As cities consider how to engage private capital to attract its share of the $6 trillion of potential capital gains in the stock market for OZ investment, the one refrain that should echo in their thoughts is that “scale matters.” The scale of potential projects will influence the type and nature of interested investors but also the impact and support of the project from the community at large. Most cities are focused almost exclusively on single asset projects – private transactions sponsored by professional investors where the city works to help attract additional capital to complete funding. Smart cities need to develop a multifaceted strategy that includes single asset projects but also includes master planned, large scale projects down to community development, neighborhood scale investments.
The OZ legislation allows for investments at any size – from $5,000 to $50 million or more. Because the regulations took some time to be clarified and they mimic, in many aspects, that of New Market Tax Credits, much of the OZ investment to date has been real estate oriented and focused on multifamily and mixed-use projects in census tracks that have already become investment targets of private capital. For cities to encourage investments in census tracks that have suffered long stretches of disinvestment, municipalities will need to look to larger, planned areas as projects that couple multiple single asset projects centered around public investments that reduce private capital risk and enhance return.
Cities also need to develop a strategy to encourage investments at the other end of the scale spectrum - neighborhood and community scale investments. Given the current bias towards real estate deals, it is easy to understand why most cities may have overlooked community scale projects. But there are some key advantages to promoting investments at this scale. Firstly, community scale investments do not require professional or accredited investors and therefore encourage broader participation. Secondly, this scale of investment can have a more immediate and direct impact on the economic growth and social equity of a neighborhood.
One of the open secrets of OZs is that the nature of OZ transactions is private and only requires nominal involvement, if at all, of local government rending municipalities blind to much of the ongoing activity. As such, local governments must make their involvement a necessary ingredient in order to both collect data on transactions and to ensure that projects address critical city concerns of increased resilience and social equity. Cities must provide some added value to the process for private investors and/or help to reduce risk or enhance return to successfully nudge themselves in the middle of these transactions.
EARLY STAGE OZ INVESTMENTS: BUILDING A PROSPECTUS TO SUPPORT PRIVATE TRANSACTIONS
In an attempt to be relevant, the most aggressive cites are currently preparing a marketing prospectus designed to highlight local OZ transactions and their capital requirements for completion. Those cities and regions that have developed a prospectus or that are in the process of doing so are in the top quartile of performers, but this status will be temporary as the industry moves beyond the early stage of investment ready projects.
Cities are focused on single asset projects because these are the projects that are “investment ready” at this time. A prospectus helps secure gap funding for what are mostly private transactions. There was some urgency to close transactions before the end of 2019 to take advantage of the 7-year tax reduction benefit, but most investors only calculate a 1-2% gain between the 7-year and 5-year tax reduction benefit.
INTERMEDIATE STAGE 2020-2022: SCALING UP OZ INVESTMENTS
As we move from early to intermediate stage OZ investments, investors will rely on municipalities moving conceptual, larger scale projects to investment ready status to generate a pipeline of investable assets. The most compelling projects will combine three elements to optimize potential OZ deal offerings: 1) identify specific investment strategies related to the targeted projects; 2) commit to completing pre-development activities that either support targeted projects such as infrastructure improvements and/ or build capacity to complete transactions such as technical assistance and training and; 3) clearly outline incentives in exchange for municipal deal requirements. The financial calculus that makes a project “fundable” will usually require some incentive in addition to the opportunity zone benefit.
Cities hoping to attract OZ capital will need to create a plan to secure pre-development funding activity from county, state, federal and/or philanthropic sources. Despite a municipality’s limited funding ability, many pre-development activities have a double benefit. First, this form of public investment can serve as an OZ investment in and of itself as long as it has an associated revenue source such as a fee, toll or public lease. Secondly, the pre-development project can serve as a catalyst that encourages follow on investments.
LATE STAGE OZ INVESTMENTS: COMMUNITY SCALE INVESTING
As the industry moves to the third and late OZ investment phase, cities will need to develop a holistic operating investment strategy. Operating investments favor smaller scale, community level investments. There are a series of possible operating investments to both encourage new venture business as well as to provide expansion capital for existing business that can be pursued. Many of these operating investments will also include real estate components that will provide investors the best of both worlds – the stability of real estate assets with the unlimited upside of the operating investment. A robust strategy to attract operating investments can provide a boost to local entrepreneurship and job creation. The most successful strategies will contemplate an exit strategy at the outset.
Scale matters. Right now, single asset projects reign king or queen as they are most likely to be “investment ready,” but cities must begin planning to create a pipeline of projects at a larger, master planned scale now to be ready for future OZ investments. At the same time, municipalities need to aggressively pursue smaller, community scale projects that more immediate address local needs and demonstrate the tangible benefits of the OZ legislation.