Patient capital and risk tolerance could yield high returns in Opportunity Zones

Billions of dollars in equity are laser-focused on Opportunity Zone investments across the US

But with thousands of potential targets, what locations have the potential to outperform the market?

Opportunity Zones were created as part of the Tax Cuts and Jobs Act of 2017. The policy move used a carrot – preferential tax treatment – to incentivize investment and job creation in distressed communities. In order to free up capital that may otherwise remain ‘locked up’ by investors hoping to avoid capital gains tax, the Opportunity Zones program allows the temporary deferral of taxes on previously earned capital gains. Those previously accumulated capital gains will remain sheltered within the Opportunity Fund until the end of 2026, or when the asset is disposed of. The program also offers a basis step-up of previously earned capital gains invested, and the permanent exclusion of taxable income on new gains for investments held for at least 10 years. Local governments across the country were quick to jump on board to get their census tracts on the official list of designated Qualified Opportunity Zones (QOZs). The result is a broad canvas of potential investment locations spanning 8,762 QOZs in all 50 states, the District of Columbia and five US territories.

The Treasury Department’s stated goal for the projected 10-year life of the program was to attract $100 billion in equity. Industry data shows a solid track record of fundraising success that is moving closer to that goal. According to the National Council of State Housing Agencies (NCSHA), there were 248 total funds that had raised $50.2 billion in equity as of February 27, 2024. More than half of those funds, 56%, are targeting investment in affordable housing and community development.

To put the scope of Opportunity Zones into perspective, designated areas represent 12 percent of all census tracts. Given the significant size of that investible universe, Altus Group dug into the data to discover which QOZs offer the potential to outperform the market by using the Market Insights – premium edition’s machine learning outputs to put a spotlight on specific tracts.

Our OZ analysis methodology

For a peek behind the curtain, our methodology looked at Net Operating Income (NOI) growth projections on a fair market basis for multifamily and industrial investment properties for one and five years. We applied a filter to identify properties located in census tracts with Opportunity Zones to identify those locations that were performing above average. What we found in that exercise is a sample of specific cities that have both multifamily and industrial properties that are performing above average in Opportunity Zones with above-average growth projections for NOI.

We also looked at the alpha and beta, which is derived from deploying the capital asset pricing model against returns. Using the NCREIF Property Index, we trained the capital asset pricing model to identify the risk-free growth rate beyond the benchmark, as well as the degree of risk. Effectively, we isolated the MSAs that had a positive alpha or outlook for greater risk-adjusted growth than the benchmark, as well as considering the beta. A beta of one moves in tandem with the market, while a higher beta suggests greater risk or variability and lower beta is less risky.

It's also important to note that it is not an entirely level playing field. Some states offer additional incentives that a developer or sponsor can stack on top of Opportunity Zone benefits. For example, a number of Opportunity Zones overlap with Low-Income Housing Tax Credit (LIHTC) in Qualified Census Tracts (QCTs). Maryland and California are examples of states that offer additional tax credits and grant programs for qualifying developments and/or job creation in Opportunity Zones.

Spotlight on Opportunity Zones with upside potential

While the selection of Opportunity Zone markets may vary according to a variety of factors based on investor interests, the markets identified below have positive alpha, moderate or low beta, and a greater likelihood for NOI growth over the next one to five years, according to Altus Group’s proprietary machine learning models.

Phoenix MSA

• Statewide, Arizona has 169 QOZs, including 84 in Maricopa County and 28 in Pima County. According to Novogradac, Arizona ranks #2 in attracting Opportunity Zone capital with nearly $2.3 billion in capital that has been raised.

• Altus found 88 QOZs in the Phoenix MSA that have above-average projections for one and five-year NOI growth on multifamily assets.

• The Phoenix MSA in general has an alpha of 4.9% for multifamily assets. In other words, you can expect your returns to be 4.9% higher than the benchmark returns. The beta is slightly higher than 1 at 1.7 (largely due to growth that has occurred over the past few years that has outpaced market growth), which implies slightly higher risk but also greater potential for growth.

Riverside-San Bernardino MSA

• California is home to 879 Opportunity Zone census tracts across 57 counties. The state also offers the added advantage of being able to stack different tax advantages, grants and incentive programs on top of QOZ projects.

