Since the end of the COVID-driven recession, a growing chorus has sounded an alarm about the impact of commercial real estate on the budgets of several major U.S. cities. In these instances, rising office vacancy rates, declining property valuations, and the respective impact on tax revenues and city budgets are a source of growing concern for municipal bond investors considering several cities are significant issuers within the market.
While we previously explored the effects that commercial real estate (CRE) may have on the CMBS sector, this post views the situation from the perspective of cities and municipal bond investors and we consider this challenge to be manageable for most cities. Indeed, our anticipation for fiscal deterioration in some cities needs to be placed in the context of performance dispersion across property types, revenue diversification, the proportion of revenues from CRE, and cities' flexibility to adjust tax rates as needed.1
CRE continues to face headwinds from multiple sources, including higher interest rates, weakening fundamentals, and tighter lending conditions (Figure 1). While commercial property values have already begun to correct, valuations are likely to adjust further as strains in the market become more ingrained and transaction volumes slowly increase.
CRE Valuations Will Take Time to Correct
PGIM Fixed Income and CoStar CPPI as of November 2023.
While availability rates in the office sector continue to rise nationally as post-COVID work arrangements become more permanent, we expect significant performance dispersion across both property types and geography.2 Newer, well-located Class A properties can be expected to attract tenants and maintain asking rent levels, outperforming Class B and C properties in need of significant capital expenditures. In addition, performance will vary by region, with San Francisco as an example of a major city that continues to underperform (Figure 2).
Office Fundamentals Differ by City
PGIM Fixed Income, CoStar, Kastle Systems, JP Morgan Research as of November 2023.
Despite this challenging backdrop for CRE, it is critical to remember the path that valuations for the sector as a whole have taken since COVID. For most property types outside of office, there was significant appreciation immediately following the onset of the pandemic. As a result, we expect non-office valuations to be near, or even above, pre-pandemic levels after the current correction (Figure 3).
Meanwhile, residential real estate values are up 47% from pre-COVID levels and are expected to remain resilient given the tailwind of strong demand and tight inventories.
Non-Office Valuations Expected to Remain Near or Above Pre-COVID Levels (%)
PGIM Fixed Income, Case Schiller Home Price Index, Green Street Advisors as of October 2023. Pre-COVID defined as January 2020. Current CRE prices reflect Green Street’s appraisals.
A Diverse Tax Base
While U.S. cities receive an average of 30% of their revenues from property taxes, some cities, such as Phoenix and Philadelphia, collect much smaller portions. Others, such as Boston at more than double the national average, receive much larger portions (Figure 4).
Property Tax as a Percentage of Total Revenue
PGIM Fixed Income, City Audited Financial Statements as of the fiscal 2022 reporting year.
Similarly, the proportion of real estate assessments generated from residential, commercial, and industrial classes varies from city to city, with some more exposed to a significant decline in CRE values (Figure 5).
Percent of Total Assessments Generated from Commercial Property
PGIM Fixed Income, City Audited Financial Statements, Moody’s Investors Service as of the fiscal 2022 reporting year.
As an example, New York City generates 27% of its revenues from property taxes. However, only 45% of assessed values are commercial. Of those commercial assessments, only 53% are offices. Of those offices, only a portion (estimated at 60%) is categorized as Class B or Class C properties and, therefore, subject to severe declines in value. The net result may be that only 3-4% of New York’s revenues are related to Class B or Class C offices that are expected to decline in value.
While this will be a headwind to New York’s overall revenue growth, we view this as an example of manageable budget risk for the city, particularly in relation to its strong financial profile. While New York City experienced a $1.6 billion (5.1%) property tax revenue decline in 2022 due to contractions in CRE, the city maintained its strong credit profile. As of its last financial audit, New York maintained over $6 billion (or 5.7% of revenues) of surplus and fund balance reserves in its main operating fund.
Although highly unpopular to businesses and voters, many cities also have the legal ability to raise tax millage rates, or rate per $1,000 of assessed value, to make up for declining real estate assessments, which can help to keep property tax revenues relatively stable. While some cities have limitations on the amounts their millage rates can be raised, their assessment practices are typically conservative, lagged in timing and, therefore, provide a buffer against the volatile nature of real estate market values.
Although severity will vary by region, the diversity of revenues generally means that the decline in CRE valuations—and any potential decline in tax revenues—should be manageable for most U.S. cities.
The Limited Impact of Conversions
Considering the national home affordability and office vacancy situations, some cities are already considering plans to re-purpose some of the less desirable office space to residential properties. As they do so, cities are looking for ways to incentivize conversions of empty offices into affordable multi-family housing. We view this as having limited economic impact as these projects often require significant upfront investment. In some cases, a project may make economic sense given the potential for new revenue from parking or retail space. In other cases, a project may not be economical based on the cost of the property, conversion costs, number of units dedicated to low- and moderate-income residents, and financing costs. Therefore, we don’t view conversions as a wide-ranging remedy for lost revenues from lower CRE valuations.
While in the early stages, efforts by a few states and discussions at the Federal level to consider increasing subsidies to incentivize conversion projects have taken place. If governments commit to these subsidy programs, conversions could become more viable and widespread.
Retrofitting vacant offices may work in limited situations. However, these conversions likely won’t work on a mass scale without significant subsidies, thus limiting any potential benefit from a tax revenue perspective. That said, we expect the challenges to city budgets from declining CRE valuations to remain manageable. Although the challenges will affect overall tax revenues and cause some deterioration in certain cities’ fiscal situation, the fiscal consequences for most cities are likely to be minimal given the diversity of revenues, the relatively small portion of property taxes generated from commercial properties, and the flexibility to increase tax millage rates when assessments decline. Moreover, the divergence in commercial and residential property values may help to further smooth the overall impact on city budgets.
1 The dispersion across property types is consistent with our most recent fixed income themes. For more on our themes, please see our Q4 Market Outlook.
2 Availability rate is defined as the total amount of square footage available divided by the total rentable square footage. We view availability rate as a better indicator than vacancy rate in the current market environment as it accounts for subleasing.