The high price of opportunity zones

In the current political climate, few policy initiatives can claim bipartisan support. But, the opportunity zones (OZ) program has enjoyed rare bipartisan support—especially unusual for a tax bill. The concept was pioneered by the Economic Innovation Group, a centrist advocacy group, which promoted the idea in a 2015 policy paper as a means to “unlock private capital to facilitate economic growth in distressed areas.” The legislation was co-sponsored by both Republican and Democratic lawmakers and championed by the Trump Administration, and ultimately was enacted as part of the Tax Cuts and Jobs Act (TCJA) of 2017.

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The program was seen as an innovative new way to bring investment into underdeveloped neighborhoods. It became the Trump Administration’s signature place-based economic development policy and has been popular with real estate investors and developers as well as community groups, leading to a burst of investment funds targeting Opportunity Zones. An August 2020 report by Trump’s Council of Economic Advisers estimated that funds earmarked for opportunity zone investment “raised $75 billion in private capital by the end of 2019, most of which would not have entered OZs without the incentive.” However, Novogradac, a professional services firm focused on the real estate sector, places the total closer to $10 billion.

But despite the bipartisan pedigree and lofty goals, OZs have had their share of detractors from the start. Skeptics feared that the program would end up subsidizing projects that might have occurred anyway in neighborhoods that are technically still distressed but are already improving, particularly those adjacent to already thriving districts, thus not needing government incentives to encourage new development. In this way, program benefits could accrue mainly to wealthy investors and existing property owners in the OZs while doing little to expand economic opportunities. Another concern was that subsidized projects in designated zones would divert investment away from non-subsidized projects and non-designated neighborhoods.

Three years on, it’s time to assess the record.

A rigorous new study has concluded that Opportunity Zones are not fulfilling their promise, inflating residential prices without expanding investment in the designated areas. By using an enormous database of residential sales transactions the real estate data management and analytics company Cherre Inc, along with outside academics, has undertaken the most comprehensive analysis yet of opportunity zone property market dynamics. They determined that the program did not significantly increase transaction volumes but did raise real estate prices in designated areas by four to six percent over properties in comparable neighborhoods not included in the program.

Moreover, the team discovered bias in the selection process. Census tracts with higher average real estate prices were more likely to be selected, even if they satisfied the program’s demographic eligibility criteria. In short, the OZ program selected neighborhoods with higher home values and raised residential prices more than in districts with comparable demographics, and yet has not increased investment in these selected communities. Thus, the program has not been fulfilling its core goals and should be revised to better target projects that would assist lower-income residents and improve depressed neighborhoods.

A brief program history

Although authorized by TCJA in December 2017, the program took a while to get going, and the timing has proved unfortunate. Governors began designating districts in early 2018, but the designations were not completed until June.

Another hindrance for the program was the delay in translating the authorizing tax law into program regulations. Although the Tax Cuts and Jobs Act outlined the broad program parameters, the IRS did not publish detailed guidance until October 2018, which was subsequently revised in May 2019. Final regulations were not published until December 2019 and did not become effective until February 2020—just as the COVID pandemic was about to devastate the economy, sink property markets, and sharply cut property investment.

The timing for the program roll-out was obviously not ideal but enough time has transpired to allow for at least preliminary analyses of the program’s effectiveness.

Key program features

The Opportunity Zone program is designed to increase investment in disadvantaged communities. While each state nominated the districts to include in the program, every district must meet specific eligibility criteria. For example, an OZ’s poverty rate must be 20 percent or higher, and median family income must be less than 80 percent of statewide or area average. Ultimately over 8,700 Opportunity Zones (representing 12 percent of all census tracts) were designated.

The primary mechanism for encouraging investment is through tax incentives for investors who place new capital in businesses operating in the OZs. Investors in qualified OZ funds can defer taxes on capital gains earned outside the OZ until the end of 2026 (or until the asset is sold, if sooner). Moreover, the taxes on those capital gains are reduced by 10% if the investment is held for at least five years, and by 15 percent after seven years. Finally, investors get a permanent exclusion from capital gains taxes on appreciation of OZ assets held for at least ten years.

Notably, these tax benefits were made available to a broad range of businesses, not limited to real estate investment. Indeed, job creation is a central goal of the program, so investments in operating companies are specifically encouraged. However, that goal appears to have been optimistic. A report from the Urban Institute concluded that “the vast majority of OZ capital appears to be flowing into real estate, not into operating businesses, because of various program design constraints.”

Among other issues, UI argues that “the 10-year time horizon is too long, too illiquid, and too fixed to make the incentive useable for non–real estate business investments” and yet “is not long enough for long-term community ownership of such assets as affordable housing, health care centers, or schools.”

