The COVID 19 pandemic dramatically accelerated remote work trends, increasing work-from-home frequency by the equivalent of about four decades of pre-pandemic growth. The now broad-based acceptance of hybrid and remote work has meant that the once-anticipated broad-scale return-to-office (RTO) appears to have largely stalled as of mid-2023.

Kastle Systems' widely followed Back To Work Barometer shows office occupancy in major U.S. office markets at just under 50%, where it has held relatively constant since the beginning of the year. Similarly, WFH Research has published monthly survey data on remote work patterns since the start of the pandemic. It finds that the percentage of full paid days worked from home fell considerably with widespread vaccine availability in early 2021, but has further fallen only marginally and at a very slow pace, sticking at approximately 30% since early 2022 (chart 1) and indicating an ongoing transition.

Chart 1

Mass transit ridership reflects a similar trend. Weekly ridership plummeted at the start of the pandemic and has since staged a slow and still-incomplete recovery, with average weekly ridership through May 2023 remaining 30% below 2019 levels (chart 2). In our sector outlook for not-for-profit transportation infrastructure, we estimate that public transit ridership will recover to only 85% of pre-pandemic levels by 2026 under our base-case scenario, and because of a secular trend of falling ridership pre-dating the pandemic, will not rebound to pre-pandemic levels for a long time (see "Outlook For U.S. Not-For-Profit Transportation Infrastructure: COVID In The Rearview Mirror, Yet Transit Stuck In Second Gear," published Jan. 11, 2023, on RatingsDirect).

Chart 2

S&P Global Ratings believes there are several key factors that, over the next few years, have the potential to increase downside credit sensitivity for some large U.S. cities, particularly those with significant economic reliance on large central business districts and limited ability to adjust budgets quickly.

Despite the challenges facing commercial real estate due to RTO trends, we do not expect a broad-based decline in general obligation credit quality among large U.S. cities, particularly those with a foundation of strong credit characteristics and the capacity to proactively manage emerging risks. For those facing significant disruption, several potential stabilizers could either blunt or slow the direct budgetary spillover from RTO stagnation, which we expect will create some room for budgetary accommodation. We also find that the pace of downtown recovery is not following a one-size-fits-all formula: Factors such as location, local unemployment, industry composition, and commute times point to different cities having markedly different recovery paths (chart 3). We believe that cities that don't see RTO trends moving in the right direction are more susceptible to a downward spiral of a reduction in both tax revenue and attractiveness of downtowns and are at the greatest risk of experiencing pressures to credit stability.

Chart 3

As Office Vacancies Escalate, Commercial Real Estate Braces For A Wild Ride

As loans used to finance office buildings mature and tenant leases expire in the next several years, we expect rebalancing in the current office market will play out until a new equilibrium is reached, with the interim period likely to see ongoing steadily falling office real estate valuations. Office vacancy statistics for 15 major U.S. cities indicate that most have a vacancy rate that is higher than the U.S. average; a majority have seen a greater basis point increase in vacancies than the U.S. since the start of the pandemic (chart 4). We selected these cities for size, amount of total office inventory, and geographic diversity. They are: Atlanta, Austin, Boston, Chicago, Denver, Houston, Los Angeles, Miami, New York, Philadelphia, Phoenix, San Francisco, San Jose, Seattle, and Washington, D.C.

Chart 4

As office leases that were in effect at the start of the pandemic expire, we expect vacancy rates will keep climbing as businesses reexamine their space needs and, in many cases, downsize or move to higher-quality class A office space, to the detriment of older class B and C buildings. Near-term macroeconomic softening will also drive up vacancy rates, as employers trim payrolls leading to rising unemployment rates through the next few years (see "Economic Outlook U.S. Q2 2023: Still Resilient, Downside Risks Rise," March 27, 2023). Cushman & Wakefield expects national vacancy rates will increase through 2023 and peak in 2024, before beginning a comeback that will depend on location-specific factors such as the pace of local jobs recovery.

Solid Economic And Revenue Growth Contribute To Stable Financial Footing--But For How Long?

In the past decade, the largest U.S. cities have enjoyed strong economic growth, despite near-panic circumstances that prevailed at the onset of the pandemic. The last three fiscal years were characterized largely by revenue overperformance and strengthening balance sheets across the 15 U.S. cities discussed here. Many also still have significant federal stimulus money on hand that, while in most cases must be earmarked for spending by the end of 2024, offers some additional near-term flexibility. Heading into the current fiscal year, most large cities were at a financial and, in some ways, economic high point, which provides some cushion to manage the near-term budgetary volatility that could accompany pressured valuations or tax appeals from commercial property owners.

