The rapid shift to hybrid work models has left many office buildings in America’s biggest cities partially empty, a development that could threaten cities’ tax bases and the vitality of their central business districts. Most city leaders recognize the seriousness of the problem and have proposed solutions that generally fall into one of two categories: converting offices buildings to housing, or luring residents and businesses downtown, often with the use of incentives. We think both approaches are well-intentioned, but face daunting challenges. Simply put, filling the holes left by departing office workers will not be easy, in our view.
The size of the problem
A widely used barometer by Kastle Systems puts the size of the problem in stark relief. Over the past 38 months, the percentage of in-person use of offices has fallen from around 99% to 50%. We believe office occupancy is unlikely to return to pre-pandemic levels. The steep decline has the potential to cut property tax receipts, particularly in large cities such as Dallas, Chicago, Washington, D.C., and New York, where commercial real estate represents anywhere from 20% to 45% of the taxable real estate base.[i] Most major cities rely primarily on taxes from residential and retail space. The weak office market could also cut income and sales taxes receipts as fewer people come downtown to work. It is worth pointing out that, so far, sales tax revenues have generally held up well.
Conversion to housing
The idea of turning office buildings into housing can be appealing. Most cities are short of housing, particularly affordable housing. Data from CBRE Research shows that a number of such conversions are currently underway and more are in the planning stages.[ii] But conversions tend to face a long list of challenges, including engineering and zoning hurdles. Many rules for residential building codes, from bathrooms to windows, would have to be rewritten to make conversions possible. The economic hurdles may be steeper still. The confluence of rising interest rates, higher construction costs and slowing rent growth has raised the price tag for building projects. And banks may be reluctant to lend, especially those that already have significant exposure to the commercial real estate market. In its latest Financial Stability Report, the Federal Reserve pointed to the risk banks face from a possible fall in commercial property values.[iii] The bottom line: we believe most conversions may not make economic sense without some kind of government help.
Reviving urban centers
Cities are also exploring more broad-based approaches to revitalize business districts threatened by the office slump. Muriel Bowser, mayor of Washington, D.C., recently unveiled an ambitious “Comeback Plan,’’ which seeks to create 35,000 jobs in high-growth sectors, add 15,000 downtown residents and add seven million square feet of residential units by 2028.[iv] The plan includes incentives to convert offices to housing as well as incentives for job creation and job retention. In a number of places, the job incentives are tied directly to the time employees spend in the office. Many cities and states have been using money left over from various pandemic-era relief programs to jumpstart their revitalization efforts.
A problem without precedent
In our view, these government initiatives, many of them unorthodox, should be thought of as experiments. That is not a criticism, but a recognition that we are in new territory, and no one can say with any confidence how well any of these programs will work. The post-COVID-19 exit from offices has no historical precedent, so there is no case study to fall back upon.
We think it is equally hard to predict what will happen to commercial real estate valuations or tax collections. All such data tends to be reported with a lag, so it may be some time before we have a better read on the depth of the problem.
One thing is clear to us: downtown office occupancy isn’t likely to return to pre-pandemic levels anytime soon. As a result, cities and states may have their work cut out for them as they seek to preserve their commercial tax bases and maintain the vibrancy of their downtowns.
Derek Endsley, Senior Fixed Income Analyst
Joe Prestamer. Research Associate
[i] Loomis Sayles analysis of city 2022 comprehensive annual financial reports.
[ii] CBRE Research, 2 December 2022, https://www.cbre.com/insights/viewpoints/office-conversions-a-second-chance-for-underutilized-space.
[iii] Federal Reserve Financial Stability Report, May 2023. https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf
[iv] DC Comeback Plan, https://mayor.dc.gov/release/mayor-bowser-unveils-dcs-comeback-plan#:~:text=The%20Comeback%20Plan%20is%20a,rich%20neighborhoods%2C%20and%20thriving%20people
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