Its critics repeat a now-familiar charge: that the initiative doesn’t provide the social impact it purports to. This, they argue, is due in large part to the fact that funds are flowing toward real estate projects and not operating businesses that create jobs and wealth in undercapitalized communities.
While it’s true that real estate transactions have made up the bulk of projects thus far, it’s not the whole truth. In a survey of NES Financial clients and prospects, for example, half of all new fund types in the second quarter of 2020 were focused on operating businesses.
Understanding why real estate transactions predominated the first two years of the OZ initiative is therefore essential in painting a full picture of OZs’ impact. It is not, as some would have you believe, simply about greed and corruption. Rather, it’s about how OZ rules have been developed.
For instance, when the initiative kicked off in 2018, initial guidance dictated that a significant majority of operating business activity needed to be transacted within the Opportunity Zone itself. This is intuitive if your operating business is, say, a barbershop, or a laundromat, both of which likely serve primarily local clients. But for companies selling products online or to those who live outside the OZ — or who may look to import raw materials from other areas for use in their products — the rules were unclear.
Eventually, a subsequent round of guidance provided clarity by addressing gating issues that were limiting OZ-incented investment in operating businesses, and clearing up unclear tax guidelines related to the start-up, operation, and wind-down of a qualified opportunity funds (QOFs). Yet this evolution — from confusion to clarity — speaks to the challenges inherent in any new initiative of this size and scope. We should remember that, for all the discourse surrounding it, the OZ initiative is still relatively nascent: announced at the end of 2017, OZ census tracts weren’t even defined until the second quarter of 2018; IRS guidance, meanwhile, wasn’t finalized until December 2019, and several different phases of guidance were rolled out during that initial 18-month period.
In this context, to judge the initiative’s efficacy with operating businesses as a resounding failure feels misleading. Even despite the short runway and problematic rules, operating businesses — and operating business/real estate hybrids — did come to fruition; Arctaris Impact Investors, for instance, recently announced a $40 million commitment to invest in the revitalization of Erie, PA’s downtown corridor.
The long-term nature of the initiative also supports investment in operating businesses. As Steven Glickman, co-founder of the bipartisan public policy organization Economic Innovation Group, noted in late April, “Real estate has a natural cap on returns, making it unlikely for funds to have more than a two to four times multiplier over 10 years. That’s not the case for operating businesses. This may be the heyday for operating business investment. We’re already seeing a movement toward that.”
At the end of the day, however, the best way to tell whether any OZ projects — real estate, operating businesses, or otherwise — are having a positive social impact is actually to measure it. Though even as legislators agree that such measurement is needed, they have yet to pass a bill that mandates funds to do so. This not only opens the door for the type of criticism we’ve seen of late, but sows concern among OZ fund managers and investors, who fear that measuring impact themselves will be an added burden.
While the latter group may have been mostly right just a few years ago, this is no longer the case today. With a partner focusing on specialty finance administration, fund managers can easily track and measure impact – using a framework like the one developed by Howard W. Buffett as part of an automated technology platform or the OZ Reporting Framework from the U.S. Impact Investing Alliance, the Beeck Center and the New York Fed.
Measuring impact will not only save OZ participants time and money. By demonstrating tangible, data-driven results — what it has achieved, where it still needs improvement — it will also help further immunize OZs to critiques like those raised above.
Ultimately, effectively measuring impact will go long a way towards preserving this vital initiative — now, and during the difficult economic recovery to come.
Reid Thomas is chief revenue officer and managing director, NES Financial, a JTC Company.