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Turbocharging Opportunity Zones

Milken Institute Review
Turbocharging Opportunity Zones

Portions of the Tax Cuts and Jobs Act of 2017 were designed to spur investment — and thus prosperity — in distressed communities by providing incentives to unlock nearly $6 trillion in unrealized capital gains held by investors.

The mechanism is straightforward: the act defers taxes on realized capital gains if the funds are reinvested in “opportunity zones” (economically distressed areas nominated by governors and certified by the U.S. Treasury), with the investments themselves eligible for tax-free gains if held for 10 years. This transforms many low-income communities into far more attractive investment prospects.

Since almost all of the designated opportunity zones have a poverty rate greater than 20 percent along with disproportionate quantities of underutilized labor and land, kickstarting investment has the potential to make a huge difference. To fully realize that potential, though, local community lenders — especially minority-owned banks — need to step up to ensure that residents and small businesses don’t remain bystanders.

Indeed, the involvement of the entire community is vital because, for all of opportunity zones’ promise, there is a significant risk that investments in them will mainly end up in safer large real estate projects, accelerating gentrification at the expense of the people the law is meant to help. Indeed, if this happens, residents will become victims rather than beneficiaries, pushed out of their neighborhoods by rising rents and condo conversions, and in no better position to obtain good jobs than before the tax breaks became law.

Opportunity or Threat?

To appreciate the ramifications, it is important to understand the economic reality confronting residents of low-income communities, especially minority households. Over the past 30 years, the average wealth of non-minority families in America has increased 84 percent. This is 20 percent faster than that of Hispanics and a daunting twice as fast as the accumulations of black families. Developing small businesses within opportunity zones is thus critical to spreading the wealth more equally. Small businesses account for 48 percent of the private-sector workforce. And while some analysts are inclined to get carried away in touting the importance of small businesses to the economy, there’s no question they do drive job creation, raise wages and elevate living standards.

Unfortunately, while minority populations are growing, minority-owned small businesses are not. For minority-owned businesses to progress up the ladder, it is essential to increase their access to capital at competitive costs.
Located in all 50 states and U.S. territories, opportunity zones have significant potential to draw equity investments into distressed communities.

Happily, the latest round of regulations (April, 2019) that govern opportunity zones have made investing in operating companies far more appealing. However, there is an urgent need to confirm that such investments help the residents of these communities, and not just outside investors.

While minority populations are growing, minority-owned small businesses are not. For minority-owned businesses to progress up the ladder, it is essential to increase their access to capital at competitive costs.

Seats at the Table

One way to ensure this is to persuade opportunity zone investors to collaborate closely with minority-owned banks, community leaders and local business owners who know the neighborhoods as they investigate opportunities. While a certain amount of larger-scale real estate and infrastructure investment is inevitable (and necessary), one also must focus on small-business growth and job creation. And community development financial institutions (CDFIs) and minority-owned depository institutions (MDIs) can be critical to that mission.

CDFIs — and some MDIs that also qualify as CDFIs — are required by the Treasury Department to dedicate 60 percent of their lending to historically disadvantaged communities in return for a variety of government benefits. This level of dedication to low-income communities makes them highly attuned not only to the needs of the communities, but also to the best investment opportunities.

Accomplishing the goal of the Opportunity Zone statute’s original intent will require investors to recognize that the tax breaks come with a responsibility to help the communities in which they invest. But this is easier said than done. Analyzing the potential return on a single $300 million real estate project is much less problematic than sourcing, executing and managing $300 million dispersed among a dozen smaller enterprises with owners lacking blue chip credentials. To address this issue, local CDFIs and MDIs — institutions that have often been in these communities for generations — can play a vital role.

Moreover, leveraging CDFIs and MDIs to provide the debt for opportunity zone investments will mean integrating them into the economics of such investments, and thus the rising tide. Local CDFIs and MDIs that are
fortified with outside capital will be able to provide increased access to credit to the mom-and-pop small businesses in these communities, which are unlikely to receive investment otherwise.

Another way to achieve the goal is to revise the legislation governing opportunity zones to allow investors to make equity investments in CDFIs themselves. As currently written, the law prohibits businesses from having more than 5 percent of their capital in “unqualified” financial assets (i.e., banks with receivables and loans cannot receive opportunity zone investments). Although there may be a rationale for excluding certain financial institutions, excluding local lenders that target mom-and-pop businesses was a mistake.

In particular, the stock of CDFIs that are MDIs should be included as qualified investments. Our recently published research indicates that, when compared with average lending patterns for all banks, MDIs are more likely to support low-income customers. Unfortunately, MDIs are too few in number and are typically capital-constrained. Wells Fargo alone has over three times more branches than the nation’s 167 MDIs combined. And MDIs hold far less in total assets than non-MDI banks. This translates into far greater operational hurdles for MDIs to expand services to their local communities, especially in a highly regulated industry.

To succeed, MDIs require more funding — equity capital in particular — to support expanding their services and providing more funds to fast-growing minority communities. With a legislative fix allowing opportunity zone investments in CDFIs and MDIs, these institutions would not only better serve their communities, but also become important sources of help for opportunity zone investors seeking to maximize both financial returns and social outcomes.