• The Riverside-San Bernardino MSA has 102 Opportunity Zone census tracts where the growth projection for one and five years for multifamily NOI is better than average. Riverside-San Bernardino MSA has a 3.8% alpha for one and five-year growth projects for multifamily. It also has a 1.4 beta, which makes it slightly more risky than average.

• The city has good demand for multifamily due to high costs in other areas, such as nearby L.A. and Orange County, that are pushing families further out in search of safe, affordable housing options near good schools.

• Analysis of industrial projects in the Riverside-San Bernardino Opportunity Zones showed an overall average of flat alpha and flat beta, which means it will move in tandem with market benchmarks on returns. However, 58 of the 102 Opportunity Zone census tracts showed above-average growth for NOI in both one and five years.

Florida

• Florida features a total of 427 QOZs that are located in every county in the state.

• The Miami MSA is home to 48 Opportunity Zone census tracts where there is above-average net operating projected income growth on multifamily for the next one and five years, based on Altus Group’s machine learning models. Multifamily has an alpha of 3.3% and a beta of 1. Those census tracts also include the cities of Fort Lauderdale and West Palm Beach.

• The Tampa MSA has 40 Opportunity Zone census tracts that show industrial NOI growth for the next one and five years that are well above average. Industrial shows an alpha of 3.2% and a beta of 1.

Maryland

• Maryland has at least one Opportunity Zone in each county and an overall total of 149. The state also offers enhancements to several of its economic development tax credit programs for businesses located in Maryland Opportunity Zones that meet certain requirements. The enhanced tax credit programs are generally tied to job creation within those zones, such as its Job Creation Tax Credit Enhanced Credits, Biotechnology Investor Incentive Tax Credit (BIITC) and Maryland Innovation Investment Tax Credit (IITC), among others.

• The Baltimore MSA has 24 Opportunity Zone census tracts.

• Industrial shows good above-average NOI growth with a 3% alpha and a beta that is less than 1, for lower potential risk associated with industrial investment.

• Investors interested in Baltimore Opportunity Zones should move quickly to take advantage of their state program, as deadlines are fast approaching.

Texas

• The state of Texas has 628 designated Opportunity Zones.

• Austin has 28 Opportunity Zone census tracts that Altus has identified for above-average multifamily NOI growth over the next one and five years. Multifamily has an alpha of 2.1% and a beta of 1.2.

• San Antonio also has 28 Opportunity Zones that are projected to have above-average NOI growth over the next one and five years, with an alpha close to 2% and beta of 1, which implies that the market is no riskier than the overall benchmark

Salt Lake City MSA

• The state of Utah has 46 designated Opportunity Zones.

• Salt Lake City has 15 Opportunity Zones that have above-average projections for 1 and 5-year NOI growth.

• Salt Lake City industrial alpha is 1.0% and beta of .75 for expected returns above the benchmark, with somewhat lower risk.

When the Opportunity Zone program was first introduced, there were a lot of skeptics who were quick to point out the potential downside. However, the program has worked. Investments into opportunity zones has helped to bolster underserved communities by creating needed housing and jobs. In addition to the positive social and economic impact on communities, developers and fund managers can leverage the available data to better choose where to invest that can drive favorable results for their investors.

Selecting Opportunity Zones that can deliver above-average results is always a priority, but it is even more important in the current high-interest rate environment that is putting downward pressure on risk-adjusted returns. Boosting the return profile to offer incentives beyond tax advantages is attractive for all stakeholders. The biggest reward, as you might have guessed, comes to those who are willing to deploy patient capital, and keep their investments for a longer period of time. However, it is important to note that Opportunity Zone investments demand a certain risk tolerance; even though the city/sector combination may have moderate beta, the specific location for an opportunity zone may be riskier than other areas in a city. Fortunately, Opportunity Zone investors are typically familiar with the underserved areas in which they invest – with boots on the ground, an understanding of the surrounding community, local partnerships in place, and patient capital, Opportunity Zone investments can offer an incredible ROI over the long run.

Although the Opportunity Zone program is scheduled to sunset at the end of 2026, designated Opportunity Zones remain active until 2047. It is also possible that new legislation could be introduced to extend the program in some form beyond 2026 for new investment.