Wall Street Sours on America’s Downtowns

From a Wall Street Journal story by Heather Gillers headlined “Wall Street Sours on America’s Downtowns”:

Wall Street is betting against America’s downtowns.

Investors are paying less for bonds linked to New York subways and buses. Downtown-focused real-estate investment trusts trade at less than half their prepandemic levels. Bondholders are demanding extra interest to hold office-building debt.

Downtowns have been a mother lode for American cities over the years, providing billions of dollars in tax revenue along with their distinctive skylines. In turn, investors who bet on downtown office towers, or on the trains and buses delivering workers to them, could generally trust they held a winning hand.

Now, with white-collar workers spending more time in their home offices, a phenomenon that shows few signs of ending, investments linked to downtowns are trading at falling prices in volatile markets.

“You could see this as a slow-motion change or as the beginning of a slow-moving train wreck,” said Richard Ciccarone, president emeritus of Merritt Research Services. “I hope it’s not a train wreck, but it could be.”

Investors’ dimming view of downtowns isn’t good news for cities’ finances, nor for their residents. It puts under strain some of city governments’ traditional ways of extracting wealth: collecting property taxes on office buildings, taxes on wages earned within city limits, and fares from office workers’ commutes.

Residents of some cities are bracing for austerity. Many New York library branches expect to close an additional day each week under cuts proposed as the city faces rising labor costs and budget gaps projected to reach $7 billion in 2027. From New York to Chicago to San Francisco, residents and visitors complain about empty downtown streets and transit stops that have become way stations for the mentally ill and homeless.

City vs. suburb

Analysts at Asset Preservation Advisors, a municipal-bond management firm, are watching downtowns closely. The team remains confident of certain tax-backed bonds sold by New York City and Boston, but has grown wary about debt of some other Northern urban centers and big California cities, even bonds backed by those cities’ full taxing power.

“The suburbs are going to be one of the big winners in this, and the potential losers could be the large cities that have depended on people coming back and forth to work,” said Ken Woods, founder and chairman of the firm.

Office buildings are only about 50% as full as before Covid-19 across 10 major metro areas, according to keycard tracking by Kastle Systems, a building-security company. Federal transit data show public-transportation ridership at less than 70% of pre-Covid levels in major metro areas.

President Biden said more than a year ago it was time for America to get back to work “and fill our great downtowns again.” Yet even in the federal workforce, more than half of employees worked remotely at least one day a week last year, according to one survey.

One indication of investors’ wariness of downtowns can be seen in how they price bonds backed in part by commuter fares. The lower a bond’s price, the higher its interest yield. In New York, some bonds partly backed by bus, subway and commuter-train fares yielded a lofty 1.25 percentage points above top-rated municipal bonds on June 14, a spread 56% wider than before Covid, according to ICE Data Services, a financial analytics company.

While the bonds remain investment grade and many asset managers are comfortable holding them, Asset Preservation Advisors has stopped buying fare-backed debt of the New York Metropolitan Transportation Authority unless it matures relatively soon.

In another indication of investor worries, those who buy a common type of low-rated commercial mortgage-backed security are demanding 9.25 percentage points more interest than that on 10-year Treasurys as of June 12, according to research from Bank of America. This spread is three times as big as before the pandemic for such securities, which finance a property mix that is around 30% office space.

Office space

Subsidiaries of Pacific Investment Management and Brookfield Asset Management recently defaulted on more than $2 billion in commercial mortgage-backed securities related to office towers in New York, San Francisco, Los Angeles and other cities.

Share prices of the five largest real-estate investment trusts that concentrate on downtown office buildings were down 63% on June 15, on average, from the end of 2019. Price declines were much smaller for REITs focused on retail property (down 7%) and apartment-focused REITs (down 8%).

What has happened to the value of downtown office buildings isn’t easy to gauge, because sales have slacked and many office rents don’t adjust with shifting demand—they are locked in place by long leases.

“Over the next 10 years, we’re gradually going to come to grips with this, and the stuff will slowly reprice,” said Stijn Van Nieuwerburgh, a Columbia Business School professor.

He and colleagues at Columbia and New York University estimate that the value of office property across U.S. cities is 38% lower than before the pandemic, equaling a loss of about $500 billion.

