The Guru Is In
The Hole in the OZone
By David A. Smith
5 min read
Two years into the era of Opportunity Zones, its impact on our industry has been minimal: whatever benefit the OZone may provide other types of real estate, it’s not boosting Low Income Housing Tax Credit (LIHTC) production. Why are we the OZone’s empty hole – and, of greater interest to Guru readers, what can we do about it?
Fundamental land-use economics dictates that the market price of any developable land parcel or legacy structure will be a function derived from its post-development ‘highest and best use’ (as the economists normatively call maximum profitability).
In supply constrained urban America, affordable housing means market-quality accommodations delivered for deserving lower-income households, and priced at occupancy costs (rent plus utilities, or mortgage payments plus real estate taxes and utilities) they can afford, which by economic algebra are guaranteed to be well below market. When it comes to developable urban land or property, all other things being equal, affordable housing will never be urban land’s highest and best use, and our industry will never be able to buy the land or shell structures we covet. We may be legislated into the OZone, but once there we’re priced out by competing uses.
That’s why for the last half century, government (mostly federal) has consciously provided incentives exclusively for affordable housing: cheap loans, deferred payment loans, favorable depreciation to generate paper losses, or tax credits whether Historic or LIHTC. Though the specifics change with precedents and presidents, one way or another each delivered a monetizable benefit to properties based on their use as affordable housing.
In parallel with use-specific incentives, ever since the 1980s’ Enterprise Zones we’ve also had geographically targeted incentives, of which OZones are just the newest. Though place-advantaging, OZones are use-agnostic. Nothing in the code or regulations specifically or particularly advantages affordable housing as an asset class.
OZones incentivize particular places: each state draws boundary lines around areas (presumptively, those of economic deprivation) that it wishes to make into magnets for capital. And not just any capital: by making the OZone’s principal investment benefit a deferral or waiver of tax on capital gains, either rolled over or earned by the new investments, the OZone seeks the only type of money that generates capital gains: economically motivated equity.
If we’re in an OZone hole, we spent three decades unwittingly digging it for ourselves, because we systematically removed from our investments the thing that makes OZones desirable: namely, all the economic capital gains potential normally attendant upon owning rental property. Residual value is absorbed by Deferred Development Fees, attenuated by extended use covenants, capped by nonprofit rights of first refusal, diverted into soft debt whose accreted balance exceeds any economic equity. Instead, residuals in LIHTC properties derive not from the property’s economic fundamentals but rather from its ability to attract new resources via a resyndication. In short, our own industry has refined away as ‘impurities’ all the economic upside and capital gains potential.
OZones make economic capital gains more valuable. Our CRA-motivated bank investors don’t normally earn capital gains. Our economically hamstrung investments shun economic capital gains.
We’re invited to the game. We just can never win it.
Tempting though it is to blame our plight on anonymous offstage malefactors, our failure to win isn’t the legislators’ fault: OZones were never designed to solve a housing deficit, they were designed to solve a deficit in equity investment. They’re predicated on the notion that in a capital-deprived neighborhood, any type of equity-based economic development is a good form of urban land use – which, to judge by our last several decades’ experience, is probably a sound notion.
Instead of ruing our misfortune, if we in affordable housing want to use the OZone incentives, it’s up to us to bring our own supplementary incentives. With today’s HUD long gone from the new-subsidy business, the housing incentives we bring have to be state or metropolitan-level. They include inclusionary zoning boosts, resident income subsidies, cheap or free government-owned land or development rights (e.g. air rights), real estate tax abatements or exemptions, sales tax exemptions on construction materials or fast-track development approvals that bypass or override NIMBYism.
Although some industry-led suggestions have been advanced to modify the OZone statute or regulations, in my view neither will have much traction or impact in the current cycle. Instead of aiming low, we should look farther and higher:
- Farther. Anticipate that sometime before 2024 the OZone sunset date will either be extended or removed and build a strategic campaign that allows the LIHTC to flow even as economic benefits also flow and
- Higher. Lift our eyes beyond the LIHTC horizon and develop the forms of non-LIHTC affordable housing that communities need: workforce housing, shared ownership/shared appreciation, or recovery’s boarding house, to name only three that I’ve written about in previous columns. These forms of affordable housing will have economic potential; they’re needed in OZones; and localities will embrace them.
Finally, the next time major tax legislation is coming through, let’s not be so preoccupied with frantically defending our own pea patch that we miss the chance to shape potential new virgin territory that we could lucratively farm.
