Declining Valuations Are a Danger to Local Tax Collections

Even last year, before the total CRE devaluation from post-pandemic highs took place, the issue of metropolitan tax collections had raised its head.

“The divergence in commercial and residential property values makes it hard to predict the fiscal consequences for local governments broadly,” Thomas Brosy of the Tax Policy Center, a venture of the Urban Institute and Brookings Institution, wrote in 2023. “Total property tax revenue accounts for 30 percent of local general revenue, but the pain from this transition will likely be concentrated in major cities with big commercial districts.”

Look at office alone, as KBRA recently did, and the implications are uncomfortable when you consider three factors: ongoing hybrid work, tech employment downsizing in the face of a shift to artificial intelligence, and in some urban centers an oversupply of commercial real estate.

There are record office vacancies and rising loan delinquencies. KBRA looked at some major metropolitan areas and then considered how the impact on local tax collection. Recent figures in many major cities seem to have plateaued at occupancy rates of 50% to 55% of pre-pandemic levels.

Many companies don’t need as much space as they’ve used in the past and nationally about a third of all office leases will expire by 2026. Will companies keep unnecessary space? Probably not. The net absorption rate for office space — occupied space less vacated during a period — has run negative in 10 of the 16 quarters since the beginning of 2020.

“While high interest rates and a shortage of office building sales contributed to a slowing in commercial property revaluations through most of 2023, impending forced sales and foreclosures are expected to result in updated valuations that fall below many office buildings’ recent sales prices, and in some cases below their outstanding loan balances,” KBRA wrote.

As values fall, so can either the ability of cities to realistically charge as much and of property owners to pay as much as in the past. But not all cities will see the identical results.

“Commercial office revaluations will affect property tax revenues and the overall fiscal condition of cities differently, based on factors specific to each including the degree of reliance on the property tax, the proportion of the property tax base represented by commercial office space, the effective tax rate on commercial property, the performance of the residential real estate sector, and the assessment process,” they wrote. “Appeals for reassessments, which may become more common with continuing declines in rents and occupancy levels, can also affect how commercial office revaluations impact property tax revenues.”

For New York City, the commercial share of total property tax revenues is 25%; 37% for Chicago, 26% in Los Angeles, and 54% in Dallas. But the valuations are all done differently. New York uses the previous year’s net operating income. LA looks to expected future income. Chicago uses a combination of market value based on cap rate, a 25% taxable percentage for commercial properties, and a factor intended to maintain the assessed value at a third of fair market value. Dallas uses a mix of current market value, building improvements, and revenue, with appraised values set at 100% of estimated market value.

Because of these differences, valuations of similar properties can vary sharply and shift in varying ways with time. The result will be pressures that vary on property owners and city tax revenues that could sharply drop, but years after the market changes that have taken place. KBRA also notes that cities have ways to “counteract reduced property taxes attributable to declining CRE values.”

“In addition, many cities are exploring the cost-effective repurposing of older buildings for other uses,” they wrote. “For these reasons, the impact of CRE distress on property tax revenues in the nation’s largest cities is expected to be manageable.”