What Do Falling CRE Values Mean for Municipal Bond Investors?

Declining commercial real estate (CRE) values are changing the dynamics of the nation’s largest metropolitan centers. The post-COVID-19 realities of increased office vacancies present financial challenges for many cities. In addition to declining property tax collections, mass transit, hotel occupancies and sales taxes remain under pressure as fewer people utilize central business districts.

Here we focus on the challenges facing office properties and commercial property tax revenues, the impacts on credit quality and credit ratings, and the mitigating factors.

Working from Home Has Reshaped Commercial Real Estate

Across the country, CRE property values are dropping, especially big-city office properties. The rapid shift to work-from-home (WFH) and hybrid working arrangements has left many downtown office buildings clamoring for tenants.

While office occupancy rates have slowly increased since the height of the pandemic, they are far from their pre-COVID levels, as Figure 1 highlights. According to Kastle Systems’ Back to Work Barometer, more than half the office space in the nation’s 10 largest cities remained vacant as of early August 2023. The company, a property security provider that tracks employee badge swipes, reported that average office occupancy was 47.3% as of August 9.

Select Cities See CRE Occupancy Gains

Occupancy rates generally remain in the doldrums compared with pre-pandemic levels, but many cities have seen gains versus 2022. Compared with 2019, Washington, D.C., has fared the best, with July 2023 office occupancy rates down “only” 22.4%, as Figure 2 illustrates. Not surprisingly, San Francisco logged the worst occupancy rate, off nearly 56% compared with pre-pandemic levels.

However, compared with 2022, San Francisco boasted the largest increase, with a 38% gain in office occupancy. Washington, D.C., wasn’t far behind, with a 36% gain, while Miami showed the lowest year-over-year increase at 3%.

City Tax Revenues Could Decline and Weigh on Credit Ratings

Falling occupancies and building owners’ refinancing needs could put substantial strain on office values, especially older, less-functional properties in central business districts. Additionally, approximately $1.5 trillion of maturing CRE loans may need refinancing over the next three years.¹ Given the trajectory of interest rates, property owners likely will be refinancing this massive debt at higher market interest rates, further straining CRE values.

This could cut revenues of cities that rely heavily on property taxes and have legal restrictions on raising those taxes (e.g., California’s Proposition 13).

Overall, property taxes account for approximately 61% of the tax revenue cities and counties collect, followed by various sales and income taxes.² Lower property tax proceeds combined with fewer office-based employees could burden city budgets. Accordingly, officials would need to find other revenue sources and/or reduce spending on essential services.

Effect of Sliding CRE Values on Muni Credit Quality

The overall impact of declining CRE values on broader municipal (muni) credit quality should be muted relative to cities. States and counties have broader tax bases and rely less than cities on office properties for tax revenue.

School district credits are typically among the more property-tax-dependent local government issuers. However, most state laws protect school funding from lower assessed values, requiring states to backfill lost property tax revenue for their schools.

Of course, sharply declining office values could result in rating downgrades for some cities. However, we believe severe credit stress for most cities will remain unlikely, given these five offsetting factors:

1. Reserves Remain Strong

Most large U.S. cities have solid reserve levels, providing these entities with substantial cushions against future revenue shortfalls. For example, the median general fund balance for the nation’s 10 most populous cities was approximately 27% of annual expenditures in 2022.³ For the city sector overall, the median balance was 53% of general fund expenditures.

Also, the trend in city general fund reserves has been positive, especially since the onset of the pandemic. Figure 3 shows the growth of general fund balances as a percent of expenditures from 2009-2022.

Even in San Francisco, among the most vulnerable entities to WFH trends and declining office values, the general fund balance is solid. The City and County of San Francisco finished fiscal 2022 with a $2.8 billion unrestricted general fund balance. This was equal to approximately 45% of San Francisco’s fiscal 2022 general fund expenditures.⁴

2. Time Is on City Officials’ Side

Most large U.S. cities prepare multiyear financial plans. This practice, along with the likely slow-moving nature of CRE property value declines, should give officials sufficient time to prepare.

It typically takes up to two years for the effects of a major economic event to show up on a city’s tax rolls. Therefore, it should take at least that amount of time for property value declines to affect actual revenue collections. In addition, the presence of long-term leases should help slow the decline in property values — unless distressed sales accelerate the property declines.

3. Revenue Streams Are Diverse

Large cities generally have diverse income streams, with property taxes representing only a portion of revenues. The median exposure to property tax revenues as a percent of general fund revenues was approximately 28% in fiscal 2022.⁵ Furthermore, for many cities, residential properties, not commercial land, account for most property tax revenues.

For example, in San Francisco, central business district office properties represent only 14% of assessed values, accounting for 4% of total general fund tax revenues. Meanwhile, residential properties represent approximately 66% of assessed values.⁶

Figure 4 shows the percentage of property tax revenues for select large cities derived from commercial (office retail, hotel, industrial) versus residential properties.

4. State Laws Help

Many states have statutory and constitutional limits on annual property tax growth. This means assessed values may be substantially lower than pre-COVID-19 or even current market values.

Accordingly, property values have some room to decline before the assessed value takes a hit. Given this dynamic, if a building sells at a substantial discount, the city will likely see a smaller property tax revenue reduction. Also, most residential properties’ assessed values will likely continue to grow at their constitutional/statutory limits, providing some offset to lower office-assessed values.

5. New Construction, Property Sales Counteract Some Effects

Over time, new construction and the redevelopment of obsolete properties may replenish some of the declining CRE property tax revenue. Additionally, sales of older or high-profile properties at prices exceeding current assessed values can offset the effects of lower CRE values and may replenish some of the declining CRE property tax revenue. Additionally, sales of older or high-profile properties at prices exceeding current assessed values can offset the effects of lower CRE values.

Our Process Considers CRE and Other Challenges

We believe most large cities are equipped to meet their CRE challenges and preserve muni credit quality stability, although at somewhat lower credit ratings. Also, changing commercial property values don’t have immediate or one-to-one corresponding effects on the credit quality of cities. Furthermore, offsetting factors, including lag time, state regulations and new construction, should soften the blow of declining CRE values on municipal credit quality.

It's also important to remember that the CRE market stress is mostly limited to the nation’s largest cities, with potential implications for general obligation (GO) debt. But the muni market is much more than GO bonds. It’s a vast and diverse market, with opportunities from issuers of varying purposes and sizes and securities of differing credit quality.

We believe investing in this wide-ranging market requires an active strategy driven by fundamental credit research. We apply our researched-focused approach consistently in all market climates and amid all market challenges, including the current CRE troubles. We believe this steady approach enables us to respond quickly and opportunistically to changing conditions.