Unintended Consequences: TIFs, Article XI and Opportunity Zones
“Success is the ability to go from one failure to the other with no loss of enthusiasm.” – Winston Churchill
Government and municipalities often conjure up incentives to achieve their economic goals. Often, it starts out with the best intentions. Affordable housing programs help tenants living near the poverty line afford decent housing. However, never underestimate the ingenuity of developers and the sway of lobbyists onto politicians to have the end result skew what the architects of the program had intended. I’ve talked before about the HUD 221 (d) 4 program. It was supposed to incentivize building projects in lower income areas. We just closed a 40-year fixed rate loan at 4.65 percent at 85 percent Loan-to-Cost (in a middle-income area of North Carolina). Greatest deal in the world – for the developer.
Tax Increment Financing (TIF’s) is a huge carrot for developers. It is dangled to them by city officials to redevelop a certain area of blight within a city. Essentially, TIF’s freeze taxes on a property for 20 plus years and the TIF is financed by floating a bond based on the future increase in tax base in that area. Chicago is the unofficial king of TIF’s with 162 designated areas formed over the last 25 years. Was blight eliminated in all of those areas? Not quite, and it certainly diverted resources away from the non-designated areas by indirectly increasing the taxes incrementally in those areas. New York had only one major TIF of note recently. It was used successfully in the construction of Hudson Yards. I say successfully because it would have taken years of bureaucracy to be built conventionally due to all of the approvals that would have been necessary. The TIF truncated this process. Cynics would point out that developing luxury housing on the west side of Manhattan isn’t helping low salaried residents and, in fact, pushed them out of that area. A more extreme example of that point is when Fort Worth created a TIF to lure a Cabela’s to the area. One would be hard pressed to argue how luring a luxury hunting and fishing chain helped the city achieve its goals of aiding the common citizen. In St. Louis, advocacy groups Take Back St. Louis and Team TIF pointed out that the city had forgone $700 million of property taxes from 2000 to 2014 by granting abatements and TIFs. Clearly, there is pushback. Meanwhile, I know of one foreign bank that is looking to buy up these residual TIF credits from developers as an investment. Perfectly legal to do but, again, was this what was initially contemplated when the program was formed?
Article XI is a New York City program that is a new twist on the recently expired 421a and J-51 tax abatements. In Article XI, 40-year tax abatements are granted to building owners that maintain affordable housing for at least two-thirds of the units within the building. Through this program, the de Blasio administration financed 32,116 apartments in 2017 alone. While I applaud the desire to keep apartments affordable for the lower and middle class, in some cases it caused huge windfalls for the building owners who were already content owning the buildings without the abatements. Again, unintended consequences. By limiting the tenants’ income, they are indirectly keeping a lid on rents. But could the loss of tax revenue to the City coffers be the best method to create affordable housing in the City?
Opportunity Zones are the new gold rush in the real estate industry. The federal government wanted to spur development in thousands of areas nationally that needed a kick start in development. Many of these areas are far from being blighted (municipalities can designate 5 percent of census tracts that do not meet the definition of a lower-income community), which raises eyebrows right there. The fact that the incentives are as lucrative as they are should ring some warning bells. While it is certainly talked about in the industry, it is underrated with regard to exactly what a ridiculously good deal this is for the investor. Consider that the only way to truly defer taxes on the sale of an appreciated real estate asset was to perform a 1031 exchange and buy a property for the same asset value. It is always a mad scramble to find a suitable asset for the buyer in terms of size, risk profile and swapping into an asset that had some binary risk that it flopped. With the Opportunity Zone, you can invest in a portfolio of assets if you’d like with tax deferments and tax reductions that seem quite excessive when you take a step back. You can also use unrealized stock gains making the potential market for Opportunity Zones as much as $2 Trillion. That’s why Opportunity Zone funds have been able to quickly raise hundreds of millions to specifically invest in this.
One caveat that nobody is talking about are the “end game” provisions on the capital gain deferral. If there’s no liquidity event in 2026, paying 85 percent of the original capital gain could still be problematic for investors with limited liquidity. The refinance wave that will occur in 2026 will only be useful if seven years has been enough time to increase values. The biggest beneficiaries will likely be neighborhoods that have already been making gains and only need a little boost, but instead will receive a flood of new investment. However, many of the opportunity zones don’t appear to be areas that only need five to seven years to jump them into the next tier, and that has the potential to hurt investors that need to cash out in order to pay their taxes in 2026. Notwithstanding this caveat, the advantages of the Opportunity Zone structure are outstanding. We have many properties in-house that qualify.
Dan E. Gorczycki is a Senior Director in the Debt, Joint Venture & Structured Capital group of Avison Young, LLC, with an expertise in Opportunity Zone investments.