Opportunity Zones Are Permanent. Investor Demand Will Still Be Cyclical

By Jill Homan and Joseph Darby

President Trump and Congress made Opportunity Zones permanent through the Working Families Tax Cuts (“WFTC”), providing investors and low-income communities with long-term policy certainty and addressing the looming expiration of Opportunity Zones created by the Tax Cuts and Jobs Act in 2017 (“Opportunity Zones 1.0” or “OZ 1.0”). In addition to permanence, the WFTC landmark tax legislation renewed the core incentives and strengthened the benefits available for investments in rural communities.

That achievement creates a durable foundation for Opportunity Zones (“Opportunity Zones 2.0” or “OZ 2.0”), while the pace of investment will continue to reflect capital gains activity, market conditions, and the strength of the projects available to investors.

Simply, Opportunity Zone fundraising is inherently tied to the creation and realization of capital gains. In practice, the potential supply of OZ capital is tied to the equities market, as well as business sales, real estate dispositions, and other liquidity events.

When markets rise, investors accumulate appreciated assets. When they sell those assets, rebalance concentrated portfolios, or complete major transactions, they generate gains that may be reinvested into Qualified Opportunity Funds. When markets decline, investors may have fewer gains, use capital losses to offset them, or simply postpone selling appreciated positions.

OZ 2.0 is permanent, while the capital available to it will remain cyclical.

While the permanency of OZ 2.0 creates certainty for investors, it removes some of the statutory deadlines that helped drive investment into OZ 1.0. At the same time, many investors are evaluating the performance of first-generation OZ projects that were conceived in an unusually difficult economic period.

For OZ 2.0 to succeed, sponsors will need to offer compelling, well-underwritten investments that can compete for capital in today’s more demanding market.

OZ 1.0 had Deadlines that Forced Decisions

The original program’s statutory structure created a powerful incentive for investors to act by certain dates to maximize the available OZ benefits. Under OZ 1.0, an investor received a 10% increase in basis in the deferred gain after holding the QOF investment for five years and an additional 5% after seven years. Because the deferred gain had to be recognized no later than December 31, 2026, an investor needed to invest by the end of 2019 to obtain the full 15% basis increase and by the end of 2021 to obtain the 10% increase.

Those deadlines were built into the statute and directly affected the value of the incentive. Investors entering after 2019 could no longer qualify for the full 15% basis adjustment, and those entering after 2021 could no longer qualify for the 10% adjustment. As a result, the law itself created clear decision points that encouraged investors and advisers to evaluate Opportunity Zone investments before those benefits expired.

The deadlines acted as forcing functions for OZ decisions. Investors, accountants, and wealth advisers had to make investment decisions and reach a decision before a specific date. Funds could organize fundraising campaigns around a tangible tax milestone. The approaching expiration of a benefit created urgency.

That urgency will be weaker under OZ 2.0.

For qualifying investments made after December 31, 2026, the gain is deferred until an inclusion event or the fifth anniversary of the investment. An investor holding the qualifying investment for five years receives a basis increase equal to 10% of the deferred gain; an investment in a qualified rural opportunity fund receives a 30% increase. In effect, the deferral period and basis adjustment are measured from each investor’s investment date rather than from a single program-wide recognition date.

While that structure benefits later investors, it also eliminates the broad calendar deadlines that previously pushed investors to act quickly.

Without that forcing function, sponsors will have to create urgency through the quality and availability of their investments. Advisers will need to make OZ planning a routine part of conversations with clients who are anticipating liquidity events, rather than relying on a one-time statutory deadline to draw attention to the program.

Investors Remember the Difficult First Vintage

The next challenge is that many OZ 1.0 investments were launched under conditions that could hardly have been anticipated when they were underwritten.

A significant number of early OZ real estate projects were modeled in a low-interest-rate environment. The federal funds target range remained at 0% to 0.25% throughout 2021. During 2022, the Federal Reserve raised that range by 425 basis points, ending the year at 4.25% to 4.5%.

That shift matters because long-term real estate deals are highly sensitive to the cost and availability of debt. A project underwritten with the expectation of inexpensive construction financing and an affordable permanent loan may have to refinance into a dramatically different market.

At the same time, many OZ projects began construction during or immediately after the COVID-19 pandemic. Developers faced supply-chain disruptions, labor constraints, volatile material prices, and rapidly changing economic conditions. The Bureau of Labor Statistics reported that input costs for wood-product manufacturing rose 22.6% through April 2021, while output prices rose 44.6%, as demand increased and producers struggled to expand supply.

Some projects therefore experienced several shocks in succession:

• Pandemic-related delays;

• Higher lumber, labor, and construction costs;

• Rapidly increasing interest rates;

• Tighter lending standards and subsequent difficulty refinancing;

• Lower asset values as capitalization rates adjusted; and

• Near-term oversupply in certain property types or local markets.

As tax-incentivized real estate private equity projects, many OZ investments made in this environment accordingly faced the same pressures as many conventional real estate investments. The difference is that OZ investors often committed to a holding period of at least 10 years to realize the long-term tax-free appreciation.

