Kosmont on How California Cities Should Ready Themselves for Opportunity Zone Investment

How should local jurisdictions in California prepare for Opportunity Zone investment, given both their lack of OZ oversight authority and any clear IRS guidance on how to employ this new federal financing tool?

Larry Kosmont: Readiness will be the distinctive factor for most of the local municipalities and counties hoping to attract Opportunity Zones. California has 879—a little over 10 percent of the market. The city of Los Angeles has 194, and Los Angeles County has 274. For California municipalities to miss this opportunity would really be a waste.

California is typically a preferred investor market for a multitude of reasons, such as climate, labor force, diversification, the ports, quality of life, and more. But all of the states  have access to this capital gain exemption and investment motivation program. When it comes to OZs, our competition is the 49 other states, plus the territories, and the roughly 8,000 municipalities, public agencies, and counties that have Opportunity Zones in them.

Moreover, California is typically slow on entitlement approvals and high on costs, and the CEQA process can present formidable challenges to project approval, particularly in terms of time constraints. OZ investors need to make a profit to take advantage of the program’s tax benefits, so this overlay of complexity puts us in a questionable competitive position to other states.

OZ investors will face further complexities in Los Angeles. Los Angeles has a district form of government, and the city’s Opportunity Zones exist in 13 council districts—sometimes spanning multiple. This means that any potential OZ investor fund must achieve political support from at least one and possibly two councilmembers, in addition to planning approvals, in addition to CEQA approvals—all in a city known to be comparatively slow to respond to developer application requests.

How do we position Los Angeles so it can respond more favorably? That must come from a concerted effort in the mayor’s office, and it must be driven by a very clear set of priorities supported by a well-developed investor prospectus for each zone. In other words, the city has to say: “We’ve looked at our Opportunity Zones, and here’s what we’re willing to do for private-sector investors for certain kinds of projects in these zones.” That would be a significant piece of the competitive equalizer that LA could apply to this program.

Will the city do it? It’s too early to tell, though it’s on the mayor’s radar. But if LA does not produce a winning OZ strategy, it may find itself in a secondary position in terms of competitiveness. The private sector may be compelled to single out the opportunities of least resistance, instead of being funneled to LA’s priority projects. While the city has a substantial number of opportunities, in my view, if LA doesn’t equalize the playing field, OZ investors may look elsewhere.

Drawing on your extensive experience advising on redevelopment throughout Southern California, broaden your comments to the other 87 cities in LA County and other counties in the SoCal region. Who is most ready?

Long Beach is a good example of a city that is mobilizing early to take advantage of Opportunity Zones. They’ve retained a special on-staff adviser, set up a website, and are mobilizing their team across city departments. That’s a really good start. Many smaller communities, like Whittier, Pomona, and others, are starting to think about how to position and expose their OZ opportunities.

For the most part, cities in LA County are just getting their arms around becoming Opportunity Zone-ready. Those that are adequately preparing are doing three things. First, they’re taking inventories of the sites in their Opportunity Zones and figuring out how to promote them and what they want developed there. Second, they’re figuring out what their zoning process might be for those areas. And third, they’re figuring out how to blend the compliance requirements of Opportunity Zone investing with their economic development strategies and whether additional inducements should be provided.

Given that there’s so little public regulation of the market-driven Opportunity Zone program, how might the public sector incent the flow of capital toward “public good” investments?

The interesting twist in the OZ program is that it is not based on an incentive that City Hall has to sign off on. It is an investor-initiated, market-driven program that is underwritten by a tax saving. Because of that, we are telling all our local government clients: It’s dependent on you to figure out how to make investment opportunities in your community evident to the private sector investors who are shopping for opportunities.

Right now, investors’ attention is being led by broker and developer activity on the real estate side. But where I see an opportunity for cities is on the business investment side. Business investment presents great upside for communities because enabling local businesses to expand and flourish could be the antidote to gentrification and dislocation—which are legitimate concerns about this program for many local leaders.

Many cities have small businesses that have been around for years but have never been able to achieve adequate capitalization to expand into different product and service lines. One way cities can achieve upside from Opportunity Zones is by scouring their communities—working with their chambers, business brokers, and local lenders—for local businesses that have been capital-starved and that could expand with access to investor capital. These businesses are the hidden gems for communities seeking to take advantage of Opportunity Zones.

If the regulatory clarifications due in mid-January further opportunities in business investment as opposed to real-estate development, cities could take on a matchmaking role—connecting local businesses needing capital to investors looking for a value-add business opportunity, as well as a potential tenant for a collateral real-estate investment in the Zone. An effective business-investment oriented strategy could help local communities drive OZ investment activity toward existing and new businesses in areas that would benefit from capital that hasn’t been available to them prior to this point.

But the pending regulations need some clarification. For example, in order to create employment opportunities for residents in Opportunity Zone areas, the program should allow investors to prioritize working with local stakeholders by supporting existing business eligibility to participate.

How are banks and lenders, which have historically played an oversized role in California’s development and growth, responding to the promise of Opportunity Zones?

I anticipate that lenders will see the OZ program as a productive avenue of business development, so long as the underlying transactions achieve their internal debt equity and value ratios and meet other project-specific investment metrics.

The lending marketplace is starting to see the potential of the OZ program—especially since the last clarification in regulations, which appear to say that debt is an accepted capital stack member of an OZ investment platform. In other words, you can put in capital on the equity side, leverage that equity with debt, and increase the potential for your capital base and profits to grow. So, the OZ program will drive some loan volume, which is good for lenders.