As values weaken, some office-building owners are challenging their tax bills. If lower tax assessments result from these challenges, leading to lower tax revenue from the office buildings, big-city officials will face an uncomfortable choice: Collect less revenue or lean more heavily on other taxpayers.

Office-building property taxes make up about 10% of revenue in major cities, according to a calculation by Green Street, a real-estate analytics firm. It projects “a dire picture for future city budgets with high levels of remote work.” Older Northeastern, Midwestern and California cities with high debt loads and pension liabilities already were facing budget struggles, a contrast with sprawling metropolises in South and West states.

Los Angeles this year began charging a tax on home sales above $5 million. New York Mayor Eric Adams supports putting two newly state-authorized casinos in the city. Many ideas for reinvigorating downtowns appear years away from a financial payoff, such as converting empty office space to homes, entertainment venues or even day cares.

The cities aren’t going broke. Even those most affected by remote work remain home to many wealthy people and companies. Certain residential neighborhoods benefit from the work shift. The big price swings of publicly traded securities linked to office towers and transit will have limited significance if the underlying assets recover quickly.

Cities’ operating expenditures declined in 2022, on average, according to budget figures compiled by the National League of Cities, an advocacy group. Adjusted for inflation, cities had the largest drop in both spending and revenue in almost 40 years except for that following the 2008-09 financial crisis.

Federal aid provided when Covid struck staved off deeper budget cuts. Sales- and income-tax revenue surged in 2020 and 2021 when stocks boomed and consumers spent stimulus checks.

Both the tax windfalls and the aid money are running out.

Asset Preservation Advisors manages about $6 billion in municipal bonds for affluent households and other clients. The team—which works from the office four days a week—combs through data such as cellphone activity in downtowns and sewer hookups for new homes in expanding metro areas.

Go west (and south)

Increasingly, the team is finding opportunity in suburban bonds in lower-tax Southern and Western states that have drawn companies and workers now untethered from Northern big-city centers. Securities-industry jobs, traditionally tied to Wall Street, have increased by 20% or more in Utah, Georgia, Tennessee, Texas, Wyoming and North Carolina since 2019, according to the U.S. Labor Department.

In Florida, hedge fund Citadel Securities from Chicago moved its headquarters to Miami and Elliott Management from New York moved its headquarters to West Palm Beach. Investment giant BlackRock opened a satellite office in West Palm Beach in January.

One city Woods’s team has backed away from is San Francisco, where the tech industry embraced remote work early on and now is laying off employees.

“We’re seeing an emperor without clothes to a certain degree,” said Woods. “We just want to be very cautious.”

Meta Platforms, Salesforce, Yelp and Block have announced plans to sublease or not renew office space. Twitter stopped paying rent on some of its San Francisco offices, according to a lawsuit by its landlord, an affiliate of Pimco-owned Columbia Property Trust, which later defaulted on the building.

Cellphone activity in downtown San Francisco was at 32% of its pre-Covid level as of last winter, according to research from the University of Toronto.

San Francisco laid out budgetary risks when it sold bonds in March. About a quarter of its office space is vacant, according to real estate services firm CBRE, in the biggest increase from before Covid of any major city. Downtown ridership on the Bay Area Rapid Transit system in April was 34% of its prepandemic level. S&P Global Ratings downgraded some of San Francisco’s commuter rail bonds on June 1, though they remain investment grade.

There have been some signs of recovery. Downtown sales tax revenue was 19% higher in the last three months of 2022 compared with that period in 2021.

A particular concern, in Asset Preservation Advisors’ view, is a flurry of requests from landlords of downtown office buildings to reduce the properties’ tax values. A result of those appeals could be that San Francisco’s annual property-tax revenue, currently around $3 billion, will be $100 million to $200 million lower than expected in each of the next five years, according to a forecast by the controller’s office.

The firm is cautious about counting any city out, though. In the early 2000s, it decided to mostly steer clear of bonds from its hometown, Atlanta, concerned about city finances and a bribery scandal.

In 2012, its credit analysts took another look and noticed improved city governance, a rainy-day fund and pension cuts, as well as Atlanta’s population growth, bustling airport and universities. The firm soon started buying Atlanta bonds again.

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