California Won’t Budge On OZ Conformity But Gets Bulk Of Investments

The attractiveness of opportunity zone investment is somewhat blunted in California because the state hasn’t conformed to the federal government’s capital gains incentive. Although the state’s stubbornness hasn’t taken it off the OZ map, some remain unconvinced about the initiative's effectiveness.

Commercial real estate has garnered the bulk of OZ investment in the state, several panelists concluded at a Bisnow Opportunity Zones Update Digital Summit on April 16. Therefore the intended beneficiaries, small businesses in economically distressed communities, have been left out.

“I still don't think there's an appetite to conform at the state level,” California State Treasurer Fiona Ma said.

The nonconformity means that although opportunity zone investors receive capital gains tax incentives at the federal level, they still have to pay those taxes in California, where the rates are higher than in other states. Ma said that the state was reluctant to conform even when the program was just getting started, and other subsequent instances of tax conformity occurring related to the coronavirus pandemic federal stimulus packages haven’t helped matters.

Yet the OZ dollars keep coming. Over the course of a little more than two years, Bridge Investment Group raised about $2.25B of equity that has been deployed into about $5B worth of assets in opportunity zones, Bridge Investment Group Managing Director Pete LaMassa said, adding that about 30% of the $2.25B has come from California investors, with the next largest state’s share a single-digit percentage.

“Despite the fact that California is nonconforming, it doesn't really matter. People are still very interested,” LaMassa said. "We've made some good investments in California. We love Sacramento, so we're working on looking at our third deal in Sacramento. We just feel that there's a tremendous benefit there because a lot of people are moving out of the Bay Area and moving north. But then we also have projects in Hayward, California, Los Angeles, Long Beach. We're looking at some projects in San Diego.”

In April 2020, California had the highest OZ investment amount at over $1.19B, as reported by Novogradac & Co. LaMassa attributed California’s status as one of the world’s largest economies as the reason for its share of OZ dollars even with the state’s nonconformity.

With much of opportunity zone investment going into multifamily, according to Brownstein Hyatt Farber Schreck shareholder Erik Jensen, it could be concluded that if California offered the capital gains tax incentive, there would be a greater investment toward alleviating the housing shortage.

“We are seeing most of the projects here are real estate, and most of those projects that are real estate are multifamily,” Jensen said. “It seems that very few of those are actually targeted low-income housing. But there is a housing shortage in a lot of places in this country, so if you just take a look at the simple supply and demand, perhaps not now but 10 years down the road as more of these come in, it's going to help ease that.”

Opportunity zones are hardly the only vehicle for increasing housing creation, as Alliant Strategic Investments CEO Eddie Lorin pointed out, calling housing the “ultimate impact investment.” There are 45 bills in the California Legislature to address affordable housing, Ma said.

One of the reasons opportunity zone investments tend to be made in real estate versus other ventures is the program is tied to census tracts. Although a building isn’t going to move, a business might, Farella Braun + Martel partner Julie Treppa said.

“When we're talking about a 10-year investment timeline, it's hard to say that you're going to meet these requirements during that whole 10-year period if you're investing in a small business that might grow and move elsewhere,” Treppa said.

CRE versus small business investment isn’t cut-and-dried. JMA Ventures, which has four opportunity zone projects in construction, predevelopment or acquisition stages, has had mixed-use projects with commercial uses located in opportunity zones. JMA Ventures President Todd Chapman said his firm pitches the benefits of locating businesses in the developments to entrepreneurs who could take advantage of the tax incentive. However, the challenge is the opportunity zone program’s complex regulations can overwhelm the resources of small businesses, he said.

Accelerator for America President Aaron Thomas said he has seen opportunity zone investment go to some tech businesses in places like Southern Virginia and Oakland, but much of the capital goes toward housing creation in coastal cities with acute housing shortages.

"I think in places that have been missing [economic] dynamism for generations — the Midwest, the South — people are talking a lot about business formation and the capital allocation in the businesses in those zones, but it's just been a lot harder to see the capital flow there,” Thomas said.

Regardless of whether the investments are being made in CRE versus small businesses, criticism about the program not helping low-income communities persists.

"What we have also seen is that there are very few projects where the projects wouldn't have happened anyway,” California Community Economic Development Association Executive Director Roberto Barragan said. “And opportunity zones have been a nice way for companies to shelter capital gains in real estate development, but it really has not benefited small business, nor has it really created projects in low-income areas that wouldn't have happened otherwise.”

Although the program had been touted as one that would benefit low-income neighborhoods, it lacks the additional incentives that could do that, though it is something the Biden administration will hopefully implement, Barragan said.

“In some of the neighborhoods that my organization serves, those returns are unavailable,” Barragan said. “So unless the program facilitates some additional incentive to the investor, they're not going to put their money there.”