Bonds

Commercial real estate decline will cause pain in city budgets

A decline in the commercial real estate sector, particularly among offices, is expected to hit city government finances in coming years, analysts say.

“Office use nationally is not going to return to pre-COVID levels,” said HilltopSecurities Head of Public Policy and Municipal Strategy Tom Kozlik. Nationally, office use is about half of pre-COVID levels, according to Kastle Systems data, and he said “that level is probably [close] to the level that we are expecting to continue at in the near- to medium-term.”

As a result, “public finance needs to recognize the new reality [and its] permanence,” Kozlik said. “For some regions and entities, this is going to require adjustments in budget plans.”

And “the political anguish related to this shift” and how cities address it, will grow, he added.

The national office vacancy rate has steadily climbed from early 2020 to record levels — in the fourth quarter of 2022 it was 17.3% and Moody’s Investors Service expects this to increase in 2023.

The increase in office vacancies is pushing down rents, which is lowering building valuations, and, analysts say, will lower commercial property tax revenues in addition to other lost tax revenue resulting from fewer workers in cities.

In April, Wells Fargo reported non-performing commercial real estate loans in the first quarter of this year increased 52% compared to the fourth quarter of 2022.

Individual credit analysts contacted by The Bond Buyer saw the commercial real estate decline as a bigger problem for municipal credit than did ratings agencies.

“High commercial office vacancies pose a serious problem, especially in central cities,” said Richard Ciccarone, president emeritus at Merritt Research Services. “Central business districts are being threatened by the current threat to offices, much like they were in the 1970s and early 1980s. Decreased traffic in the center cities has been made worse by the real and perceived risk in criminal activity, which coincidentally has gone up in over the past few years.”
 
A decline in commercial real estate valuations will force cities to recoup lost property tax revenues, said Howard Cure, director of municipal credit research at Evercore Wealth Management. Cities depend on these revenues, he said, so “municipalities either must pass the property tax burden on to residential properties or find some other way to increase revenues. Shifting the burden to homes and apartments is often not politically palatable since residents vote.”

While states may offer assistance, Cure said, such aid “often gets cut during recessionary periods.”

Other options for cities would be to increase “fees and fines or, if available, an increase in sales tax rates.” Cutting services to balance the budget would be unlikely, Cure said, since “you don’t want to have declining services, which would provide another excuse for workers not coming into the office.”

Besides the low office usage, higher interest rates will “work to suppress commercial real estate market values,” said Michael Rinaldi, head of U.S. local government ratings at Fitch Ratings, resulting in “revenue and economic headwinds.”

“The degree of risk posed depends on a number of factors, including local assessment practices and the share of total revenues derived from taxes on office properties,” Rinaldi said. “In cities like New York and San Francisco, offices can make up 20% or more of the property tax base, though property taxes from this class are part of a broad and diverse revenue structure coming off a period of very high growth.”

Both cities have begun to assess the issue.

“New York City has taken measures in its multi-year forecast to account for a potential decline in office market values and San Francisco assumes relatively flat property taxes due primarily to expected softness in commercial office values that offsets value appreciation in residential and other property taxes,” Rinaldi said. “Whether these measures prove sufficient to avoid incremental budget pressures will be determined by the severity and length of office vacancies moving forward.”

But, most cities are strong financially, being beefed up by federal pandemic stimulus dollars, S&P Global Ratings Director Scott Nees said. The decline in commercial real estate is not a significant concern in next few months, he added, noting as an example that S&P affirmed the AAA rating on San Francisco in March.

But commercial real estate is not the only sector suffering as a result of COVID-19, said Nick Samuels, senior vice president at Moody’s. It also financially hurt retail real estate and mass transit systems. These have led to lower property values, to which cities must adjust.

S&P Senior Director James Fielding said rising interest rates are leading to lower real estate values and rental rates, which will cut municipalities’ revenues. Adding clouds to the outlook, S&P expects the U.S. economy to enter a mild recession later this year and that would lower city government revenues from many sources.

Ciccarone said in some cases, high office vacancy rates will lead to delinquent tax collections and foreclosures. “As vacancy rates remain elevated, landlords are likely to see lower cash flow as tenants downsize their space requirements.”