Gains in real estate values have been considerable over the past decade, as the median city's market value has risen by 73% (chart 5). The growth pattern continued even through the pandemic, as evident in the median average annual growth rate of 6% in the past three years, a trend that was mirrored in general revenues, which have risen by 13% on average since 2019 (table 1), largely defying early pandemic fears of a major revenue shock. Strong revenue performance allowed cities to swell available general fund balances by 39% at the median in the past three years, with only one city (Atlanta) reporting a very small drop in reserves since 2019.

Chart 5

Residential Property, Not Commercial Real Estate, Drives the Tax Base

A key indicator of relative credit risk will be how well real estate valuations perform overall in the coming few years and to what extent growth in non-commercial classes of property offsets losses from commercial. Residential real estate is the largest component of assessed value of major U.S. cities (60% at the median, compared with 39% for commercial in our 15-city sample), and offices comprise a subset of commercial properties (chart 6). Despite falling office valuations, it's possible that stability, or even growth, in other areas could countervail at least some of the expected losses from underperforming office properties, given the relative size of the residential tax base compared with commercial. It is also worth noting that there's significant segmentation within the office market itself, so that stable demand for newer, higher assessed Class A office space may blunt the losses expected from the older buildings with high vacancy rates.

Chart 6

In these 15 cities, property taxes generally have been stable up to now with a few exceptions, while growth in sales and other taxes has been more than enough to offset losses from reduced downtown activity. Most large cities have diverse revenue streams with a median of 44% of general revenues coming from property taxes, which could provide stability if property taxes drop from commercial real estate devaluations. WFH Research finds that downtown spending has decreased by $2,000-$5,000 per person annually since the start of the pandemic. Although such figures point to what should be weaker city revenue collections, we've still observed strong revenue performance overall.

Dollar-Based Tax Levies Will Provide Stability In Some Cases; Tax-Shifting To Residential Is The Result

Many cities are not subject to property tax rate caps, or, they may be levying well under their statutory cap. This means that a drop in the assessed value for commercial real estate does not result in a direct loss of tax dollars, but rather shifts the tax burden to other classes of taxpayers--including residential properties, which are almost universally the largest segment of the tax base.

However, many cities will see a tax shift to residential that could, among other things, exacerbate the home price affordability issues that have become endemic in cities for some time. Along with this shift, policymakers could be more reluctant to raise property taxes, given that doing so would directly affect voting homeowners and renters. And considering the prevalence of dollar- rather than rate-based taxation against a backdrop of near universally high housing costs, we believe tax-shifting could become a greater long-term concern in many areas.

Strong Credit Quality, Sophisticated Management, And Long-Term Planning Help Mitigate Risk

Most large cities with sophisticated management teams that engage in multiyear financial planning and many are already incorporating losses from commercial real estate into their outyear revenue forecasts. We expect that the gradual onset of declines in commercial real estate valuations, given staggered lease terms and loan maturities extending out several years, will allow some time for contingency planning, as will the typical lag of a year or more before changes in the market value of real estate are fully reflected in the assessed value on which property taxes are calculated. A gradual onset will buy some time for a smoother fiscal response to mitigate revenue shortfalls or service disruption, while increasing the likelihood of offsetting economic and revenue growth in the interim.

We will be watching for an early indicator of potential credit stress: how quickly, and to what extent, assessed values reflect stress in commercial real estate. Just as important is how cities choose to address potential revenue shortfalls in their budgets and long-term financial plans. Revenue shortfalls of a few percentage points of budgeted expenditures are usually accommodated without upsetting structural budgetary balance, so a key sign of rising risk will be large and increasing outyear budget gaps that represent more than the typical amount. Through fiscal 2022, we have not seen property taxes or other revenues affected by RTO have a material impact on budget outcomes, based on audited results, so the risk lies primarily in the future and likely over a medium-term horizon.

Housing Availability and Affordability Remain Important Factors For Long-Term Stability

Recent trends in U.S. Census data indicate that college-educated workers are moving away from high-cost coastal cities in search of a lower cost of living, particularly for housing, a trend fueled by post-pandemic remote work flexibility. Metro areas with lower affordability and a higher share of office workers are more vulnerable to these departures and could take more of an impact to the tax base over time. Not all major high-cost metros have seen net outflows, but the rate of inflows has slowed in recent years, reversing a notable trend over many decades. Net outflows from Los Angeles, San Francisco, and San Jose, where more college-educated workers are leaving than arriving, are fueling net inflows to places like Atlanta, Dallas, and Houston, further weakening downtown recovery prospects in these large, coastal cities (chart 7).

Chart 7

As downtowns look to remake themselves, there is much speculation from the market regarding converting old office buildings into apartments. This is a big "if," however, as office conversions may not be economically viable for developers or even possible without significant public subsidies and changes to local zoning restrictions. Furthermore, significant limitations to what is feasible to convert make this option less of a silver bullet than some cities might hope. However, despite the cost and logistical difficulties of repurposing, cities continue to explore office-to-residential conversions and they could still be part of the solution for tax base stability.