Rising Revenues From Residences Could Bail Out City Budgets As Commercial Valuations Stumble

Looming shortfalls in CRE valuations, and a lower daytime population in central business districts, pose a threat to city budgets, which tend to rely on property and sales taxes. For some cities, the numbers are challenging.

But, a new report from Standard & Poor's argues that with prudent budgeting and an influx of cash from climbing residential property values, cities can avoid the worst of the impending damage stemming from CRE revenue falls — for now, at least. Many cities ought to be able to adjust to the lingering impact of the pandemic on downtown populations, S&P said in its report.

“Even if they are experiencing significant pressure in the commercial real estate markets, large cities do have some protections and some time to formulate a response,” S&P Director and lead analyst Scott Nees told Bisnow.

The report notes that the fiscal pressure on cities comes in the form of a “trifecta” stemming from the widespread adoption of remote work: falling CRE valuations, reduced tax collections in urban cores and damage to the financial health of public transit systems.

The challenges are nationwide. New York is facing a $5.8B deficit for fiscal 2024, despite cuts to city spending earlier this year. San Francisco faces a budget deficit of about $780M that will probably be dealt with with across-the-board cuts to city departments and other measures. Even some smaller cities are feeling the pinch: Milwaukee, for example, is facing an estimated $122M budget gap this year.

The most affected cities will see credit pressures amplify in the coming years, the S&P report says, and while most large cities will be able to meet short-term budget issues, significant uncertainty remains, especially considering conditions in the CRE market are still evolving.

One measure of protection for cities is a lag of several years before changes in real estate values are reflected in assessed value, so the drop-off in tax revenue isn't immediate, Nees said.

“It's probably going to be more staggered for the places that are experiencing declines in assessed value,” Nees said. “That also allows time for the countervailing effects, say if you have growth in residential or in other properties that are actually doing well, to maybe offset some of the losses you're seeing in the struggling commercial properties.”

Also, cities that experience a loss in commercial property values will probably shift the levy to residential properties, where valuations have been rising in recent years, though that has tapered off somewhat in recent months. To some extent, residential offers a way to offset commercial property revenue declines, but it isn't assured for every city.

“The city can shift the levy onto residential homeowners, which on the one hand that that shields your budget, but on the other hand, creates a different problem, namely higher taxes for homeowners,” Nees said. “I wouldn't be terribly surprised if we see some reluctance on the part of policymakers to raise taxes, because they know that's going to hit directly to the voting homeowners.”

Still, many cities have been able to build reserves coming off a decade of strong market value growth, much of which was driven by residential real estate, Nees said, so cities might have some wiggle room when it comes to residential tax rates.

"Most cities are actually more dependent on residential property tax receipts than they are on CRE,” said Tracy Hadden Loh, a fellow at the Bass Center for Transformative Placemaking of Brookings Institution, and it isn't especially a function of geography.

Honolulu, San Diego, Minneapolis, Austin and Miami are the top five cities nationwide that collect more in residential property taxes than commercial — over 20% more, in the case of the top three, according to Brookings data. 

A much smaller number of cities are in the reverse position, collecting more commercial real estate taxes than residential. The top commercial-dependent are Chicago, Washington, D.C., Detroit and Denver.

“Cities in high-growth regions where office demand was strong until recently have also seen large increases in home values during the pandemic, and so higher residential property tax receipts can make up for, or even exceed CRE losses,” Hadden Loh said.

Similarly, the loss of sales tax revenue from the spending of office workers in the downtown area is partially made up by residents spending more time, and doing more spending, in their neighborhoods, Hadden Loh said.

Still, a thick cloud of uncertainty hangs over office properties and the downtowns that contain them feeding into continued concern over what could happen to valuations. So, there is still a strong element of variability when it comes to municipal revenue, Nees said.

Though there have been efforts by employers to bring more workers into the office more of the time, remote work has entrenched itself, with 28% of days worked from home as of April, according to WFH Research.

Among those jobs that can be done remotely, as of February, only 20% were being done 100% of the time in the office, and office occupancy in 10 major metros is 47.6% as of the end of May, according to Kastle.

The economic impact of that shift is hard to measure precisely, but there is an impact, with the estimated per-person reduction in annual consumer spending in large U.S. cities down by at least $2K each year, or as much as $5K, S&P says.

Even so, different cities are seeing different patterns of downtown recovery, at least according to the number of people physically present, as measured by cellphone data. Cellphone use in New York, San Jose, Washington, D.C., and Phoenix in the last year has topped 60% of pre-pandemic usage patterns, putting them at the top among U.S. cities by that metric.

At the bottom are cities with less than 50% of their pre-pandemic cellphone use, including Seattle, Philadelphia and San Francisco, which rests squarely at the bottom, with less than 40% of its pre-pandemic cellphone use.

"We believe that cities that don't see RTO trends moving in the right direction are more susceptible to a downward spiral of a reduction in both tax revenue and attractiveness of downtowns and are at the greatest risk of experiencing pressures to credit stability,” the S&P report says.

For those facing office market disruption, several potential stabilizers could either blunt or slow the direct budgetary spillover, the report says.

One factor working in cities' favor is the fact that for many, revenues were growing before the pandemic, and while 2020 represented a panic and a temporary drop in revenue, the overall pattern of economic growth returned in 2021. The last three fiscal years have been characterized by revenue overperformance and strengthening balance sheets, and many cities also still have significant federal stimulus money on hand.

Of the 15 major cities that Standard & Poor's examined for the report, general revenues were up a median of 12.7% from 2019, with property taxes representing a median of 43.5% of those general revenues. Residential properties contribute more revenue than commercial properties in most places: on average, roughly a 60-40 split.

On the other hand, not every city has adapted. The cities that are in the most trouble are those that are both disproportionately dependent on CRE and where the residential base is small relative to the worker base, such as D.C. and Boston, Hadden Loh said.

Also, some cities have stable or declining housing markets that can’t make up for CRE-related losses, such as Chicago and Philadelphia, though most of Chicago’s property tax revenue goes to pension obligations and not the city’s general fund, so the impact there is indirect.

“We're still in — I wouldn't say early times, because this has been an issue for the last few years — but we still don't know what the endpoint looks like,” Nees said. “What lower valuations mean for U.S. cities on a case-by-case basis involves significant uncertainty.”