Funding mechanism has become a gravy train for developers and distorts the free market, critics say

By KEN WYSOCKY for the Badger Institute’s Spring 2018 issue of Diggings

With the stroke of a pen in 1975, Gov. Patrick Lucey signed a bill that gave municipalities a valuable tool for financing infrastructure improvements on blighted urban land: tax incremental financing (TIF). In the ensuing decades, municipalities in virtually every Wisconsin county have used it to coax developers to convert difficult-to-improve property into higher-value real estate that generates more property tax revenue.­­

Developers, municipal officials and politicians have all embraced the funding mechanism, originally designed to fill the void left by reductions in federal block grants. In fact, there were 1,238 active tax incremental districts (TIDs) in 456 municipalities in 2017, according to data compiled by the Wisconsin Department of Revenue.

But a growing number of politicians and other observers are less enamored with how tax incremental financing is used. They generally see TIF as an initially good idea that has become a gravy train for well-connected developers and distorts free-market principles.

Changes to TIF regulations have broadened over the decades and diluted the financing mechanism’s original intent, which was to fund infrastructure improvements — water and sewer lines, for example, or cleaning up environmental contamination, detractors say. By assuming the cost of these improvements, municipalities removed expensive obstacles to profitable development. But today, many municipalities — in addition to finance infrastructure — are handing out direct payments to developers.

As the rules governing TIFs relaxed, the funding mechanism has become overused, if not downright abused, critics say. They’re particularly concerned about violations of the crucial “but-for” test, in which municipalities must determine that a development would not occur “but for” the financial assistance from a TIF, and about handouts to wealthy developers who don’t really need the help.

“One of the biggest problems is that there’s now such an ad-hoc, free-wheeling nature to TIFs,” says state Sen. Duey Stroebel (R-Cedarburg), who is also a longtime real estate developer. “There’s also the whole issue of what defines blight. Blight has essentially become whatever officials define it to be … even if it’s a prime piece of real estate, there’s a way to define it as blighted.

State Sen. Duey Stroebel“I know it might seem strange that a developer is against TIFs,” he adds. “But while the original intent was good, they’ve now morphed into something so much different.”

Stroebel prefers a free-market approach, noting that property in a desirable location shouldn’t require added incentives to encourage development. For instance, in charming Cedarburg — hardly a hub of blight — the city is giving Brookfield-based developer HSI Properties a $1.925 million public subsidy to build an apartment complex on a 4.25-acre prime parcel owned by St. Francis Borgia Catholic Church.

Moreover, Stroebel asserts, the use of TIF perversely affects the market value of property. “Instead of the market truly defining what land is worth, the price goes up once landowners know that TIF is involved,” he says.

Rick Esenberg, president of the Wisconsin Institute for Law and Liberty, a conservative law-and-policy think tank based in Milwaukee, asserts that too often TIF becomes a form of corporate welfare for wealthy developers, with municipalities picking winners and losers. And its spread becomes contagious; think of it as municipal peer pressure, where one municipality sees neighboring communities attracting development with TIF and feels compelled to join the party to remain competitive.

“When developers know they can be subsidized in this way, it becomes much harder for anyone to refuse to do it. And because the prerequisites for TIFs have expanded and aren’t rigorously observed, there’s really nothing for which you can’t use a TIF. Developers know it and communities know it … so it becomes more of a presumption than an exception,” Esenberg says.

Direct payments to developers

Esenberg and Stroebel question why TIF projects increasingly include direct payments to developers. Wauwatosa officials, for instance, are close to approving a TIF that would pay $13.8 million to developer Mayfair Hotel LLC over the course of 18 years.

The money would defray some of the costs associated with converting an 11-story, 150,000-square-foot office building into a 12-story, 196-room luxury hotel near N. Mayfair Road and W. North Ave., according to news reports.

It’s difficult to assess how widespread the practice of direct payments has become. According to a 2009 study of 81 closed TIDs, compiled by the Wisconsin Taxpayers Alliance (now the Wisconsin Policy Forum), grants to developers accounted for just 2.7 percent of expenditures.