Still, lenders are going to wait and see if these projects really come through their debt application funnel. And I believe that they will look at these programs very much like they do any other: Are the equity/debt ratios appropriate? Is the market strong enough to support the investment? Unless lenders are invested in a Community Reinvestment Act programs, this is going to be pretty much business as usual for them; it’s just that there may be more of it coming from areas that hadn’t consistently generated loan applications in the past.

Will Opportunity Zones align well with other sources of development funding, like cap-and-trade funds, transportation funding measures, affordable housing streams, and EIFDs? 

On some level, all these public funding sources are compatible with Opportunity Zone investment. But there’s a major caveat: Timing is of the essence for OZ investors. Investors have six months from accruing their capital gains to place their investment. Real-estate-based investments have 30 months to measurably increase their value to the community in order to be eligible for capital gains preferences.

For California, 30 months is a constrained period. Ground-up development takes time in California, especially in urban or mainstream suburban areas. A lot of things can happen that would render a developer or investor unable make that deadline—a CEQA challenge, zoning delays, development agreement challenges, or the like.

On top of that, funding sources that come from government typically include other conditions of approval, such as prevailing wage, project labor agreements, or the fulfillment of affordable housing units. Those aspects of public funding programs present complexity and timing issues for OZ investors. Any attempt to converge public funding with an OZ project will have to be very specific, clear, and well timed—otherwise, the private OZ investor will shy away from it.

I believe that EIFDs are the form of public incentive most compatible with OZs. EIFDs are relatively quick to form—they can take about 18 months. This aligns with OZ projects that want to be quick to get out of the gate. At the same time, EIFDs are long-term programs—45-year tax-increment zones. Creating an EIFD portrays the commitment of a local jurisdiction to the area in which the OZ investor is making the investment.

EIFDs benefit from early investment. To the extent a local agency can identify Opportunity Zones and draw EIFDs around them, OZ projects present an opportunity to generate early tax increment. That revenue capture is beneficial, not only to the community, but ultimately also to OZ investors, because their investment can be made more secure by tax increment generated in a surrounding EIFD.

Overall, in my view, EIFDs and Opportunity Zones are fundamentally compatible. In the right setting, OZ investment coupled with EIFD districts may be the best match of public and private ingredients for economic development that California has right now.

What are likely to be the characteristics of the first projects out of the box?

The first projects out of the box will be projects that recently received entitlements and are in areas that are fundamentally appealing to typical investors.

For example, if a developer recently achieved a zoning entitlement for apartments or a mixed-use project that is development-ready—that is, it’s been through CEQA and zoning processes—that would present an ideal opportunity for investors. That is the low-hanging fruit, and we are likely to see it in places like Santa Ana, the Inland Empire, and Long Beach, and perhaps some suburban cities in LA County.

The second round will be projects that have a single-purpose use, are well located, and can make a reasonable case for zoning approvals or an abbreviated CEQA process, like a Mitigated Negative Declaration. These are projects that don’t quite have clearance but are close to achieving it, and are in preferred areas of investment.

The Opportunity Zones program is just getting out of the box. Funds are being formed now with the inherent understanding that the regulatory clarifications to come are going to limit most projects from aggressively moving forward in the next 60 days. Assuming the January regulations continue to be relatively permissive and expansive, we expect that the investor floodgates could open up by Q1 of 2019. And when they do, they will target projects that are profitable, achievable in a timely manner, and that demonstrate the capacity to comply with the regulations.

In light of the new programs and legislation that the state is pursuing to fund economic development in disadvantaged communities—Opportunity Zones, EIFDs, and a concerted effort toward greater density and development—is it worth revisiting redevelopment, or is that game over?

I think at its core, the redevelopment program as we knew it before 2011 is not politically viable. The state’s priority today is not about RDA 2.0; it’s about sustainability 2.0, and using tax-increment financing to make investments through EIFDs, CRIAs, AHAs, and other “sustainability and housing districts” the state has created since the demise of redevelopment.

But the state needs to make these sustainability and housing districts more accessible and user-friendly. Right now, they are overlapping and confusing. To accelerate local investment in sustainability and housing, Governor Newsom’s economic development team will have to push the Legislature to simplify and streamline TIF districts, especially EIFDs and CRIAs.

One example of a substantial improvement to EIFDs came in the 2018 Legislative round: SB 1145 from Senator Connie Leyva enables tax increment in EIFDs to be used for maintenance and operations for the first time ever in California, effective January 1, 2019. Those kinds of improvements to sustainability and housing districts will help advance economic development.

In terms of Opportunity Zones, California could help its own case. After all, this is a program in which governors from all 50 states, with some cooperation from local agencies, picked their eligible districts; the U.S. government simply ratified and certified them. We picked our 879 districts ourselves, so we’re vested. It’s our opportunity to win or lose at this game.

The way we can win is by doing two things. First, we can grant our Opportunity Zones the same kind of CEQA protections that big stadiums have—where, for example, there’s a bracketed period of time for CEQA challenges to be brought against projects. Why would we not give economic development projects the same flexibility that we give to billionaire sports projects? That has to happen.

Second, California has a very expensive income tax rate sheet, and capital gains are hit hard. It would be very much in California’s competitive interest to apply some kind of concession to the income tax rate levied on OZ projects—particularly projects that include affordable housing or transit-oriented development or that accomplish sustainability goals that the state is encouraging through other mandates. This would make our state competitive with roughly 40 other states that either don’t have a state income tax or were willing to modify their state income tax programs to essentially match the federal benefits provided by the OZ program.

Again, California has over 10 percent of the marketplace of approved Opportunity Zones. The question is: Will it achieve a proportionate share of OZ investment? Maybe. If the state can minimize CEQA delays, adjust our tax code for OZ projects, and tweak our sustainability and housing districts, then I think we have a shot. This, to me, is the stage that California must create in order to be competitive in the business of Opportunity Zones.