Investors considering OZ 2.0 will remember that experience from a risk-return perspective.

They will ask what happens if construction takes longer, costs rise, interest rates increase, lease-up falls behind schedule, or refinancing proceeds are lower than projected. They will scrutinize the sponsor’s capitalization, both in equity and debt, and their ability to contribute additional equity.

The first generation of OZ investing taught the market that a long statutory holding period does not protect a project from near-term financing risk.

The Required Return May Be Higher Under OZ 2.0

The cost of OZ equity is therefore likely to remain elevated. The other side of the coin is that investors will require the same investment returns, but with more conservative underwriting calibrated to their OZ 1.0 experiences.

An investor considering a new QOF is being asked to exchange a liquid asset (or cash generated from an appreciated asset sale) for a long-term, relatively illiquid investment. That investor must compare the proposed OZ return with other opportunities available in the market.

Today, those alternatives may include preferred equity or “rescue capital” for existing real estate, including OZ 1.0 - projects. These investments can offer attractive current returns and, depending on structure, may sit ahead of common equity in the capital stack. They may also involve assets that are already constructed, leased, or operating, thereby reducing some of the development risk associated with a new project.

A new OZ 2.0 development must compete with those opportunities.

The investor will need to understand the reasons to invest in an OZ 2.0 fund for a ground-up project that carries entitlement, construction, and lease-up risk when that capital can be placed into an existing project at a preferred return. Moreover, the OZ 2.0 fund will need to adequately compensate that capital for illiquidity and execution risk.

The tax benefit remains meaningful, but sophisticated investors will not value it in isolation. Just like OZ 1.0, the deal needs to work. And now it needs to work with more conservative underwriting and the opportunity cost of alternative investments.

This does not mean OZ 2.0 will fail to attract capital. It means that sponsors should expect investors to demand more disciplined underwriting and a clearer risk premium.

A Strong Equities Market is Both an Opportunity and Competition

Elevated equity markets can help OZ fundraising because appreciated securities create potential gains. Investors who rebalance a concentrated portfolio or monetize a long-held position may have a natural reason to consider a QOF.

But a strong equities market can also make it harder to persuade investors to sell.

An investor may hesitate to leave a liquid, appreciating portfolio for a private investment with a long hold and limited distributions (until after construction, lease-up, and stabilization, which could be three years or more). The investor may also believe that remaining in public equities offers a better risk-adjusted return than funding a new real estate or operating business venture.

Thus, the relationship between OZ demand and the equities market is not linear.

Rising markets create embedded gains, but those gains become OZ capital only when investors choose to realize them. Fund managers must reach investors at the moment of realization and present a project compelling enough to justify the transition from liquidity to illiquidity.

From the new administration taking office on January 20, 2025, until August 3, 2026, the S&P 500 is up 26.8%. The embedded returns offer two schools of thought: investors may hold substantial embedded gains, but they also have attractive liquid-market alternatives.

OZ 2.0 will Require Better Fundraising Infrastructure

The absence of a statutory deadline means that OZ fundraising must become more systematic.

Fund managers will need sustained relationships with accountants, wealth advisers, estate planners, business brokers, merger-and-acquisition professionals, and other advisers who know when clients are approaching taxable transactions.

The optimal time for an investment discussion is before the gain is realized or not long after the investor is already deep into their 180-day investment period.

Sponsors will also need credible, continuously available deal pipelines and similar sources of investor capital gains. Investors experiencing gains at different times will not be able to direct into a single project with a narrow closing window. The market may increasingly favor continuously offered funds, multi-asset strategies, or sponsors with several projects at different stages of development.

However, flexibility cannot come at the expense of investment discipline. Investors should understand where their capital will be deployed, how long cash may remain uninvested, and whether the fund is accepting money before suitable assets have been identified.

Permanence gives the industry the opportunity to create an enduring distribution and investment infrastructure. It also places more responsibility on sponsors to generate demand without relying on statutory urgency.

The Underlying Deal Still Determines Investor Demand

Ultimately, investors will underwrite the sponsorship, deals, and market under OZ 2.0 just like they did under OZ 1.0.

The tax incentive can improve the result of a good investment. It cannot transform weak economics into strong economics.

The strongest OZ 2.0 offerings will acknowledge the lessons of OZ 1.0. They will use more conservative leverage, realistic construction contingencies, credible interest-rate assumptions, and sufficient reserves. They will demonstrate why an investor should accept development risk and illiquidity when other capital-market opportunities are available.

Opportunity Zones are now permanent. Investor demand will not be.

The new program removes the expiration risk that constrained OZ 1.0, but it also removes the deadlines that helped motivate investors. OZ 2.0 enters the market as investors remember pandemic-era disruption and continue to face higher refinancing costs and challenges with their OZ 1.0 projects.

To attract capital, OZ 2.0 sponsors will have to offer more than eligibility and tax benefits. They will have to offer investments that justify a long-term commitment in a competitive and cyclical capital market.