Only 11 of those TIDs provided grants to developers, but in those 11 districts, grants averaged almost 20 percent of expenditures. While it’s hard to ascertain the percentage of current TIF expenditures that are developer grants, observers believe direct payments are much more common now.

“We’re seeing more and more of these kinds of payments,” Stroebel says. “They’re problematic because there’s even less accountability in those situations. It’s one thing if taxpayers are subsidizing specific infrastructure improvements. But if a developer says it has a million-dollar income gap that must be filled to make a project feasible … who provides the data that proves the developer actually needs that money to make it feasible? The developer. It’s like the fox guarding the henhouse.”

Cedarburg's TIF-funded Arrabelle apartment project is expected to be completed by fall 2019. Rendering by AG ArchitectureRegarding the Cedarburg project, John Czarnecki — a member of the Common Council since 2014 and a principal at Commercial United LLC, a real estate development firm — defends the use of such grants on a case-by-case basis. For the 69-unit Arrabelle apartment project, for instance, the subsidies were necessary to help ensure HSI Properties could meet its profitability targets.

HSI initially planned to build a 100-unit project on land currently occupied by an abandoned church school building. But after residents objected to the size, the city asked HSI to scale it back. Only then did HSI ask for financial assistance via TIF, says Czarnecki, who did not run for re-election in April.

“It all came down to the building that Cedarburg approved there, which features high-end apartments, is too expensive to build for the rent the market will support,” he points out. The math is simple: Fewer units means less revenue generated.

Is the church property truly blighted? Czarnecki says it is because the school, which closed a few years ago, is vacant and the building is “functionally obsolete.” He says the project passes the “but-for” test because, without a TIF, the project would not have moved forward. In the end, city officials had to opt for the HSI project or gamble that something better would come along.

More pressure on government services

Stroebel and others point out that TIF projects, such as apartment complexes and mixed-use commercial buildings, put increased pressure on municipal services such as police and fire protection, schools, garbage collection, road maintenance, snowplowing and the like.

But while the now-developed property typically increases in value and generates more property tax revenue, that additional revenue doesn’t go toward funding the increased demand for services. It also does not relieve the property tax burden on residents for quite some time because the bonds typically are issued in terms of 20 years or more.

“The demands on infrastructure increase, but everyone else (except the property under development) keeps paying for them,” Stroebel says. “They (TIF proponents) say there’s no tax impact, but the benefits to residents are years and years off. So taxpayers subsidize the development until the bonds are paid off. It’s like a drug for some developers — they can’t develop without it. I think communities get hoodwinked. It’s a shame.”

The converse also is true: If developers improve properties without TIF assistance, the gains in property tax revenues immediately benefit the community, rather than waiting decades.

Instrumental to development

TIF proponents take issue with the criticisms. To illustrate the effectiveness of TIDs, the League of Wisconsin Municipalities (LWM), for instance, noted that the 1,128 TIFs that were active in August 2015 had generated property value growth of more than $16 billion since their inception — or $14.4 million per TID. In addition, 447 TIDs were terminated (the debt paid off) in Wisconsin between 2000 and 2015, adding nearly $9 billion of new value to tax bases.

Furthermore, the league asserted that property value growth occurs at a faster rate in TIDs. The total equalized value of all active Wisconsin TIDs increased by 6.4 percent from August 2014 to August 2015. In comparison, the state’s overall equalized value grew by only 2.4 percent in that period, according to the league.

“TIF is a very effective mechanism for municipalities to share in the equity creation of property value with a developer,” says Pete Moegenburg, president of Moegenburg Research, a Brookfield commercial real estate appraisal and consulting firm and a 29-year industry veteran. “Without that assistance, development often won’t occur.”

Moreover, Moegenburg says, without the additional financial shot in the arm provided by TIF, most developers could not afford to develop profitable projects.

He cites 5 percent annual increases in construction costs (think lumber, steel, concrete and labor, just for starters) since 2010. Then there’s often the issue of contaminated brownfield sites that require expensive clean-up, another disincentive for developers. In short, he says, many TIF opponents are long on vague rhetorical criticism but short on intimate working knowledge about the nuts and bolts of how real estate development really works.

