OZ Investment Slows Amid Economywide Headwinds As Extension Looms

Published by Michael J. Novogradac on Friday, March 1, 2024

Journal Cover March 2024   Download PDF

Capital raising for qualified opportunity funds (QOFs) tracked by Novogradac slowed to $3.5 billion in 2023, down from $9.7 billion in 2022 and $9.2 billion in 2021, as described in further detail on Page 10 of this issue.

This slowdown led to considerable speculation as to the cause: 

  • a nationwide decline in business and real estate investment opportunities, due in part to high inflation and interest rates;
  • a decrease in investable capital gains; and
  • the looming Dec. 31, 2026, date for recognizing deferred capital gains.

The reason, as with most things in life, is likely the derivative effect of all the above. This conclusion is supported by the observed decline in QOF fundraising for multifamily investment.

Decline in Business, Real Estate Development Business Opportunities

The demand for investment capital for multifamily housing, including in OZs, declined in 2023.

Annually adjusted multifamily housing permits issued in January 2024 dropped to the lowest level in nearly six years (excluding pandemic-impacted April 2020) and multifamily housing starts dropped to the lowest level (excluding April and May 2020) since 2019. The year-over-year comparison is striking: According to the Federal Reserve Bank of St. Louis, national multifamily permits (five or more units) were down 26.6% in January 2024 compared to a year earlier and multifamily starts were down 37.9%.

Multifamily housing wasn’t the only market that struggled in 2023. Real gross domestic product (GDP) growth–a measure of overall business activity–was sluggish in 2023 after regressing during the first half of 2022.

For multifamily development, three drivers fueled the downturn: rising construction costs and estimated operating expenses, higher interest rates on construction and permanent loans, and flat projected rental income. 

Rising Construction Costs, Operating Expenses

Construction costs, as tracked by international property and construction consultancy firm Rider Levett Bucknall, increased 5.3% in 2023–a higher figure than the consumer price index (CPI) for all items, which rose 3.4% from the end of 2022 to the end of 2023.

The 2023 CPI increase was at a slower rate than the previous year (6.5%), but still significantly higher than the post-Great Recession norm. That continued in January, as the year-over-year inflation rate of 3.1% was higher than any month from December 2011 through March 2021. The 10-year Treasury yield–an indicator of anticipated inflation–was at 4.3% in February. That rate remained below 4% from September 2007 until October 2022.

Multifamily property developers also face the likelihood that operating expenses will increase at a faster rate than inflation. Multifamily software property management company Yardi Matrix reported that expenses for multifamily properties grew by 9.3% from mid-2022 to mid-2023, a rate more than triple the inflation rate for the same period. 

Elevated Interest Rates

Construction and permanent loan interest rates are critical factors in determining the financial feasibility of multifamily housing developments. Inflation is a factor that significantly affects interest rates and multifamily permanent loan rates by early 2024 were around 5.5%. That is a drop from 2023, but still higher than any period from the Great Recession until inflation kicked in during 2021.

Flat Rental Income

Operating expenses (as mentioned earlier) were up nearly 10% in 2023, but rental income didn’t follow and isn’t expected to do so anytime soon. Fannie Mae in January predicted national multifamily rent growth in 2024 of 1.0% to 1.5% on the heels of a reported 0.8% growth in 2023. 

Investable Capital Gains Declined in 2023

The drop in QOF investment in 2023 is likely partly due to the decline in investable capital gains. 

A large portion of investable capital gains is driven by increases in readily tradable stocks. While the stock market’s peak in early 2024 set records, the market didn’t perform well through most of 2022 and 2023. The Dow Jones Industrial Average began 2022 above 36,000 and after plunging below 30,000 in mid-2022, the Dow didn’t match its early 2022 level until December 2023. The same is true for the S&P 500, which as of mid-February, still hadn’t returned to the levels of late 2021.

A decreasing or flat stock market–the case through most of 2023–means less capital gains, which means less QOF investment.

Looming Date for Recognizing Deferred Gains

Investors face a Dec. 31, 2026, date to recognize deferred capital gains invested in a QOF. The benefit of the tax deferral achieved by investing in a QOF loses value as the recognition date approaches. 

Investing eligible capital gains in a QOF now also pushes those deferred capital gains to a year after Trump-era tax provisions are set to expire. The Dec. 31, 2025, expiration date of many Trump-era tax changes, and how Congress and the then-sitting President address the pending expirations, hovers over all federal tax matters–including an extension of the OZ incentive past its current Dec. 31, 2028, sunset date.

