The Opportunity Zone in PropTech
Of all the areas of innovation that we are following closely in 2020, the Opportunity Zone space is most intriguing, especially at it relates to PropTech.
Before I get into why I think it’s a huge market opportunity, let me share a brief overview of what an Opportunity Zone is.
The Opportunity Zone Program was created as part of the 2017 Trump tax cuts, and it allows investors to pay zero federal taxes on profits from investments made in economically distressed communities as long as the investments are held for at least 10 years. Any capital gains reinvested in an Opportunity Zone fund can also qualify for the preferential tax treatment.
Economically distressed communities are what are known as Qualified Opportunity Zones (QOZ) and across the country there are 8,700 communities identified as such. Over 35 million Americans reside within these QOZ’s.
To receive the tax benefits, investor are required to invest their capital through an Opportunity Zone Fund, which in turn can invest the fund proceeds in either real estate or a variety of businesses. For a business to qualify for an Opportunity fund investment it has to meet the 50% gross income test, which means it has to generate at least 50% of its business income from a QOZ. Below is the direct interpretation of the rule from the IRS website:
“Q. What is the 50-percent-of-gross-income test?
- A Qualified Opportunity Zone business must earn at least 50 percent of its gross income from business activities within a QOZ. It must do so for each taxable year. The proposed regulations provide three safe harbors that a business may use to meet this test. These safe harbors are the:
- Hours-of-services-received test.
- Amounts-paid-for-services test.
- Necessary-tangible-property-and-business-functions test.
Q. Must a Qualified Opportunity Zone business meet all three safe harbors to satisfy the 50-percent-of-gross income test?
- No. It’s enough for a QOZ business to satisfy just one safe harbor.
For example, 50 percent or more of all the hours of services that a business receives and uses were performed in one or more QOZs. This business satisfies the hours test and, therefore, the 50-percent-of-gross-income test.
Second example, a QOF owns a business that operates in multiple QOZs. The business received and used 100,000 hours of services during the year. Of those:
- Employees spent 25,000 hours in QOZ 1.
- Independent contractors spent 20,000 hours in QOZ 2.
- Employees of independent contractors spent 10,000 hours in QOZ 3.
- The remaining 45,000 hours were outside of a QOZ.
This business satisfies the hours test and therefore the 50-percent-of-gross-income-test. The aggregate hours of services in QOZs during the tax year were at least 50 percent of all hours of services obtained by the business in all locations.”
Now that we are all on the same page and understand how a business qualifies as a QOZ investment, let’s go over some of the benefits for the real estate tech community.
What’s the “Opportunity Zone” in PropTech?
Opportunity Zone’s matter to the PropTech community for a variety of reasons.
- PropTech is a natural ally of QOZ: A lot of PropTech startups have received funding from major real estate developers like Tishman Speyer, LeFrak, Moinian, UDR, Hines and Rudin. These developers are well versed in the benefits of tax incentives when it comes to real estate investments so it would make sense that they start seeking tech investments that have an Opportunity Zone component as well.
- Higher Multiples: Investments in tech companies on average generate significantly higher investment multiples than real estate. As of today, only a fraction of all QOZ investments have gone to businesses with the bulk going to traditional real estate investments. This means not enough attention is being paid to the benefits of QOZ businesses which provides a huge market opportunity for investors. As QOZ investors start looking at businesses to invest in, PropTech will look attractive.
- Incubator: For a venture fund looking to set up an incubator or accelerator, QOZ’s provide the ideal setup. In one fell swoop, you can acquire or lease a building in a QOZ, receive the tax benefits, while simultaneously spurring economic activity in a distressed community and meeting your diversity goals by tapping into a new pool of founders from within the QOZ. In addition, the QOZ provides excellent marketing for your venture fund. It helps differentiate your accelerator or incubator from the competition because you provide an additional investment opportunity for companies within the QOZ that incubators outside of the QOZ cannot provide.
- Raising Capital: If you are startup looking to raise funds, being located in an Opportunity Zone or servicing customers in an Opportunity Zone can provide a huge incentive to potential investors, given the tax benefits.
- 8,700 localities and 35 million people: The QOZ landscape provides a rich opportunity for PropTech companies to service the needs of 35 million Americans while generating significant tax benefits to their investors.
If you look at the broader tech ecosystem as a whole, if Uber or WeWork were started today would they initially be launched in QOZ’s? What percentage of their business in the US comes from these 8,700 QOZ communities? Would investors encourage those companies to launch from within a QOZ?
Think about all the delivery and gig apps (from food, home care, housekeeping etc), doesn’t it make sense for these companies to launch or locate in a QOZ if a substantial part of their business comes from there?
How about Insurance and PropTech startup Lemonade, what percentage of their business comes from residents located in QOZ’s, if not a huge percentage shouldn’t the company launch a subsidiary just to focus on this market?
Are construction tech startups like Katerra delivering their services to clients in QOZ’s throughout the US? Are there any new office buildings or apartments being built in any of these 8,700 QOZ’s? I bet there are and are the companies delivering services in these communities QOZ businesses? I bet most aren’t and/or haven’t even looked into it.
I can go on and on listing various businesses and why launching from within a QOZ or servicing QOZ communities makes economic sense.
There is a huge opportunity for existing startups to map out where in the US they generate most of their income and if 50% of their income comes from within a QOZ, they should seek funding from Opportunity Zone funds that are focused on funding QOZ businesses.
For anyone living in a QOZ who is starting a business, look for investors that are targeting companies in QOZ’s and it could be the opportunity for your company to get off the ground while making a difference in your local community.
The amazing thing is that the government encourages people to invest in your startup or company if you meet the needs of the 35 million Americans living in Qualified Opportunity Zones. The whole island of Puerto Rico is an Opportunity Zone.
If done right, Opportunity Zones can be a boon for local communities, entrepreneurs and investors.
This a blue ocean and we are certainly covering the relationship between Opportunity Zones and PropTech in depth this fall at the ASDSummit as part of AnySizeDeals Week 2020 – The Festival of Real Estate Innovation in Las Vegas.
From September 8 – 11, 2020, join the leading real estate owners and innovators at The Venetian Resort in Las Vegas for 4 incredible days of collaborating, networking, dealmaking and sharing insights on the trends transforming the industry.
Join us in Vegas by REGISTERING at AnySizeDealsWeek.com.