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As Returns Shrink, Opportunity Zone Funds Adjust Their Strategies

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LONDON—Hardly anyone is rooting for a recession. But if one comes and resets pricing on commercial assets, opportunity zone fund investors could benefit. With return expectations of 15 to 20%, it’s not easy for them to find good deals.

“The opportunity fund folks have a model to get in and get out,” says DLA Piper’s Global Real Estate Practice Co-chair John Sullivan. “They invest three to five years and get reasonably healthy returns so they can get their carried interest.”

That strategy could be problematic in a full-blown trade war or geopolitical crisis, according to Sullivan.

“The investors that have a much longer-term investment horizons, such as sovereign wealth funds and certain pension funds, may be a little less concerned about the impact of trade and tariffs or the 2020 election,” Sullivan says. “They are investing with a 30-plus year time horizon and know that the value of Class A office in Manhattan, for instance, is going to go up and down, but over time will probably be a good bet.”

Buying isn’t much easier for opportunity zone funds in this current low cap rate environment. With scores of bidders chasing assets, returns have shrunk. “It can be difficult for those types of funds to find investments that meet their return requirements in a really strong market,” Sullivan says. “If you get some economic disruption and an economic downturn and maybe some financial distress, they would be able to buy with the hope of higher returns.”

Despite some hurdles, Sullivan says opportunity zone funds are finding deals. “There are literally billions of dollars of opportunity fund money out there and they are making investments,” he says.

These opportunity buyers are adjusting their strategy. “They are pushing out to major markets beyond the gateway cities, they are doing development or they’re getting paid to take that element of risk. And, in some cases, maybe they’ve lowered their return thresholds.”

Even if there is some distress in the market, opportunity zone funds won’t be alone in seeking deals.

“You could see more activity from the from the opportunity zone funds and that subset of private equity, but you could also see more investment by any of the investors,” Sullivan says.

But Sullivan doesn’t think there will be many distressed deals hitting the market anytime soon. He points out that even during The Great Recession, the bargain buying opportunities didn’t materialize as buyers expected. And, today commercial real estate loans are in a much better place than they were then.

“I continue to think the overall fundamentals of the real estate market are still pretty good,” Sullivan says. “Leverage is generally low. I think that if we have a correction in real estate, at least it’s likely to not be that severe to be an opportunity for a lot of these investors.”