Location, location...diversification

When it comes to local news, real estate is perhaps second only to the weather as a perpetual concern. The health of U.S. cities and municipalities is heavily linked to property values as the taxation of property is often a significant part of their revenue stream. While the prices of residential real estate have soared since the pandemic, the office commercial real estate (CRE) market has suffered sharp declines. The S&P Case-Shiller Home Price Index is up 49% since the end of 2019, while the Bloomberg office REIT index has declined 48% over the same time period. The work-from-home phenomenon may have enhanced home values, but it has slashed office use and property values. S&P Global reports that U.S. office vacancy rates were 19.7% at the end of the fourth quarter of 2023, a massive increase from 13.2% at the end of the first quarter of 2020, i.e., right before the pandemic.

Almost every American city is dealing with falling office CRE values, raising the specter of falling property tax revenue and even abandoned buildings. It’s no wonder municipal bond investors are concerned. While the situation may seem dire, we believe the devaluations will not become a damaging sector-wide credit crisis. Instead, the extent of the impact will vary significantly by city and will depend on a number of factors:

• Diversification The extent of the challenge will depend on the share of total revenue that is derived from office properties and the revenue share and appreciation of residential and other real estate types within each city. Even cities with high concentrations of office commercial property are not as reliant on property taxes as many might think. For example, in New York City, offices make up 21% of the property tax base but only account for 5.5% of total revenue as its diverse economy generates government revenue streams from income, sales and residential property taxes. Similarly, Miami, Chicago and Washington D.C. generate 15% or less of their revenue from taxing commercial property. Boston, on the other hand, generates more than one third of its total revenue from this tax source.
• Solid foundation Most U.S. cites are starting from a strong credit position, supported by diverse economies and revenue sources, as well as the benefits of the continued economic expansion and the large federal transfers from pandemic relief bills. In fact, S&P currently rates 54% of local governments at the AA- or higher level and 97% of local governments at A- or higher. Cities like Boston, New York and San Francisco, for instance, are all rated at the AAA or AA level by the major rating agencies.
• Taxes Cities and municipalities must balance their budgets and most have extensive flexibility to adjust revenues and expenditures. Those with the ability and willingness to increase tax and milage rates can mitigate adverse credit effects from falling commercial property values. Furthermore, property tax revenues tend to lag shifts in market values as laws governing tax levies and assessments often phase in market value changes over time, allowing governments more opportunity to adjust to the challenge thru tax changes and expenditure adjustments.

In short, predictions that downtowns will collapse are overdone. CRE stress will decrease property tax revenues for some cities and some negative credit rating actions will occur. That said, most cities will manage through the challenge relying on tax diversification and policy flexibility. Investors, then, should rely on credit work and security selection to identify the many city General Obligation bonds that will remain key components of a diversified municipal portfolio.