Spotlight

How do Commercial Real Estate Values Impact the City’s Property Tax Revenues?

This spotlight investigates how the current trends in the commercial office space market are likely to impact NYC’s property tax revenues. This year, primarily as a result of non-property taxes, the City is taking in far more revenue than expected; however, these trends are not projected to continue in future years.  Meanwhile, the plateauing of office occupancy indicates that market values may dip in the coming years. Usually, property tax revenues are relatively stable, because of a 5-year “smoothing” formula that accounts for market fluctuations. In previous downturns, this rule has protected the City from revenue losses. But the pandemic’s impact and the uncertainty of office space use given the shift to hybrid work is a large enough change that we could see the percent decline in the property tax revenues nearly match the percent decline in market values for the city’s office space.

The Class 4 commercial category, which accounts for 39% of the City’s property tax revenue, and an estimated 19% of its overall revenues, is comprised of different building types including office, retail, and hotel, among others. Property tax valuations for FY 2021 were first published in January 2020 and reflect pre-pandemic economic conditions. Almost all property types within Class 4 experienced declining values as the impact of the pandemic was incorporated into the FY 2022 valuations, with an overall decline of 17.4%. Data from the City’s recently released final tax roll for FY 2023 show that although market value estimates for Class 4 rebounded, they remain lower than the 2021 estimates (Table S.1).

Table S.1: Class 4 DOF Market Values by Select Property Types FY 21-FY 23

While Class 4 property values remain below the FY 2021 levels, economic conditions for most property types are improving, suggesting that DOF’s market value estimates will continue to grow for most categories. Hotels were most impacted initially because of the travel restrictions that effectively shut down the travel industry causing market value estimates to decline by almost 24% for FY 2022. Although not reflected in the FY 2023 valuations, hotel demand continues to rebound, as seen in Chart 11 of the newsletter above, and even the retail market has shown some signs of stabilizing.[2] However, as evidenced elsewhere in this newsletter, office properties, which by themselves account for approximately 20.2% of the overall property tax levy (including residential classes) in FY 2023, are lagging.

The current state of the office market

As noted in this newsletter over the last few months and again in Chart S.1. below, the overall office vacancy rate (direct and sublease) has not shown signs of improvement and has in fact reached a new all-time peak in the first quarter of calendar year 2022. Both the direct vacancy rate at 16.0%, and the indirect (or sublease) vacancy rate currently at 5.0%, exceed the vacancy rates of the 1990s recession and are far greater than the peak vacancies experienced during the 2001 and 2008 downturns.

Chart S.1

The fast rise in the direct vacancy rate, nearly 5 percentage points higher year over year, is particularly concerning because, unlike space available for sublet, direct vacancies cease to generate rental income. The rise in the direct vacancy rate has been both steeper and faster than in previous downturns.  The increase in sublet space, in turn, could result in even higher direct vacancies if market conditions remain weak and leases are not renewed.

How do vacancy trends and market values impact property taxes?

In past real estate cycles, deteriorating market conditions and slowing growth in the Class 4 market did not result in a decline in Class 4 tax revenue. In FY 2011 for instance, when market value growth slowed to 0.9 percent, taxable billable assessed value continued to grow by a strong 4.7 percent (Table S.2).

Table S.2: Class 4 Taxable Billable Assessed Value[3] and Market Value During the Previous Downturn

Taxable billable assessments continued to grow despite the drop in market value because market value changes (both positive and negative) are phased into assessed values over a 5-year period for properties in Class 2 and 4. This smoothing mechanism usually creates a pipeline of phased-in values and lessens the impact of year-to-year fluctuations in market value estimates on tax revenues.[4]

However, in the case of market value drops as severe as those that occurred in the FY 2022 tax roll, the taxable billable assessed values can also drop abruptly. Under NYS property tax law, billable assessed values for Class 2 and Class 4 properties are based on the lower of two values– 1) the actual assessed value (AV) which is 45% of the current-year estimate of market value and 2) the transitional AV, which is the result of the 5 year phase-ins of past market value increases.[5]  The “pipeline” is formed when the actual AV is higher than the transitional AV, as it is in most market conditions.

Table S.3 shows an illustrative example of how the impact of changing market values (up or down) on Taxable Billable Assessed Values can be mitigated by this pipeline, but only when the drops are less severe. In years 2016-2020, the phase in of market values in the pipeline resulted in a gradual increase in taxable billable AV, thereby protecting the property owner from sharply rising property taxes.  In 2021, the decline in the market value estimate was moderate, so the remaining pipeline still led to an increase in the taxable billable value.

Table S.3:  Illustrative Example of the Impact of Changing Market Value on a Sample Property

However, in 2022 the decline in market values is so steep that the relationship flips: actual AV is lower than transitional AV, and taxable billable drops sharply from $57.15 to $47.25, as shown above.

This sudden drop and flipping to the lower actual AV is what happened to most office buildings in FY 2022 as shown in Chart S.2 below. Office market values plummeted by 16 percent. While in FY 2021, 95 percent of office properties had billable AV corresponding to transitional AV, by FY 2022 the share had shrunk to 15 percent as the drop in market values “blasted through” the pipeline.

 Chart S.2

Taxable billable AV jumped back to the transitional AV for 40% of office properties in FY 2023, indicating that some pipeline has been restored. However, the majority of office properties (60%), still have an actual AV below their transitional AV. This indicates the potential for tax revenue upside is limited (because of the 5-year phase-in), while a drop in market value estimates could more directly and immediately decrease the tax levy.

To assess the downside risk associated with the fact that 60% of office properties still have an actual AV below transitional and no pipeline to mitigate a market value decline, we compare our current baseline forecast for the FY 2023 Executive Budget[6] with alternate scenarios. Our baseline assumes that office market values will be essentially flat in FY 2024. Office vacancies peak in early 2022 and begin to decline by the end of the year ending slightly lower than in CY 2021. In the “soft-landing” economic scenario (in which the Fed is able to bring down inflation without pushing the economy into recession) that underpins the forecast, office employment growth moderates but remains positive.

However, the risks to the office market are both macro-economic and specific to the transition toward hybrid work schedules, which could lower demand structurally, even if job creation continues.    As an alternate scenario to this baseline, we simulate what would happen if market vacancies did not improve by year-end in CY 2022.[7] We simulated two scenarios. The first is based on the direct vacancy rate remaining 5 percentage points higher than in 2021, driving a 5% decline in estimated market values for FY 2024. The second scenario assumes a sharper 10% drop in market value stemming both from a higher direct vacancy rate and declining rents. The comparison of these downside scenarios to the baseline are shown below.

Table S.4: Office Property Tax Levy Baseline vs Downside Scenarios

Given the current post-pandemic starting point, a decline in market values would now cause property taxes to decline immediately with little offsetting effect from the pipeline, with a 5% drop in market value estimates resulting in a 4% drop in corresponding office property tax levy, or $200 million. A more severe downturn in market values of 10 percent would cause the office property tax levy to decline almost exactly by 10 percent, or $600 million. Property tax revenues are typically associated with stability and have helped in previous recessions to offset declines in other more volatile tax categories, such as income taxes.  However, given that the protective pipeline for the office market was significantly diminished during the pandemic, that stability does not describe office-specific property tax revenue in this period.

These risks are one more reason why the Mayor and City Council would be wise to deposit an additional $1.8 billion into the Rainy Day Fund, bringing this year’s total contribution to $2.5 billion (50% of the amount by which this year’s non-property taxes exceed the average of the past 6 years), and bringing the total amount in long-term reserves to 10% of City revenues, enough to weather nearly 2 years of the next recession, whenever it comes, without major cuts to essential services.