April 18, 2024

KT Business

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Cities Face Cutbacks as Commercial Real Estate Prices Tumble

6 min read

In San Francisco, a 20-story office tower that sold for $146 million a decade ago was listed in December for just $80 million.

In Chicago, a 200,000-square-foot-office building in the city’s Clybourn Corridor that sold in 2004 for nearly $90 million was purchased last month for $20 million, a 78 percent markdown.

And in Washington, a 12-story building that mixes office and retail space three blocks from the White House that sold for $100 million in 2018 recently went for just $36 million.

Such steep discounts have become normal for office space across the United States as the pandemic trends of hybrid and remote work have persisted, hollowing out urban centers that were once bustling with workers. But the losses are hitting more than just commercial real estate investors. Cities are also starting to bear the brunt, as municipal budgets that rely on taxes associated with valuable commercial property are now facing shortfalls and contemplating cutbacks as lower assessments of property values reduce tax bills.

“They’re being sold at massive discounts,” Aaron Peskin, president of the San Francisco Board of Supervisors, said of office buildings in his city. “If you were the folks who bought at the top of the market, you’re taking a huge haircut.”

Mr. Peskin said that San Francisco’s $14 billion budget is facing the prospect of a $1 billion shortfall over the next few years, in part because of lost commercial real estate tax revenue.

“In the short term, it means less money in municipal coffers and a less robust downtown,” he said.

Since the pandemic, cities across the country have benefited from an economic rebound and an infusion of billions of dollars in federal relief money that was disbursed through the American Rescue Plan of 2021. That left municipalities so flush with cash that they were giving city workers raises, refurbishing local basketball and tennis courts and upgrading sewage systems.

But now budgets are starting to tighten.

A fiscal report published by the National League of Cities last year found that optimism among municipal finance officials has started to wane amid concerns of weaker sales and lower property taxes coinciding with the expiration of federal funds.

Cutbacks could lead to what Arpit Gupta, a professor at the New York University Stern School of Business, has described as an “urban doom loop” across the United States.

In a research paper that was updated late last year, Mr. Gupta and his colleagues estimated that the national office market lost $664.1 billion in value from 2019 to 2022. To fill the budget holes created by the lost tax revenue, they posited that cities could cut services or raise other kinds of taxes. But that would come with its own downsides, including prompting businesses and residents to leave, exacerbating the problem by further eroding the tax base.

Mr. Gupta compared the dynamic to the conundrum that rust belt cities experienced in the 1960s and ’70s when manufacturers shuttered and local governments struggled to balance their budgets.

“Some cities that tried to raise taxes and cut back on public services found that those responses accelerated the process of urban flight,” he said. “It sort of compounded itself.”

The stress bearing down on the commercial real estate sector has been evident since the pandemic accelerated the trend of remote work. That has been complicated by high interest rates, which have made refinancing expensive, and stress in the banking sector, which is holding about $3 trillion of outstanding commercial real estate debt.

The situation is reminiscent of the turmoil that the commercial real estate sector experienced during the 2008 financial crisis, when credit dried up. This time, however, the changes in how and where people work suggests that a deeper structural shift in the market could be setting in — at least until interest rates fall.

Glen Seidlitz, principal and founder of the Washington-based commercial real estate advisory firm Six23, said that many building owners and investors are trying to restructure their loans and in some cases looking for new capital. But for the most part, because of lower occupancies and higher borrowing costs, the sector is in decline.

“It feels like the lenders really recognize the fundamental problem, which is, if interest rates are going to stay higher, it means there’s less capital to buy real estate and if there are less buyers to buy real estate, obviously prices are going to reflect lower demand,” Mr. Seidlitz said. “And so until there is stability, there’s just this spiral that will occur as a function of it.”

Anxiety over commercial real estate ratcheted up last month when New York Community Bank disclosed unanticipated losses on real estate loans that were tied to office and apartment buildings, sending its stock plunging. At a congressional hearing in February, Treasury Secretary Janet L. Yellen acknowledged that the sector could pose financial risks and said that regulators were watching for signs of trouble.

The risks for municipalities depend on how reliant their tax bases are on revenue from commercial real estate.

A Moody’s Investors Service report last October said that the credit ratings of Atlanta and Boston were among the most vulnerable to swings in commercial real estate prices but that upheaval in the sector would be a threat to large cities for the next several years.

“The shift to more work away from the office, compounded by the preexisting trend of increased online purchasing, has peeled a substantial amount of spending away from business districts,” Moody’s analysts said in the report.

Thomas Brosy, a research associate at the Urban Institute’s Tax Policy Center, noted that declining valuations tend to be a “lagging indicator” as new leases fetch smaller rents and owners appeal tax assessments when other buildings sell for low prices. He suggested that within the next three years, cities will have to make hard choices about spending cuts and tax increases.

“It’s going to start to be painful,” he said.

Major metropolitan centers are already preparing for the worst.

San Francisco, which is experiencing a surge in tax assessment appeals for commercial buildings, has had to defer maintenance on city facilities to save money. Mr. Peskin, who is considering running for mayor of San Francisco, said that he had been pushing for policies that would encourage converting vacant downtown office space into apartment buildings.

New York City’s comptroller laid out a “doomsday” scenario last summer where the value of the city’s offices settled at 40 percent below their prepandemic peaks. This would translate to budget shortfalls of approximately $322 million in 2025 and $1.1 billion in 2027.

In Washington, where the office vacancy rate topped 20 percent at the end of 2023, the fiscal situation is also dire. Signs advertising leases are emblazoned on some of the capital’s prime office buildings, while downtown retail spaces sit empty.

The owner of the Washington Wizards and Washington Capitals has been angling to vacate the city’s Capital One Arena and move the teams to Virginia, potentially dealing another blow to a downtown already struggling with closures of restaurants and retail stores. The DowntownDC Business Improvement District business group estimates that the arena helps generate $341 million in annual spending.

The city’s chief financial officer, Glen Lee, projected last year that Washington would face a budget shortfall of $464 million from 2024 to 2026 and attributed much of that gap to declining commercial real estate tax revenue. In an update last month, Mr. Lee warned that the health of the sector was deteriorating more than previously expected and that shifts in demand for office space could have lasting consequences for Washington.

“As more people work from home, the district’s transportation and office real estate sectors are likely to experience significant shifts,” Mr. Lee said in a letter to the mayor and the chairman of the City Council about the capital’s finances. “With fewer commuters, there may be less demand for public transportation and office space, leading to a potential reduction in real estate prices.”

He added: “Overall, the pandemic and the shift towards remote work are likely to have far-reaching economic consequences for the district.”

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