“Labor costs have increased exponentially, too,” Moegenburg points out. “And at the same time, the income generated by projects has remained relatively flat … The result is that developers need a cushion to provide some means to succeed.”

Moegenburg also scoffs at the notion that TIF equates to capital cronyism. “They call it corporate welfare … like developers get a TIF approved, then run off to Las Vegas for the next party,” he says. “TIF is a very real financial consideration provided by municipalities to assist in developing property … improving it to its best and highest use.

“Crony capitalism is a terribly simplistic and ill-founded argument against TIFs,” he adds. “People that make that argument probably don’t have a lot of dirt beneath their fingernails.”

Moegenburg does concede that some TIF projects don’t meet the strict letter of the law posed by the “but-for” test. But if developers don’t obtain sufficient financial resources from communities, they either will walk away from developing, say, an apartment complex or agree to build it but “impose the costs on society” in the form of rents significantly higher than the prevailing market rates for similar units, he says.

Controversy in Eau Claire

Kerry Kincaid, who’s been president of the Eau Claire City Council since 2009, is a strong advocate of TIFs, including one created in 2014 that’s become controversial: the downtown development of the $80 million, publicly and privately funded Confluence Project. The mixed-use development is so named because the site overlooks the confluence of the Eau Claire and Chippewa Rivers.

On behalf of 19 clients, WILL in 2015 sued the City of Eau Claire and its Joint Review Board. The lawsuit challenges a $1.5 million payment to a real estate developer to cover project-related expenses as well as the review board’s designation of properties within the development as blighted. An Eau Claire County circuit court and the Wisconsin Court of Appeals have sided with the city; WILL appealed to the Wisconsin Supreme Court, which heard oral arguments in February. A decision is expected later this spring or early summer.

Kincaid says the city has used TIF for decades to spur economic growth — 12 TIDs in all, with about half of them still active. Regarding the Confluence Project, she says public support has been overwhelmingly positive.

“I’m a proponent of TIF because I have seen what a city can do by using TIDs,” she says. “Our first TID was in 2002 … to build what’s now called Phoenix Park, which has become the jewel of our city.” TIF revenue was used to pay for cleaning up the brownfield site, which helped attract private investment. To date, the project has generated $69 million in new property value and $8.2 million in additional tax income for the city, she says.

The properties that make up the Confluence Project were blighted, including vacant land and commercial buildings and unmaintained parking lots, she says. “I’m confident it could not have been developed without a TIF,” Kincaid says. “I’ve lived in Eau Claire since the mid-1970s, when the downtown was vibrant. In the 1980s and ’90s, things emptied out and downtown was hanging on by a fingernail. We brought life back to downtown, and it wouldn’t have happened without public investments through TIF.”

Kincaid also rejects the crony capitalism argument, noting that only one of the city’s TIF projects included a financial incentive for a developer. “There are no cronies, just capitalists who want to invest in improving land,” she says.

Esenberg disagrees, saying that the properties in question were not blighted as defined by state statutes. “Blight is not what you’d like it to be,” he says. “Blight is defined as slum-like conditions where the physical condition imperils life and property.”

Looking for solutions

So if TIF is being overused or abused, what should be done? Esenberg says the state Legislature should strengthen the “but-for” test and tighten up the definition of blight, as well as more narrowly define the circumstances under which TIF can be used.

Stroebel suggests several remedies, including the use of so-called pay-as-you-go funding instead of cash incentives for developers; this technique is already used for some TIDs. Under this scenario, developers would have more skin in the game by funding some of the costs up front, then getting repaid via new property tax revenue generated by any increase in the site’s value.

“It’s better because instead of a city borrowing money, the developer technically fronts the money, and he gets paid off by the incremental increases in property value,” he explains.

Stroebel says he has introduced bills to reform TIF use every year he’s been a state legislator, since 2011. “But special interests recoil at them,” he says. “We get good sponsorship, but, again, it’s about special interests that bring funding into the political process.”

Ken Wysocky of Whitefish Bay is a freelance journalist and editor. This article appears in the Spring 2018 issue of Diggings, a publication of the Badger Institute.