AIPIS 261 - Vetting Funds for Opportunity Zone Investments with Mike Zlotnik

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Hey, it's my pleasure to welcome a returning guest back to the show. My friend and our fellow Venture alliance member Mike Slotnick. He runs a hard money lending company. We've done a lot of business together over the years and he also is, I would call him an expert in deal valuation and also running a fund and looking at syndications. And he is a wonky guy that loves looking at the math and loves looking at the numbers and loves analyzing deals and tearing them apart. I send him a lot of deals that come across my desk so he can look at them. And you know, we got to talking recently about opportunity zones and I think this is highly overrated. Now I may be wrong and you're welcome to give me some feedback. Go to jasonhartman.com ask and tell me if you think I am out of my mind. But I don't think I am. We're also going to talk about some deals we looked at recently and how really a lot of these syndicators and a lot of these fund managers are really preying on unsophisticated people, people frankly who are just naive and don't know any better and they take huge management fees, they're making all sorts of mal investments doing deals that are just lopsided deals. We're going to talk about this today and protect you and help you be a better investor and especially a better real estate investor. Mike, welcome back. How are you?

Hi Jason, thank you for having me back.

Yeah, it's good to have great. You know, so we got into a big chat over the last week or so about the promoters out there promoting these opportunity zones and we really did not dive into this pond. Now we have taken a dive into many other ponds over the years. We helped people make a lot of money in the go zone. Back in the day, the go zones were the hurricane affected areas in the Gulf Coast. I personally profited from that on my own investments and so did a lot of our clients. There came a point when they became overvalued because a lot of Money was chasing those tax incentives. And you know, it seems like we have this going on again, but the deal today, the opportunity zones, and you can be a direct investor in opportunity zone properties or you can invest in a fund and you know, I see all the promoters out there promoting it. It's a buzzword. They're probably making a lot of money doing it. But frankly, I think these deals are mostly very overrated and really a bit of a scam. I'll just say it, I don't think they're very good. Maybe I'll see some that make sense and look really good in the future and we might even promote those. But what do you think, Mike?

I think that opportunity zones by themselves don't present a great investment opportunity. What it is, it's a tax advantage. Areas where investors need to be very smart about selecting who they invest with, what type of fund they invest in. And by the way, the language Opportunity zone fund can refer to a fund or can refer to individual deal. In fact, running an opportunity zone fund is very complicated. So the initial sort of thoughts for most people is to run a single asset fund. You can have many investors, it's a pooled money vehicle that raises capital from a number of folks. But invest in a single asset. There's two separate considerations. One is opportunity zone benefits and two, the deal needs to stand as a quality deal of its own with the right sponsor. A lot of problems come from the fact that it's a hype, it's a hot subject and many hot air sponsors taking advantage of this and they're creating demand and they're going to provide subpar product in the space, get capital from investors and most folks don't understand what they're getting themselves into. Investment itself may be pretty bad. The sponsor can fail and the project could fail on top of that. What happens is they have to follow strict compliance with opportunity zone rules in order to take advantage of the tax benefits that are in the tax code. I just wanted to lay out lay of the land. The opportunity zone funds could be a good addition to the normal investment. But if you invest in capital just to take advantage of opportunity zone tax treatments, you may or may not be happy. Most likely you'll be disappointed.

Yeah, I love how you call them hot air sponsors. These are the promoters out there promoting, trying to collect your money to invest in opportunity zones, these hot air sponsors. And so you can do an opportunity zone investment. Now these are tax advantaged investments, although the tax advantage really isn't that great. And we're going to dissect that here, there is a little bit of an advantage, for sure, but it's not, you know, it's not anything to write home about, as the saying goes. So you can invest directly. You could buy properties in these economically disadvantaged areas and have some tax advantages. You can do that directly as a direct investor. Just buy a property and, you know, so forth, and fix it up. And. And now we've also discovered that you have to do an extensive amount of rehab and improvement to the property. So we'll. We'll probably have a chance to talk about that. But you can also do it through a fund. And, you know, you can always do a direct, you know, three basic kinds of investment concepts we're talking about. Okay. In general, right, There's a direct investment where you just buy a property. There's a fund where. Where the fund buys maybe many properties, many assets, and then there's a syndication where it's one deal, it's one asset, but they're bringing on a bunch of investors that's different from a fund. Mike, do you just want to elaborate on that as a general concept, not necessarily applying to opportunity zones, but it does before we dive in a little more.

