Cities are facing budget cuts as commercial real estate prices plummet
There was a 20-story office tower in San Francisco that sold for $146 million a decade ago December mentioned for just $80 million.
In Chicago, a 200,000-square-foot office building in the city’s Clybourn Corridor that sold for nearly $90 million in 2004 was demolished. purchased last month for $20 milliona discount of 78 percent.
And in Washington, a 12-story building combining office and retail space, three blocks from the White House, that recently sold for $100 million in 2018 went for just $36 million.
Such steep discounts have become common for office space in the United States as pandemic trends of hybrid and remote work have continued, hollowing out urban centers that were once full of workers. But the losses don’t just affect commercial real estate investors. Cities are also beginning to bear the brunt, as municipal budgets that rely on taxes tied to valuable commercial real estate are now facing shortfalls and considering budget cuts as a lower assessment of property values reduces the tax burden.
“They are being sold at huge discounts,” Aaron Peskin, chairman of the San Francisco Board of Supervisors, said of office buildings in his city. “If you were the people buying at the top of the market, you were going to get a huge haircut.”
Mr. Peskin said San Francisco’s $14 billion budget faces a $1 billion deficit in coming years, partly due to lost tax revenue from commercial real estate.
“In the short term, this 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 recovery and an influx of billions of dollars in federal relief money disbursed through the 2021 American Rescue Plan. That left municipalities so flush with cash that they gave city workers raises. renovation of local basketball and tennis courts and improving sewerage systems.
But now budgets are starting to get tighter.
A National League of Cities budget report released last year shows optimism among municipal finance officials is beginning to wane amid concerns about weaker sales and lower property taxes that coincide with the expiration of federal funds.
Cuts could lead to what Arpit Gupta, a professor at New York University’s Stern School of Business, has described as an “urban doom loop” across the United States.
In a research paper updated late last year, Mr. Gupta and his colleagues estimated that the national office market lost $664.1 billion in value between 2019 and 2022. To close the budget holes left by lost tax revenue, they suggested that cities cut back on services or raise other types of taxes. But that would also come with its downsides, including pushing businesses and residents to leave, which would worsen the problem by further eroding the tax base.
Mr. Gupta compared the dynamic to the conundrum that rust belt cities faced in the 1960s and 1970s, as manufacturers closed their doors and local governments struggled to balance their budgets.
“Some cities that tried to raise taxes and cut public services found that those responses accelerated the process of urban exodus,” he said. “It kind of made itself worse.”
The pressure on the commercial real estate sector has been evident since the pandemic accelerated the remote working trend. This is further complicated by high interest rates, which have made refinancing expensive, and by tensions in the banking sector, which are approx $3 trillion in outstanding commercial real estate debt.
The situation is reminiscent of the turmoil the commercial real estate sector experienced during the 2008 financial crisis, when lending dried up. This time, however, the changes in how and where people work indicate that a deeper structural shift in the market could be taking place – at least until interest rates fall.
Glen Seidlitz, principal and founder of the Washington-based commercial real estate consulting firm Six23, said many building owners and investors are trying to restructure their loans and in some cases are looking for new capital. But for the most part, due to lower occupancy rates and higher financing costs, the sector is in decline.
“It feels like the lenders are really recognizing the fundamental problem: if interest rates stay higher it means there is less capital to buy property and if there are fewer buyers to buy property then prices will obviously reflect lower demand, ” said Mr Seidlitz. “And so until there is stability, there will only be a spiral as a function of that.”
Concerns about commercial real estate increased last month when New York Community Bank announced unexpected losses on real estate loans tied to office and apartment buildings, sending its shares tumbling. At a congressional hearing in February, Treasury Secretary Janet L. Yellen acknowledged that the sector could pose financial risks and said regulators were watching for signs of trouble.
The risks for municipalities depend on the extent to which their tax bases depend on income from commercial real estate.
A report from Moody’s Investors Service last October said that Atlanta and Boston’s credit ratings are among the most vulnerable to swings in commercial real estate prices, but that industry turmoil would threaten major cities in the coming years.
“The shift to more work outside the office, exacerbated by the already existing trend of increasing online purchasing, has shifted a significant portion of spending out of business districts,” Moody’s analysts said in the report.
Thomas Brosy, a research fellow at the Urban Institute’s Tax Policy Center, noted that declining valuations are often a “lagging indicator” as new leases yield lower rents and owners appeal tax assessments while other buildings sell for low prices. He suggested that cities will have to make hard choices about cuts and tax increases within the next three years.
“It’s starting to get painful,” he said.
Major urban centers are already preparing for the worst.
San Francisco, which is facing a sharp increase in commercial property tax bills, has had to delay maintenance of city facilities to save money. Mr. Peskin, who is considering a run for mayor of San Francisco, said he has pushed for policies that would encourage the conversion of vacant downtown office space to apartment buildings.
New York City’s comptroller last summer outlined a “doomsday scenario” in which the city’s office values fell 40 percent below their pre-pandemic peaks. This would translate into budget deficits of approximately $322 million in 2025 and $1.1 billion in 2027.
In Washington, where the office is The vacancy rate was more than 20 percentThe budget situation is also dire at the end of 2023. Some of the capital’s main office buildings have billboards advertising leases, while downtown retail spaces sit empty.
The owner of the Washington Wizards and Washington Capitals is seeking to vacate the city’s Capital One Arena and move the teams to Virginia, potentially dealing another blow to a downtown already struggling with restaurant and retail closures. The business group DowntownDC Business Improvement District estimates that the arena helps generate $341 million in annual spending.
The city’s chief financial officer, Glen Lee, predicted last year that Washington would face a $464 million budget deficit between 2024 and 2026. He attributed much of that shortfall to declining tax revenues from commercial real estate. 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 transport and office space, leading to a potential reduction in property prices.”
He added: “Overall, the pandemic and the shift to remote work will likely have far-reaching economic impacts on the district.”