The current expiration of many Trump-era tax changes means the next major federal tax legislation will likely come in late 2025 or early 2026, following an election that could change control of the White House, Senate and House of Representatives. While advocates for OZ legislation correctly continue to promote their agenda, the payoff on those efforts will most likely come next year or in 2026. Read more about the effect of the looming expiration date on OZ activity on Page 12 of this issue.

Less Multifamily Development Affects OZ Investment

As seen on Page 10 of this issue, QOFs tracked by Novogradac reported $37.62 billion in equity raised through the end of 2023–a figure that’s probably one-third to one-fourth the overall QOF equity investment total, due in part to the fact that Novogradac doesn’t include proprietary or private funds that are owned and operated by their principal investors.

Novogradac data consistently shows that for trackable investments–developments in which QOFs report that they have invested funds–nearly 80% ($20.56 billion at the end of 2023) goes to real estate developments that include multifamily housing units. Many of those properties are exclusively multifamily housing.

Other research backs up the importance of multifamily development investment for QOFs. RealPage Analytics, which provides data analytics, property management software and services to professionals in rental properties and real estate, reports that the number of apartment units delivered in OZs went from about 20,000 annually in 2016 to nearly 70,000 in 2023 and is expected to double again in 2024.

That means there will be roughly six times more apartments placed in service in OZs in 2024 than in 2016. RealPage Analytics’ data also shows that 20% of all new apartments in the United States in 2024 will be in an OZ. Before the OZ incentive became law in 2017, that figure hovered around 8% annually.

It’s worth noting that the slowdown in permits and QOF investment in 2023 means there will be slowdown in the number of apartment units delivered over the next 12 months.

OZ Investment Still Making a Difference

While QOF investment declined in 2023, the incentive was designed to encourage investment in struggling communities. Evidence suggests it’s working. 

A report issued a year ago by The Economic Innovation Group (EIG), a bipartisan public policy organization, concluded that the number of OZs that benefited from investment continued to grow, highlighting that the incentive is making a broad impact. The EIG report also stated that the areas receiving OZ investment are on average among those with the highest need in the nation. The poverty rate in the OZs that received investment by the end of 2020 (the most recent data available at the time of the report) had a poverty rate nearly double the national rate and a double-digit unemployment rate.

The report cited a working paper by Harrison Wheeler, an economist from the University of California, Berkeley, which found that an OZ designation produced a “large and immediate boost” in both commercial and residential development, that OZ economic benefits “spill over” to neighboring communities and that housing values increased while rents stayed stable. 

Looking to Opportunity Zones 2.0

The Opportunity Zones Transparency, Extension and Improvement Act of 2023 includes provisions to extend the deferral date for OZ investment from the end of 2026 to the end of 2028, expand reporting requirements, allow “funds of funds” to invest in other QOFs and more. The Small Business Jobs Act, introduced in June 2023, includes provisions that would create a new category of OZ census tracts in rural areas and require reporting by QOFs and qualified OZ businesses, with Treasury required to produce an annual report on OZ activity.

While both bills could be enacted this year, the more likely opportunity is 2025 or 2026, when Opportunity Zones 2.0 legislation has its best chance to advance.

Discussion among members of the Novogradac Opportunity Zones Working Group provided a series of possible legislative modifications to the OZ incentive for the next legislative round, a topic I covered in this space last April.

Among the possible provisions is the allowing the investment of non-capital gains dollars, as well as the possibility of interim gain deferral and/or a partial exclusion for shorter holding periods than the current five- and seven-year holds. Other possible elements of Opportunity Zones 2.0 include:

  • an extension of the date for gains eligible to be invested past the Dec. 31, 2026, deadline and possible permanence, 
  • a rolling seven-year deferral period,
  • the ability to roll over interim gains into another OZ investment,
  • additional benefits for deeper impact investments, and
  • flexibility to designate replacement tracts as OZs.

With a major tax bill expected next year or in early 2026, now is a crucial time for OZ stakeholders to share with members of Congress the economic value that OZ investments bring to struggling communities.

The headwinds of an economy unfavorable to generating investable capital gains and business investment more generally (and multifamily construction in particular) created a unique storm for OZ investment in 2023. That’s a short-term struggle for an incentive that’s a long-term win.

Learn more about Novogradac's expertise and many services