It seems nobody is talking about the property tax bomb coming to almost every major city. What is causing the huge decrease in property tax revenue even though your individual property taxes have skyrocketed? Why will your property taxes continue to skyrocket?
I’m amazed that there hasn’t been a bigger emphasis on the financial cliffs that most major cities will soon face. Most cities are heavily funded by property taxes and most importantly commercial property taxes. How will cities fund their budgets that have ballooned during Covid without this revenue? Regardless of whether a city is performing better than its peers like Atlanta there will still be a huge reset in property taxes.
Why will there be such a huge reset in property tax collections for almost every city? First, let’s look at how commercial properties are valued. For commercial properties, the key valuation is the income approach and a capitalization rate (rate of return an investor requires). As interest rates have increased so have cap rates which means prices have decreased.
Commercial property values will continue falling
Below I put together a hypothetical analysis of what is occurring in the multifamily sector. Multifamily was trading at insanely low cap rates while at the same time banking on appreciating rents. As rents have stagnated or even declined in some markets and interest rates have basically doubled, many apartment deals no longer cash flow and are in trouble. The rise in Cap rates is driving apartment values substantially lower as there are better alternative investments. For example why would someone buy an apartment at a 4% rate of return, when they could buy a government bond with basically no risk at 5 or 6%?
| Pre Covid | ||||
| Net Operating Income | $ 300,000.00 | |||
| Value | $ 7,500,000.00 | assume a 4 cap | ||
| Debt service | $ 210,000 | 5.25m (70% LTV at 4%) | ||
| Net Cash Flow | $ 90,000.00 | |||
| Today | ||||
| Net Operating Income | $ 300,000.00 | |||
| Value | $ 5,454,545.45 | assume a 5.5 cap | ||
| Debt service | $ 315,000 | 5.25m (70% LTV at 6%) | ||
| Net Cash Flow | $ (15,000.00) | |||
The above example is of a good multifamily property that has declined due to the cap rates. Now think of many downtown areas they are heavily tilted towards office space where vacancy is now almost 50% and cap rates have risen substantially, this leads to 30-70% reductions in values which means considerably less tax revenue. Let’s look at Denver, CO as an example that has a large downtown office core.
Denver office vacancy exceeds 30% for first time since 1990’s
In 2019 office vacancy stood around 16%, lower than the national average. Fast forward and Denver office vacancy has almost doubled to over 30%.
At the end of the third quarter, total office vacancy in the city’s core was 30.6%, according to CBRE. The real estate services firm said it’s the first time downtown total vacancy has hit 30% “in the post-2000 era.” A spokeswoman provided quarterly figures going back to 2006, which show vacancy was as low as 9.5% in early 2008 and during the Great Recession went only as high as 17.4%.
A representative of JLL, another massive real estate services firm, confirmed that its own research also shows downtown Denver has hit the 30% mark. Note the 30% vacancy is an average across all office grades.
CBRE’s research found that Class B and C office buildings are the drivers behind downtown’s rising vacancy, with those buildings collectively having vacancy of 35.5% at the end of the third quarter, up 2.8 percentage points year over year.
The property tax bomb heading for Denver County
The media seems to be grasping onto the headline of huge increases in vacancy, but the real story is that there will be an even bigger drop in property tax revenue for Denver in 2025 (the next reassessment period). Remember, commercial properties pay about 3 times the residential property tax rates in Colorado.
With office vacancies hitting 30%, the values of these properties will plummet during the next assessment as the income generated is at a min 30% lower which means the values have dropped between 30-50% when coupled with higher treasury rates. There are some properties that I would say are now worthless, meaning the value is zero or even a liability for the owner.
Denver has a huge concentration of large office buildings that are now worth substantially less than a few years ago which will lead to an enormous drop in property tax revenue for the county of Denver. Now multiply what is happening in office to apartments, retail, etc… that are dependent on the downtown core office users and values across the board are substantially lower.
Most major cities will follow the path of Denver
Denver is not an anomaly; the same scenarios are playing out in most cities throughout the country as businesses cut back on their office footprints and leave for the suburbs. Furthermore, even in cities with good performing office sectors, the huge jump in cap rates due to much higher treasury rates will substantially reduce values as shown in the apartment example above.
Summary
Most major cities throughout the country are sitting on an enormous property tax bomb that will need to be addressed quickly. Commercial property values are plummeting due to higher interest rates which have driven up cap rates along with huge office vacancies. The current path will lead to either huge increases in taxes on residential properties or enormous cuts in services for these cities. The current spending in most major cities like Denver is not sustainable with the huge decrease in commercial property tax revenues.
I have yet to see a city even take the first step to acknowledge the huge problem ahead. Unfortunately, the most likely outcome for many cities will be a “doom loop” where cities increase taxes on everyone to account for the loss in tax revenue on commercial taxes. Chicago is an example of how this will play out with countless major companies and wealthy individuals leaving. We will see this play out in many cities throughout the country as higher taxes/decrease in services leads to more businesses and individuals fleeing to suburban markets. We saw this play out in the 80s that hallowed out many downtown cores and likely will see a repeat over the next 5 years in many major cities.
Additional Reading/Resources
- https://www.loopnet.com/
- https://www.denverpost.com/2023/10/31/denver-downtown-office-buildings-vacant/
- https://www.fairviewlending.com/commercial-property-prices-slide-13-from-peak-biggest-since-08-where-do-prices-go-from-here/
- https://coloradohardmoney.com/you-should-not-buy-a-rental-property-in-denver/
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Written by Glen Weinberg, Owner Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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