Sure. So funds, typically, as you mentioned, it's many investors, many assets. That's a general concept. Funds could be many investors. One asset, which is big, essentially a syndication. That's what syndication is. You have, there's an offering memorandum, disclosures, but a single asset. That's the major difference between fund and syndication is they typically pull the money from any investors and fund has many assets, while the syndication is a single asset. And you can do direct property investing, obviously, or you could do fractional ownership. You can be a partner in a single property.

Okay. Okay. So there's about 8,700 opportunity zones around the U.S. again, these are economically disadvantaged areas. Some of these areas may come back and may show some improvement. Some may never come back. You know, there are just some areas that no matter what you do, they just can't seem to come back. So keep in mind, they don't all turn around. Okay. Some areas just sort of never really recover, and they've been in bad shape for decades and will very likely continue that way for many decades. About 90% of these opportunity zone funds must be invested within the opportunity zone itself. Right. Do you want to elaborate on that component?

Sure. So substantially all. Well, that term substantially all yet to be defined. But the rule of thumb is here, is 90% of the opportunity zone funds need to be invested within the opportunity Zone in whatever form, shape. It's either direct investment through a fund and so forth. So these opportunity zones funds, they're limited in their ability to select their targets. It's one of the problems with opportunity zones funds. Promoters, let's call them project sponsors, they raise capital and they need to find deals now within the opportunity zones. Otherwise the fund will be out of compliance. So part of the challenge of running opportunity zone funds is that if you raise the capital, you don't have the deals. Well, money is burning a hole in the pocket. You may not invest in great deals.

This is one of the big flaws of putting your money into these pooled money deals, especially when it's about properties in particular. See, the fund that you run, Mike, is not about properties, it's about loans. And it's easier to get you for a flexible fund easily versus yeah, but here's the thing. You can alternate between loans and properties. And when it's just properties in a tight inventory market where deal flow is constricted, the fund manager will tend to overpay just because they have to deploy the capital. Right, that's what you were just alluding to. That's a real dynamic, isn't it?

Yeah, exactly. Depending on type of fund and depending on liquidity of the fund and the capital that's sitting idle, fund managers may be compelled to make investments that are not otherwise great. Our fund is a diversified fund. We have a broad portfolio and we raise just enough capital so we can deploy it in a good manner. Opportunity zone will be a little bit trickier because they start from scratch. Any fund that starts from scratch has this capital utilization problem where they're going to raise capital and they got to put it to work. Have they found good number of deals that meet the criteria of the fund? And that's the issue. It's a little bit misleading, but you're right that the funds that raise capital and don't have the deals, they will probably make some bad decisions. Just because project sponsors rate money malinvestment.

Because too much money is flawed flowing and not enough deals are flowing to deploy that capital. So the capital utilization problem exists for the fund. Okay, so you know, you gotta acquire the property after, you know, the end of last year, 1231, 2017. Of course, we're already past that. So that's no problem. Some of the rules are still being defined. Right. Talk about the incentives, if you would, and kind of why the promoters are, are being successful in getting investors to buy these properties in these very disadvantaged areas. These blighted areas how they're getting them to invest in these funds.

So the drivers for folks to invest are situations where there are significant real estate or just capital gains in general from stocks. If you are a Amazon investor from the very early days, you bought it for $10 and it's worth $1,000. Now, just for sake of the argument, you have a massive capital gain. You want to sell and move the money from investment that's generating low cash flow to some cash flowing assets or some alternative where you want to diversify. That's where this thing comes in. If you're a real estate investors, number of them have been moving from an asset to an asset through 1031 Exchange, deferring capital gains. And they want to get out of that 1031 game and essentially want to pay taxes but on reduced amount. The benefits of if you invest in an opportunity zone as an investor and you hold your money in a fund or individual asset that's in an opportunity zone for five years or more, you get 10% tax benefit. So your cost basis goes by 10%. If you had say $100,000 in capital gains, you held it for five years, you will now have $90,000 in capital gains. And if you hold the investments for 70 years, that will be increased by another 5%. So you will now have essentially liability of only $85,000. So it goes to 15%. So that 15% savings is a real savings. But you got to park the money for at least seven years. In addition to that there is another benefit, the additional capital gains on the project. So you put a million dollars into a project and 10 years later that million makes another million dollars. But you got to hold it for at least 10 years. That extra million dollar capital gains is tax free. So essentially you're investing your upside. If you hold for 10 years all the appreciation, additional appreciation on the asset will be tax free.

