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The recent downturn in certain segments of the commercial real estate (CRE) sector, namely office properties, has significant ramifications for major cities because property taxes play a significant role in funding municipal operations.
Against this backdrop, we ask: Which cities could be most affected by a prolonged decline in commercial office values? Our findings indicate that large cities may be sufficiently insulated from even a severe, elongated downturn given the strength of their balance sheets and the diversity of their revenue streams.
In recent years, the health of state and local government credits has improved noticeably — it’s strong relative to historical standards. This improvement is partially the result of generous direct and indirect federal support during the pandemic and partially the result of sustained tax growth.
One potential challenge to local government credit quality is the notable decline in office values that has come about due to the shift to hybrid work schedules and tightening credit conditions, among other factors. As property taxes are a major component of local general obligation credits, we’ve decided to analyze how office valuation declines could impact major US cities.
We found that large cities should be positioned strongly enough to withstand even more severe declines effectively. Large cities may be more resilient in these scenarios because they tend to have more durable balance sheets, mainly because of their wide range of revenues. Cities usually benefit not only from property taxes, but also from sales taxes, income taxes, and intergovernmental transfers.
Like other governmental credits, city balance sheets have been buoyed by growing tax revenue (partially driven by inflation), federal aid, and manageable expenditure growth. This gives cities ample room to absorb the tax impact of office valuation declines, especially if it isn’t paired with other major revenue impacts like income tax declines or residential real estate declines (Figure 1).
To uncover the potential impact of office value declines on city balance sheets, our municipal bond investment team ran three scenarios based on different potential declines in office valuations. Our base, bear, and ultra-bear cases analyze a 15%, 30%, and 50% decline in office valuations, respectively (Figure 2).
Figure 2 highlights that the impact by major city varies, but even in the most severe ultra-bear scenario, the budget decline figures are generally less than 5%, and the years-of-cash-supply figure is almost always greater than five. We can see that among our pool of large cities, Boston is the most affected on a budget-decline basis given its dependence on property taxes and its higher tax rate for commercial real estate. Relative to cash on the balance sheet, New York is the most affected in each scenario.
We believe the years-of-cash columns in Figure 2, which show how many years the city can absorb a predicted budget decline with just the cash on its balance sheet, are noteworthy. These range from seven years (New York) to 130 years (Philadelphia) in the bear case. We believe that this exposure is manageable because under the ultra-bear scenario, even New York, with an estimated 26% decline of available cash, can absorb that impact for four years with only its existing cash cushion.
It’s worth noting that this analysis assumes there will be no other adjustments in revenues or reductions in expenditures, which would not necessarily be the case in a more extreme bear scenario. Additionally, this decline would likely happen over at least two years, which gives cities more time to react than our table accounts for.
The bottom line is that while certain segments of the commercial real estate sector may have struggled of late, large cities are prepared to weather any subsequent storms, thanks to their durable balance sheets and diverse revenue streams.
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