Bet on the Tortoise

With the economy weakening, will the bottom drop out of the real estate market--and property-tax collections--again?
April 2001
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Finance officers and a few gray-haired elected officials remember vividly how the bottom dropped out of the real estate market in the early 1990s. An outcome of the ensuing real estate doldrums was lagging growth in property-tax receipts, which hobbled governments for several years.

So, the question is, with the economy weakening, will the bottom drop out again?

I doubt it. The recent growth in the tax's base has been solid. The real estate markets are not suffering from the overbuilding and price bubbles that caused so many distortions at the beginning of the last decade.

Take residential housing. It is one of the most volatile parts of GDP and many property-tax systems are especially susceptible to the impact of construction and home sales. Past growth cycles have seen residential construction grow like Topsy in the early phases and then plummet as a recession kicked in. But this time, residential construction has grown at a leisurely pace and housing prices, while moving upwards, have not been moon shots--with one notable exception: Silicon Valley under the spell of the tech boom.

A recent study by Lynn Brown in the New England Economic Review shows that housing permits have reflected population growth and that home construction represents a smaller part of national and regional GDPs than was the case in the 1980s. Housing prices have generally tracked the inflation rate throughout the decade without severe escalation, except in a few hot spots such as San Francisco.

As to non-residential real estate, it is generally on a much more solid footing nationally than was the case a decade ago. Today's commercial real estate industry is more sober than in years past and has repented for the excesses of the late 1980s when a generation's supply of office buildings was built the last half of the decade. In comparing the share of GDP represented by non-residential construction, such investment spending accounted for 3 percent of national GDP in the mid 1980s. It plummeted to less than 2 percent in the mid-1990s and then recovered to about 2.5 percent by the late 1990s. That relative stability is exhibited in office building construction. In the rip-roaring 1980s, commercial building peaked at 900 million square feet in 1985 and averaged more than 700 million square feet per year for the entire decade. In the much more restrained 1990s, the average was about 550 million square feet a year.

Tough love now rules commercial real estate. Banks and other institutional lenders have been tougher in providing credit for development so that speculative building has dried up. Risk factors embedded in capitalization rates have soared. Returns on real estate now require spreads that are 600 basis points above yields on 10-year U.S. Treasuries, twice as much as the 300 basis points that prevailed in the 1980s. Aside from some overbuilt submarkets (such as big-box retail and low-end hotels), commercial real estate markets around the country are sporting low vacancy rates and getting sustainable rents. Particularly strong gainers in the past few years have been the central city areas, such as Los Angeles, New York, Chicago, Boston and Washington, D.C., which for many decades languished while suburban areas blossomed. By and large, the big cities will enter any recession with much stronger property markets (and much better property-tax bases)than last time.

The sustained but gentle growth in property values has made the property tax the tortoise in the revenues race. Property-tax collections during the last half of the 1990s rose at a rate of 4.5 percent a year, only about 1 point above the rate of inflation. That was well above the 2 to 3 percent of the desultory mid-1990s, when many jurisdictions saw an absolute decline in ratables. But it was far below the double-digit gallop of the late 1980s, when inflation in housing prices and strong construction inflated tax bases up at a fabulous and unsustainable rate. (Remember, at the end of the 1980s, property-tax collections were rising at a rate of more than 10 percent a year!) That slow but steady growth has been a hardship on rapidly growing areas. But overall, it has meant that there is a buffer of solid value that will carry the sector into turbulent times with a secure tax base.

An economic slowdown of a year or so would not be fun. But that is not likely to affect assessed property values, which react to market value changes with a year's or more lag. Recession is no time to be raising tax rates, and, happily, the continuing forward momentum in taxable values will help forestall making that decision.

The above is not to put a gloss on the coming travails of fiscal adjustment. But nationwide, the bulwark of local finance--the property tax--is sitting astride a much stronger economic foundation than was the case 10 years ago.