Okay, so here's the thing. It could be not tax free but tax deferred just by doing a 1031 exchange and you wouldn't be forced to invest in any specific area. You could also do an installment sale trust and pay the gain slowly if you wanted to cash out. There are other options here that don't force you to have the tail wagging the dog, so to speak, that don't force you into mal investment.

Correct. The alternative to this is to keep doing 1031 exchange indefinitely. So this is just an alternative to 1031 exchange to park some money into a fund like this. What's most interesting, there is a sunset Essentially this date when if you sell assets and you defer capital gain taxes on this date, if you haven't sold an Opportunity Zone fund, your capital gains taxes are still due and the date is December 31, 2026.

Okay, so in other words, you must keep it for a certain amount of time, but you can't keep it past that time, Is that what you're saying?

Well, you could keep it, you could absolutely keep it past that.

Well, I mean, you can't get the benefit if you keep it past the time. Right.

You get the benefit of a tax liability reduction, but you owe the taxes on the amount that you deferred. So in other words, you had $100,000 of. Now we are approaching 2019. So there's only seven years. Actually it's eight years because end of 2026, so you hold it for seven years. At that point, if you don't sell, you hold another year, it's eight years. Well, now the tax liability is due on that $85,000 which you haven't yet cashed out, but the taxes are due. So if you actually hold the full 10 years after eight years from now, on 12-31-26, you will have to pay the tax bill on the 85% of your deferred capital gain taxes that now come in due. So it is very possible that you will have no cash, but you have to pay, pay the bills.

Right.

So you have to be prepared for this because you got to wait for 10 years in order to realize tax free benefits of additional capital gains on that investment. Does that make sense?

Yeah, that's okay. So now I want to make a disclaimer. Mike, everybody listening. You know, I've said this many times before over the last 1100 plus shows. We are not tax advisors. We are not legal advisors. Legal and tax issues are complicated. So please seek out a licensed professional for details. We're talking about the investment side of the concept here. And of course you have to talk about the tax and legal implications. But again, we are not qualified to fully understand complex situations or anything like that. And everybody's situation is different. So, you know, as they say in these disclaimers, I always love to hear this one. This is for entertainment purpose purposes only. Yeah.

And this is our understanding of these laws. These laws are new and it is very possible we misunderstand something when IRS comes out and makes a clarification and says, well, we are changing this a little bit and that change could be material as well.

Got it. Okay, good, go ahead. So what else should People know, so that's pretty important.

Ramifications. The most benefit would be to those folks that have a lot to gain from these transactions, typically, who could take full advantage of these family offices with significant. We're talking about tens of millions of dollars, very high net worth individuals who, with a lot of legal and CPA advice, could structure significant positions in these type of investments on the right projects and could take advantage of these situations. But there will be plenty of, let's call them, small investors participating in syndications with no control and no understanding of how this thing's going to flow. And tax situation. Every investment may be different while the fund manager will be running these funds and different folks will have different objectives. So thinking about just the tax benefits is a potentially disastrous type of investment. Because money will be stuck. Fund manager can make decisions that will benefit some people and hurt some other folks.

Mike, I have been rather famous in my little world for my ten commandments of successful investing. And I later, years later made a second 10 Commandments. So there are really 20, but I think I'm going to add some more. And one of them is going to be don't let the tail wag the dog. And that's exactly what happens. As these promoters are out there promoting these tax benefits. People are making bad investment decisions. I see it all the time. Just because they're trying to get a tax break. It's like, okay, I get the idea, you know, stick it to the man, you know, meaning the irs, the government, Uncle Sam. But don't make yourself a bad deal just to get a tax break. The deal should make economic sense before the tax benefit. Okay, agreed.