The impact of the commercial real estate decline partly depends on how much government funding comes from property taxes, Samuels said. While New York City, for example, gets 27% of its revenues from property taxes, Boston gets 64%. To respond to the decline, cities “may have to raise commercial property tax rates to maintain their overall property tax levy or shift more of the burden to residential property, which has performed strongly.”

Boston Chief Financial Officer Ashley Groffenberger said, “Boston is carefully monitoring the impacts of remote work on our local economy, including on our residents and businesses.”

It could be several years before the office downturn’s impact is felt by cities, analysts said.

“Long-term leases will help to mitigate changes in value and related property taxes over the near term and allow cities to adjust budgets, though the weakening economy will make it more challenging,” Rinaldi said. The average U.S. office space lease still had 5.1 years on it, according to a Moody’s research piece by Vice President Darrell Wheeler and three others.

Moody’s expects a recession this year and a further drop in office revenues, Wheeler said.  

Almost half (46%) of banks’ office loans will mature by the end of 2024, said Kevin Fagan, Moody’s Analytics head of commercial real estate economic analysis, and four others in a note, which will likely lead to refinancing.

“Refinancings will be challenged over the next 18 months,” Fagan said. “This stems from interest rates being high but is really more directly related to lending capacity issues for banks right now.” Maturing commercial real estate loans “will result in increased default rates and start to put pressure on prices, as we’ve already started to see to some degree.”

Many companies have embraced hybrid work operations, which curbs the amount companies can ultimately reduce their office footprints, Cure said. This could mitigate the ultimate impact of the decline in office use on the rental of office space, he said.

Over time, city governments will have to lower assessed values on offices, Samuels said, adding how this impacts property tax revenues remains to be seen. Some cities, like Boston and San Francisco, set a level for property taxes collections and adjust rates accordingly. Cities with a fixed tax rate may struggle more.

While most analysts spoke of the changes in office use as negatives for cities, Kozlik said they might benefit some cities over the long term. With office utilization at 49% nationally, employees working elsewhere will provide a benefit for those locations.

“Commercial and residential real estate will receive a slight boost in those areas,” Kozlik said. “There will be slight bumps in sales and use, income or wage taxes if they are collected in those areas as well. These areas are generally outside of downtown business districts.”

Samuels said weakening in the office sector would hurt school districts as well as cities.

The median share of school district revenues from property taxes is 38%, with many school districts in wealthier suburbs getting “much higher” proportions, Ciccarone said. However, he said those wealthy suburban school districts are less vulnerable to the downturn in office real estate values.

“Most state school district appropriations are designed to be higher for poorer districts,” Ciccarone said. “That causes wealthier districts to have a higher dependency on property taxes. Taxpayers in wealthier suburban districts usually have the resources and continued job stability to cover their property taxes even in tough times.”

Ciccarone said problems in commercial real estate may harm municipal bond credit quality through impacts on public pension plans with direct and indirect investments in commercial real estate. Most multi-employer public pension plans that report financial information have median real estate holdings of 8% to 9%, with a few holding around 18%.

Moody’s Vice President Tom Aaron said, “Due to their ‘risk-on’ nature, combined with their massive size and diversification, U.S. public pension funds tend to have exposure to any struggling or underperforming asset class at any given time, and we anticipate that commercial real estate will be no exception.”

Though the decline in office value and rents will hurt municipal finances in the next few years, according to an April paper from Moody’s Analytics, it is unlikely to lead to the same problems as residential real estate issues did in 2007-2009.

While banks and office owners are both getting pressured by increasing interest rates, conditions separate current commercial real estate problems from residential real estate problems 15 years ago, Fagan and his Moody’s Analytics co-authors said.

U.S. banks have much better Tier 1 capital ratios — which compare the bank’s core capital with its risk-weighted assets — than they did in 2007 and 2008, they said.

Commercial real estate loan leverage and asset pricing have been relatively conservative compared to what they were prior to the Great Recession, they said.

Most of the commercial real estate loans maturing in the next few years originated in 2013 to 2018 and the loan-to-real estate value ratios were significantly lower on average than loans originated in 2002-2007, they said.

Finally, office holders seeking to refinance their loans at maturity in the next few years will find there are many other possible sources besides the small- to medium-sized banks that are experiencing the most pressure in recent months, they said. These include large community banks and very small banks; private bridge lenders; commercial mortgage-backed securities; life insurance companies; and mortgage REITs.

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