in qualifying opportunity zone business property.
Under this model, the risk of the fund itself failing the 90% qualifying asset test is reduced, affording our team greater flexibility in selecting value-based, high-quality real estate assets that pass our rigorous underwriting standards. This structure also allows for flexibility in the variety of assets that we can invest in, and it helps to prevent foot-fault instances of non-compliance.
Lastly, the bilevel structure enables our fund to leverage the 31-month working capital provision that is currently available exclusively to QOZBs. As outlined in the proposed regulations, this provision allows for an extra 31 months for a fund to deploy its capital without penalty.
Invest the Smarter Way
Ultimately, it’s at the discretion of each investor to determine the fund structure and manager (if any) that is most suitable for their goals. As when considering any new investment vehicle, it’s important to become familiar with the array of available options in order to make a fully informed decision. That said, we would caution against gravitating toward a particular fund structure simply due to the ostensible simplicity of its implementation. While establishing a multi-asset QOF may be complex, for those who understand the nuances of the QOZ legislation and possess the operational expertise needed to fully leverage them, the benefits of a multi-asset REIT structure are patent.
Learn more about the Fundrise Opportunity Fund and how you can invest here.