My firm recently closed our first $10 million opportunity zone (OZ) fund to build three student housing projects at the University of Illinois. Like many early adopters in a new space, we dove in headfirst with the belief that we would figure out everything we needed to know about establishing and replicating this process the right way as we went. On our journey toward developing our first OZ projects, we learned a few key lessons — both good and bad — that anyone raising their first OZ fund should know.
1. Setup: Hire an attorney you know well who has extensive experience in areas like low-income housing tax credit and new market tax credit funds, and, ideally, who has already set up a few smaller OZ funds for clients. There is a significant amount of reporting and accountability required to take full advantage of the OZ program, so it is critical you hire an attorney who is familiar with the front-end paperwork to establish your fund correctly. This is not an expense worth skimping on, as you will have multiple investors relying on you to know the fund was set up properly. Depending on the size of the fund, you should account for $35,000 to $75,000 in upfront legal work to properly establish it with a qualified attorney.
2. Size: Speak to several respected contacts in the fundraising space to uncover some consistent feedback from them. Start small with an individual deal, and establish a track record of getting it from start to finish while demonstrating you can hit your targeted returns on equity. From there, replicate this same process three to four more times with single, one-off deals, and raise individual funds for each one. The key mistake that groups appear to be making in the space right now is that they are just trying to raise as large a fund as they can without having specific deals earmarked for those dollars. The slow-and-steady approach of doing one deal and one fund at a time is much more prudent, and it will allow you to establish a track record of success that you can leverage down the road without biting off more than you can chew from the start.
3. Structure: Everyone has their structure, but you should consider a very straightforward one based on the industry standard. For example, as the sponsor, we committed $500,000 to the fund to demonstrate our strong belief in the investment and that we are willing to put our own money at risk. The holding period is 10 years, although an investor could exit early without getting the full advantage of the tax benefits. The preferred return is 8%, which is standard, with a 70/30 promote on cash flow and capital to follow after that. Our projected IRR is 20%, which is on the higher end for what we have seen from other OZ investments out there. We also implement a 2% asset management fee for our firm to manage and report quarterly on the property to all of our investors, and set the minimum investment at $50,000. We arrived at this structure after gathering data about the best structure and terms to use for the fund from various contacts we have in the industry who helped us better understand the industry standard and overall investor expectations.
4. Product Type: Investors were attracted to our specific product type (affordably priced student housing at a Tier 1 university) for a few important reasons. They liked that our thesis was built around providing students a quality product at a very affordable price in a market that has a large number of Class A projects. Our familiarity with our product type also blends well with our firm’s backstory, as we have been involved in the student housing and multifamily business for well over a decade now. You should feel confident that you have a strong background in the product type you are working with and your experience in that space will translate to the success of your project. Multifamily and workforce housing, student housing and industrial appear to be the early favorites for OZ investors.
5. Investor Profile: We got this part wrong at the outset, but adjusted course once we realized we were targeting the wrong audience. We originally thought our investor pool would come from larger funds or family offices that had already had pools of capital they were looking to deploy into other projects. What we learned, however, is that our fund was considered too small for many of those groups, and that individual investors with pending capital gains events were a much better fit for the size of our first fund. When you understand your investor profile, seek out online sources including directories and third-party services that enable you to expose your fund to a wider pool of individual investors who are looking for what you are offering.
Like anything you try for the first time, there is no question you will make some mistakes and learn some hard lessons along the way. That said, you will become significantly better prepared for the next several OZ projects in your pipeline, and you can’t reach that position as a firm without digging in and deciding to take your lumps upfront. As we often say internally, it is not the challenge itself, but how you choose to respond to it that will ultimately determine your success.