Impacts on property markets

Investors started raising opportunity zone funds almost immediately after being authorized at the end of 2017, even before the OZ districts were officially designated in mid-2018 and well before the program regulations were published in late 2018. Accordingly, academics and property researchers have been eager to track the progress of these investments to assess their effectiveness.

Zillow jumped in with the first prominent study examining pricing trends in early 2019. Their study concluded that home prices grew an astonishing 25 percent in OZs during the year after neighborhoods were designated compared to only eight percent in eligible communities that were not selected and two percent in non-eligible (more affluent) areas. However, these improbable findings have been widely discredited as they were based on a limited data set and did not attempt to control for differences in building quality or even size in the pool of properties sold.

A more rigorous analysis was undertaken by a team of researchers from Harvard University and the Brookings Institute came to a decidedly different conclusion: that price impacts were most likely less than one and a half percent, and even less or negative in relatively residential districts. Their findings suggest that “so far, homebuyers don’t believe that this subsidy will generate major neighborhood change” and “perhaps because buyers think that subsidizing new investment will increase housing supply.”

However, this study, too, suffers from serious drawbacks. First, the study considers only sales transactions during 2018 (the first year of the program) when the OZs were still being selected and program rules drafted. The White House Council of Economic Advisers updated the Harvard study with 2019 data and found the annualized impacts to be twice as great. More importantly, the Harvard study relies on the Housing Price Index (HPI) developed by the Federal Housing Finance Agency (FHFA). Though based on repeat sales, this index has its imperfections as it does not explicitly measure the change in home prices before and then after the program launch. Thus, the index—and the study—do not control for property quality over time.

Enter the Cherre study

The new study titled The Impact of the Opportunity Zone Program on the Residential Real Estate Market takes a much different and more detailed analysis based on a dataset that includes over 36 million residential sales transactions, making it the largest-scale study to date. After excluding various types of anomalous data as well as census tracts with minimal transactions (to avoid distorted results), the final filtered database included 28 million transactions in 30,000 census tracts covering all 50 states. With this more granular data, the researchers were able to compare pre- and post-program pricing in two distinct approaches: matched comparisons between designated OZ census tracts and non-designated control groups, and a separate analysis of repeat sales of individual properties.

Comparing sales prices in the OZs with those in the control group of eligible-but-not-selected census tracts, the study determined that the OZ program increased prices in designated Opportunity Zones by approximately four to six percent over those in the control group—several times the effect found in the Harvard study, though much lower than the differential estimated in the flawed Zillow study. The separate analysis using only repeat sales reached comparable results.

The report is authored by Ron Bekkerman and John Maiden at Cherre along with Maxime Cohen of McGill University and Dmitry Mitrofanov of Boston College. They attribute the greater price appreciation in OZs to basic market dynamics: demand for acquisitions increases after neighborhoods are designated (likely in anticipation of improving market conditions) while the supply is relatively fixed in the short term.

The study then goes further than these other two studies to examine transaction levels. The study examines both the volume of residential property transactions and the dollar volume of these investments and found that neither increased significantly more in opportunity zones than in the control groups.

The authors of the study identified bias in the selection process favoring more expensive districts, which was then magnified by investor behavior after the program started. While the census tracts selected as opportunity zones certainly have elevated rates of poverty and unemployment as required by the program, property values tend to be higher in OZs than in non-selected districts having comparable demographics. Moreover, a disproportionate share of the price gains observed in the study occurred in OZs with higher incomes and prices.

These findings support the fear that investors would focus on neighborhoods that were already improving or adjacent to gentrifying areas, thus subsidizing projects and investments that might have occurred without the program.

Ron Bekkerman, one of the authors of the study, couldn’t help but come to the conclusion that “the OZ program did not attract new substantial investments in residential real estate.” When asked why, he explained, “Currently the program is tailored to big investors, it is about taxes on capital gains. These investors are usually just looking to park money so that is why we likely saw investments in mostly larger properties that qualified for the program.” As for how the program could be changed in order to make it more impactful on the areas it was created to help he said, “It would have been better to incentivize smaller investors that know the area, not larger ones that are only investing for the tax incentives.”

As the Biden Administration considers how it might fine-tune the OZ program, this study suggests that the rules should be tightened. They could better target lower-income areas, eliminating the more prosperous Opportunity Zones that have gotten the bulk of the opportunity zone investment so far. They could also create not just a tax saving but an expedited approvals process to help investors create lower-income housing. Finally, they could give power to local economic development authorities to approve these tax credits for the projects that they think will make the most impact. [Propmodo]