Yeah, I'm in a complete agreement with you. Another important consideration, just for the sake of. It's kind of funny, but I want to mention that these investments in Opportunity Zones cannot have a country club or golf club as a primary use, cannot have a massage parlor, cannot have a hot tub facility, cannot be a racetrack, cannot sell or consume alcohol on premises. So just, just to clarify, this is intended for good projects, not to promote bad behaviors.

Yeah, got it. There's a. No, no, no. Sinning. So good. What else should people know? I'm looking at the outline that we went over before the show a little bit. So who it's good for? Get the advice from a professional. Anything else on Opportunity Zone or Opportunity Zone funds? And then I want to talk about funds in general.

If you're considering an Opportunity Zone syndication or Opportunity Zone fund, you should most certainly look at the sponsor and their track record in projects. In general, you're underwriting the sponsor at that point. Also, do they have specific consultants, CPA legal advisors, to run the fund in a compliance compliant manner with Opportunity Zone and the project itself. If you're doing a project at this point, I would absolutely stay away from the funds. If anything, I would look at a single project opportunity in an Opportunity Zone because it's easier to understand and it's easier to manage. The funds just have enough complications running a fund and we have to combine that with complexities or compliance with Opportunity Zone rules. There will be a lot of mistakes made. So that's my two cents.

Yeah, I think that's good advice. Be careful. Don't let the tail wag the dog. A lot of these, and you know, we didn't even really talk in any real degree about the quality of the areas or the investments. You know, I downloaded the list from the IRS website and a lot of these areas, I just wouldn't touch them with a ten foot pole, you know, I mean, I just, I just wouldn't do it. They're just blighted, blighted areas that, you know, who knows if they'll come back? I don't know. That remains to be seen. But I'm not really going to dive into that component of the talk. That's a whole different show. Mike, let's talk a little bit about funds or syndications or deals in general. You know, I send a lot of deals to you that come across my desk because you're so good at evaluating them. And I got one maybe a week ago. I forwarded the email to you. It was a pitch, this and that. This person wants to borrow money. They'll do debt or equity. And you know, come to find out that this is so over leveraged they want way too much investment. It just doesn't make sense. These deals just don't make sense. And I can't believe these people can go and promote this stuff with a straight face. I really can't. There must just be so many naive investors out there with money burning a hole in their pocket. Or maybe I'm just too risk averse and too conservative because I've had too many deals go bad over the years and I just don't like getting ripped off anymore.

Who does?

Well, thank you for sending some of those deals across. I've taken a look and I always take a look at the stuff that you sent me. The few deals I looked at the typical scenario where the sponsor of a deal doesn't even communicate properly. They call something debt when in reality they're raising equity, they're trying to raise all the money plus their fees. So what happens is they want investors to take 100% of the risk, fund acquisition fees to the sponsors, get some money in their pocket to start, get some money in their pocket as they go, and get some money on their pocket on the back end if they succeed. Now, it doesn't mean there aren't all bad sponsors. There's plenty of really good sponsors. But that process of vetting deals, understanding deal structure, understanding what they're investing into, what kind of risk the deal entails, what is the upside, what are the cash flows, Takes work. It's professional work. I mean, I'm a fund manager. We screen a lot of deals. And if you don't have those skills and you invest in those deals just because there's great marketing, promoting the deal, well, you're going to get what you pay for. It looks easy if it's well promoted, pretty pictures, a sponsor with great theoretical track record, and you don't do your due diligence, you'll wind up with a crappy deal and the money will be stuck. It's one of the problems with, by the way, syndications. Your money is stuck until there's an exit strategy. Just to be very clear, if you haven't realized what's going to happen, you could park your money thinking you're going to get out in two years. Well, good luck, because the sponsor is milking the deal and your returns are crappy, but they're still charging the fees. It doesn't happen all the time, but it can. Just be aware.

