Impact Voices | November 13, 2018

Reducing risks by managing for impact in Opportunity Zone investments

John Griffith
Guest Author

John Griffith

Read all of ImpactAlpha’s industry leading Opportunity Zone coverage

Not knowing the impact of Opportunity Zone investments puts communities, as well as investors seeking tax-advantaged returns, at risk. The good news: impact investors have spent a decade building the tools to measure and manage impact, even without a federal mandate. Opportunity Zone, or “OZ”, investors should adopt them.

Since the new tax break was created in December, a flood of real estate, venture capital and impact investors have either launched a fund or are in the process of exploring one. The Treasury Department estimates that the incentive will direct as much as $100 billion in private capital into economically distressed communities over the next decade.

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But will the influx of private investment yield tangible benefits to the people who live in those communities? We may never know. Treasury has yet to require OZ investors to report the number of jobs they create or any other impact metrics, as of the latest guidance published by the agency last month.

Real risks

Starting this year, taxpayers will be able to defer and eventually reduce the capital gains taxes they owe by investing in businesses or real estate developments located in designated OZs.

Some have touted the law as a catalyst for economic growth and job creation in America’s poorest neighborhoods, but few guardrails have been put in place to ensure that OZ investments produce the intended social and economic outcomes. The lack of impact accountability is a missed opportunity for policymakers and others who might want to point to specific outcomes from the OZ legislation in the future. But it also poses real risks to OZ investors and fund managers, including:

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  • Risks to individual deals. The vast majority of OZ investments will be real estate deals, at least in the first couple years of the program. Projects that do not address a clear community need or deliver a tangible benefit to existing residents can be mired by objections from local stakeholders and face other roadblocks, leading to long delays and additional costs. And without clear impact objectives and community input, investors are unlikely to maximize the assets and resources that already exist in these neighborhoods.
  • Reputational risks. Experts have cautioned that the new OZ incentive could accelerate the pace of gentrification and displacement in certain neighborhoods, which poses headline risk to investors—not to mention real harm to families and communities. We’re already seeing early signs of the problem: since the law passed in December, prices for land or properties in some OZs have increased by more than 50 percent.
  • Political risks. Many of the developments that will benefit from the tax break in its inaugural year likely would have been built without the OZ incentive. Unless the program delivers measurable, verifiable and additional impact to distressed communities and low-income families in its first few years, it could be subject to significant changes or even repeal without a strong base of support in Washington.

For these and other reasons, social impact must be a top priority for OZ investments—even though it isn’t required by law. Investors will play a crucial role.

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“Fund managers are much more likely to adopt impact management strategies if investors start demanding it,” said Lisa Hall of the Beeck Center at Georgetown University. The center recently convened 40 real estate developers and investors to discuss OZs. “Many OZ investors will be investing in low-income and under-invested communities for the first time, and mission-driven investors can lead the way by requesting that fund managers consider local community needs, engage local stakeholders, set clear impact goals and establish transparent impact reporting standards.”

Best practice

The nascent OZ market can learn a lot from the impact investing field. Over the past decade, impact investors have developed sophisticated tools and processes for “impact management,” the practice of integrating impact considerations at each stage of the investment process. Responsible impact management puts as much weight on deal sourcing and due diligence as on impact measurement and reporting.

Community development lenders attract new investors to low-income neighborhoods

HCAP Partners, for example, the California-based mezzanine debt and private equity firm, has developed the “Gainful Jobs Approach” to drive employment growth in underserved communities. With each investee, HCAP conducts a qualitative assessment used to set a baseline for workplace practices and then develops a strategic roadmap with year-over-year progress plans to improve job quality standards over the course of the investment. “HCAP’s approach is rigorous, but also readily intelligible to the uninitiated,” wrote Tideline’s Ben Thornley and Bryan Locascio in the Stanford Social Innovation Review.

These impact management practices didn’t stem from a federal mandate. They were driven by market forces—the result of a deep understanding of the importance of reliable impact data for managing risks and meeting investor demands.

“The impact investing movement owes its growth and success to industry leaders reporting data and sharing best practices,” wrote Fran Seegull, Executive Director of The U.S. Impact Investing Alliance, in ImpactAlpha in September. Seegull added that the OZ market will need to embrace similar standards for data and transparency if it ever hopes to “experience a similar surge in interest and capital” and “generate the kind of transformative impact in low-income communities that its creators envisioned.”

Community development lenders attract new investors to low-income neighborhoods

OZ investors and fund managers will need processes and tools for: a) assessing local community needs and developing responsive impact theses; b) screening and vetting potential investments while incorporating input from local stakeholders; and c) collecting, validating and reporting data on job creation and other key metrics. The key is to put in place impact management systems that are rigorous and authentic without being too onerous or expensive to implement.

OZs have the potential to unleash hundreds of billions of dollars into communities that desperately need private investment. But we shouldn’t lose sight of the intent behind the law: improving the economic opportunities and wellbeing of low-income families and communities. If we ever hope to fulfill that promise, investors and fund managers have to start focusing on impact today.

John Griffith is a director at consulting firm Tideline.