Bubble Trouble

A puncturing of today's inflated real estate values would have negative and broadscale effects on local governments.
by | July 2005
 

Professional worrywarts have glommed on to a worthy subject: the massive residential real estate bubble. The lowest interest rates in two generations and easy loan terms have cast a magical spell over that market and fueled huge increases in values. It's no longer a question of if that fabulously frothy market will peak, but when and, then, how quickly the gas will go out of the balloon.

Since 2000, average home prices have risen 50 percent nationwide, and by much more in many local markets. One can see why folks are flocking to flipping houses. Even though the run-up in asset prices has not been as fast as occurred in the stock markets in the late 1990s, the economic implications of an "adjustment" are likely more profound. Real estate drives as much as 25 percent of the economy, and a puncturing of the inflated values would have broadscale negative effects. For local governments that depend on the property tax, it could be a disaster.

There have, of course, been real estate booms and busts before. The previous downturn at the onset of the 1990s was fairly localized and offset by the growing economy of the decade. In many jurisdictions, however, the decline in property values did not recover until the end of the decade. In affluent Fairfax County, Virginia, for example, property assessments declined between 1992 and 1995 and, as a result, property tax rates had to be increased by about 10 percent.

The worrisome thing this time around is that lending standards have been lowered and mortgage terms made increasingly easy. Home buyers are taking out loans that do not require any immediate payment of principal. With little cash flow or capital resources, some of these small fry will quickly default and the momentum on the downside could be crushing.

Local governments have a lot riding on the bubble. For one thing, the way to offset the impact of the exploding assessed values is to keep lowering property tax rates. In many parts of the country, tax rates have plummeted, since the double-digit increase in values has meant there is "too much" value to tax at current rates. Politicians are racing to keep property tax bills from rising too fast, but they have a faint glimmering that, like riding a bike downhill, there is likely to be an uphill climb ahead and peddling will be much harder. The unfortunate consequence of declining property values that would accompany a burst of the bubble would be a need to raise rates to generate the same levels of revenues.

National statistics provide some insights as to what happens when the property tax goes south. Until the late 1980s, all state and local taxes were increasing at double digit rates--pushed along by higher inflation rates. The property tax made up about one-third of all state and local tax collections. With the bust of the early 1990s, growth of property tax revenue slowed to a crawl. Meanwhile, other taxes--state income and sales--grew as the economy prospered. The property tax receded to less than 29 percent of total collections.

Come the early 2000s and there's been a sharp reversal. The economic downturn--and poor performance in the equity markets--hit state tax collections hard, but thanks to low interest rates and a shifting of assets to real estate, the property tax once again grew in importance. Between 2001 and 2003, 60 percent of all the growth in combined state and local tax collections was attributable to the property tax. Thus, by the end of 2004--before the most recent round of soaring property values--the property tax had climbed back to generating more than 32 percent of all state and local revenues.

Local officials should be worried about the spike in property values and the race to the bottom in property tax rates. It's not that they have any good alternatives. Almost any cure--caps on assessed values or schemes for averaging values--has proved to be worse than the disease. But with a volatile tax base, the need to raise rates will likely come in the midst of an economic downturn, when taxpayers are both less able and less willing to pay.

The best advice is to be very conservative in assuming what future property values will be, keep a firm handle on recurring costs and make tax cuts that are as easily reversible as possible. For those bubble-ridden areas with the most gaseous markets, stay alert and be prepared for values to decline and for future spending plans to be put on hold.

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