Okay, so talk about this one deal, if you remember it. I know you're looking at a lot of stuff. Yeah, I remember the deal that I sent you, but then I want to talk about one that I sent you about a year ago. And we talked to the promoter, very nice guy, super smart and knowledgeable, but he was charging a 50%, half, 5 0% fee for running the deal. They put no capital in the deal. They simply find a deal, create a syndication and get half. My God, I think I should go into that business. That's pretty rich. And not for the investors, but for the sponsor. It's a great deal, right?

Yeah. So let's talk about the deal you just had. Essentially a quarter acquisition of a land for 5 million bucks. Then there were land improvements that run a little over another million. And the sponsor was trying to raise over six and a half. Again, the sponsor was trying to raise more than they put in. And more than they need to put in to take the land to the exit point. First of all, it's land. It's a very high risk deal by definition. The upside was there to sell for 9.5 million after the improvements are made. It's a highly speculative deal with investors putting up all the money. The sponsor did offer Pretty good 12% Rate of return on the money, plus some points and 50% share of the profit. So the structure of a deal by itself was not catastrophic, but the sponsor had no skin in the game. And to me, it is high level of risk. And the deal itself, the land deal.

Land deals are very risky, very speculative. Because that goes back to my saying, you know, how do you know if something's an investment? It's so simple. Investments produce income, period. End of discussion. If it doesn't produce income, it's not an investment. It's simply a speculation or a gamble. And you know, listen, I don't want to say never speculate and never gamble. Certainly you can hit some home runs doing that. And I don't want anybody to be super conservative like I am and miss out on those deals, okay? But you got to have some money. Your risk capital should only be, you know, maybe 15% at the most of your net worth. Right. If you can afford to lose it, you know, it's okay to take some gambles, okay, because some of them will hit occasionally. But on the deal like this, Mike, it reminds me of the old saying, you know, I'm not worried about the return on my capital, I'm worried about the return of my capital.

That's correct.

And. And you know, that deal looked good. Yeah. 12%, you know, preferred return, which is awfully generous, by the way. It's probably not going to happen, but the guy has no skin in the game. The deal's over leveraged. It looks like a it. You know what it was reminiscent of? It was reminiscent of way back in the late 80s, the Charles Keating SNL Lincoln Savings and Loan scam. He was doing these deals that were just massively over leveraged where people would buy the property and get money back on the deal just for buying it, you know, and that's what this guy's doing.

A lot of sponsors charge acquisition fee, right?

Yeah.

I've actually looked at multifamily sponsors, self storage sponsors again. Now, a small fee of finding a good deal of 1% may be fair, but I see sponsors charging 4% to the investors just because they found a deal. And the deal is a so, so deal. What's the value of their work. I mean they found the deal and you're paying as an investor. So it's really important to understand the function of a sponsor. And what is a quality sponsor. The quality sponsors typically don't promote. They go to a single source like us. We get them all the money they need. So we basically negotiate terms that are much more fair. So we talked about 50% promote the sponsor under some deals.

Yeah.

Give you an example, we invest from a fund. Many deals that have 12% pref, which is generous, may have 70, 30 split. Again, 70% to us is the investors 30% of the sponsor until we get 18% annually and then 50, 50 split. By the way, that kind of a structure is generally fair because if you got investors 18% and the 50% of the upside goes to the sponsor, so much power to the sponsor. So deals like that are fair. There are deals that have 9% pref, 8% pref, 10% pref. And after that from that point they go 70, 30. These are reasonable deals if the projects themselves are strong. But I do like the deals with at least 8% pref, preferably 10 to 12 and low, possibly no annual fees, maybe a little bit half a percent to 1%, potentially project management fee if the numbers are right. It's really important to understand the project for the whole life cycle. What are the cash flows year 1, 2, 3, 4, 5 and so on. And what is the exit strategy? By the way, one of the problems in today's environment, big, big problem that I see today, many sponsors make very aggressive assumptions on a back end sale.

Oh sure, yeah.

They're just estimating that the cap rates are going to be low. They don't care that the interest rates are rising. And then they make offering documents so pretty because they wrote exit cap rate at 6 when we know or at least it's very likely that the exit cap rate will be significantly worse than that.

Right, right. Okay. So just remember listeners, whenever you're looking at a pooled money investment, a syndication or a fund or a stock or anything like that, right, there's really sort of two major layers. I mean there are many layers, but there's two major layers to the deal, right? One is the underlying asset. It's or assets themselves, right? What is the deal? What's underneath the deal? So when we talked about that one over leveraged deal on the raw land, which obviously is highly risky just because it's raw land, that underlying deal was a bad deal. Now the second major layer is the structure of the Syndication or the fund. And in that case it wasn't that bad, Right. Nice pref return, etc. But look, for that structure to materialize in real life, the underlying deal has got to be good or it can't fund this great structure. So you can talk all day long about a generous deal, a generous structure for the fund or the syndication, but if the underlying asset won't create the return, you're dead in the water, right? Yeah.

There's nothing to divide, there's no profit. What's funny is if there's a loss, right, the sponsor is not going to take a piece of a loss. Investors do, right?

Yeah. That's the best deal ever. You know, you use someone else's money, go out, get into the marketing business. It's really nice, very low risk deal when it's not your money, isn't it?

That's right. So, you know, for comparison's sake, I'm going to mention our flagship fund, Tempo Opportunity Fund. And we have 7% pref. And depending on type of units folks have, if they invest in a units to get 80, 20, 80% of the upside, we get paid 20% performance fee. So we have to perform. I like the deals where the sponsor gets paid mostly on the back end. That's the critical piece. If they don't perform, they should not get paid. That's the key element of the whole equation. They can have a little bit to keep the lights on, but the moment they are motivated to just buy and to run it, they buy crap.

Right? Remember, no matter how nice somebody sounds or how good their pitch is, at the end of the day, it's always what we heard come out of the Watergate scandal from many years ago when Deep Throat said, follow the money. You always gotta follow the money. The money tells the truth, it doesn't lie. It shows where everybody's motivation is. And you gotta have an alignment of interest in alignment of interest. That is a key component. Do you want to speak to alignment of interests? Just for a moment, Mike.

Deal structure, syndication structure or a fund structure is alignment of interest. Syndication deals that have heavy upfront fees, problematic funds that charge things up front when they invest in a deal before the deal performs. It's a problem. Alignment of interest is effectively getting the project sponsor or a fund manager to receive performance fees rather than asset acquisition fees, origination fees and other fees. I'll give you an example. And again, I'm not trying to promote a fund, but I know the difference. We started this fund to be extremely investor friendly. We don't charge the fund ever any asset acquisition fees. We buy an asset, we can't get paid until the asset performs. Two, we do deals, we charge points. The points, hard money loans, they flow to the fund, not to us. We don't get paid anything upfront, we only get paid to the performance waterfall. So deals with that kind of structure or very light fees. I'm not trying to say that small fees are unfair. Some small fees, half a point, maybe a point for acquisition on a great deal can make sense. But if the deal is average or worse, what are you paying for? You could go buy the property yourself, not let somebody else buy it and then just milk you. So from that perspective, alignment of interest, you definitely want to see deals with minimal acquisition fees paid to the sponsor, light annual fees and good performance fees. By the way, the back end 5050 split may be totally acceptable if they meet some kind of a decent pref like 12% and that back end performance fee. As much as it feels like you're giving half the farm to the investor, well, to the manager, it's not a big deal. If you got paid 12% preferred return and then you're getting 50% of the upside, you're aligned.

The interest and the interest are co aligned.

Yeah, absolutely. Hey, share the wealth. Let someone make some money. If they make you money, you just, it's just the, the way that's going to happen or not happen is if you have an alignment of interest. So. Good stuff, Mike. Hey, let's wrap it up. Thank you for the very interesting discussion. We'll look forward to seeing you at Meet the Masters and I think we're going to have you up on stage talking about this and, and some other things. So that's, it's going to be great. And of course we'll have you back on the show in the future. Thanks again for, for joining us.

Yeah, I appreciate. Folks, if you want to get a hold of me, there's a wonderful website called bigmicfund.com. remember the name bigmicfund.com and if you mistype it, bigmicfund.com it is not a kinky site. You'll still wind up in the same place.

Sounds good. Hey, thanks Mike.

You're welcome.

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