LRGs' revenues from the real estate sector are somewhat volatile. Proceeds from land and other asset sales, as well as property transaction fees, tend to follow market trends. Exposed LRGs might see revenues decline in the short term due to a fall in valuations and fewer property transactions. We note that recurrent property taxes based on assessed value (ad valorem) could be less volatile than transaction-based taxes because the former are usually derived from an officially-registered cadastral value, rather than what the market might dictate. However, if a prolonged market contraction depresses property prices, governments might opt to significantly write down cadastral values. Furthermore, recurring taxes from commercial real estate in large metropolitan areas are particularly vulnerable to changes in work trends and leisure activities.

Although there are substantial variations across countries, we generally view LRGs' exposure to short-term real estate market volatility as limited.  Taxes on real estate transactions and proceeds from land and other asset sales account for about 5% of total revenues, on average. We estimate that total payments related to the performance of the real estate sector, considering both direct and indirect exposure, amount to slightly less than 20% of LRGs' total revenue, on average.

We regard Chinese LRGs and French departments as more exposed to real estate market downturns.  This is because revenues from real estate transactions and asset sales comprise 28% and 20% of their total revenues, respectively (chart 1).

Melbourne, Sydney, and London are more exposed to commercial real estate.  These cities could suffer a substantial revenue reduction if their commercial real estate sectors hit hard times. This is because recurring taxes from this segment account for more than 25% of their budget revenues.

Here we look at LRGs in 20 countries outside of the U.S. and how pressure on the real estate sector is affecting their revenues. We also take a closer look at some LRGs that are more exposed to the sector.

Chart 1

China's LRGs Promote Large Land Sales To Boost Growth

Chinese LRGs generate a substantial amount of revenue from land sales, far more so than from conventional property-related taxes.  Nevertheless, China uses a build-and-transfer model to manage its land sales, mostly to achieve atypical fiscal stimulus. Before LRGs release the land to the public (mainly developers) they use a parcel of that land for preliminary public investment in infrastructure (roads, utilities, pipelines, and so on). This model minimizes losses (or deficits) for most governments as they use cash accounting to book revenues and expenditures (chart 2).

Large land sales indicate the significance of the property sector to China's local economy.  Property investment accounts for about one quarter of China's new investment, while total investment consistently hovers around 45% of GDP. We forecast an L-shape correction to China's property sales, which could slow down LRGs' land sales and weigh on the development of local economies. We expect the sector's land sales will stay flat in 2023 and rise by only 5% in 2024. This follows a decline in land sales of 23% in 2022.

Chart 2

French And Spanish LRGs Have Seen Property Tax Volatility

French departments' revenue risks mostly relate to property transaction taxes.  This dependence exposes them to the real estate market. Property transaction taxes have historically been highly volatile and have affected local budgets, while recurrent taxes on real estate have grown at about a stable 2% annually (chart 3). Swings in transaction taxes have usually occurred alongside macroeconomic shocks. Transaction taxes declined by almost 30% after the global financial crisis and we anticipate they could drop about 15%-20% in 2023 compared to 2022 following the steep rise in interest rates that has depressed home buyers' budgets.

Chart 3

In 2021, recurrent taxes on real estate (property tax) were transferred to French municipalities.  Property tax had accounted for about 56% of total real estate revenue for French departments in 2020. While they were compensated with a share of national VAT, the dependence on property transaction taxes continues to increase (chart 4).

Chart 4

The past performance of Spanish regions' revenues highlights how volatile transaction tax collections can be.  In 2022, revenues from property transaction taxes reached their highest since 2007, but we now forecast a downturn in such revenues in 2023. This will be driven by a cooldown in the market amid tighter borrowing conditions because of rising interest rates (chart 5).

Spanish regions were hit significantly by the real estate market downturn in 2008-2009 and have still only partly recovered. The sharp correction saw this revenue source plummet to just 5% of total revenues in 2009, from 11% in 2007. In recent years, the regions have diversified into other sources of revenues to reduce their exposure to real estate; in 2022 real estate transaction taxes represented almost 7% of their total revenues.

Chart 5

Property Taxes Are More Predictable But Subject To Shifts In Commercial Real Estate

Many LRGs across different countries rely on property taxes as their main and most stable revenue source. For example, in French cities, Israeli municipalities, and New Zealand municipalities these accounted for more than 25% of budget revenue in 2022. Melbourne, Sydney, London, and Toronto receive more than 30% of budget revenues from these taxes.

Recurring taxes come under different names but are universally levied on residential and commercial real estate, with property value as a base in most cases. Usually, this value remains stable despite short-term market volatility but may follow long-term price trends with some time lag. Local governments have the flexibility to raise tax rates in case of long-term downward value corrections.

However, substantial increases in tax rates on real estate may reduce a city's attractiveness for citizens and businesses, thereby further damaging its tax base. This is especially so for commercial real estate, which is currently suffering from lower demand in large metropolitan cities due to changes in work trends, commuting, and leisure patterns.

Chart 6

Dependence on property taxes levied on commercial real estate may exert downward pressure on budgetary performance in large metropolitan cities. Based on information from a group of selected cities, we estimated that owners of commercial property pay more than 50% of recurring real estate revenues.

Chart 7

A contraction in the real estate market could lead to a significant revenue decline for large metropolitan areas. Melbourne, London, Sydney, and Toronto are examples of metropolitan areas that depend heavily on recurrent taxes on real estate. On average, 27% of their total revenue comes from recurrent taxes on commercial real estate, followed by 17% from residential real estate.

Real Estate Market Exposure Goes Beyond Direct Taxes

The real estate sector represents a substantial part of local economies. On average, it accounts for about 13% of GDP and in France, New Zealand, Canada and Spain this figure tops 15% (chart 8). A structural contraction in real estate may lead to a corresponding loss in tax revenues from companies operating in the sector. This could result in a larger revenue decline than the direct payments from the real estate sector would suggest.

China appears to be an outlier, because we used the so-called narrow scope definition reported by the central government. Nevertheless, property investment (promoted by LRGs' large land sales) is one of the main drivers of China's high investment.

Chart 8

Related Research

• European Housing Markets: Sustained Correction Ahead, July 20, 2023
• Local And Regional Governments' Positive Momentum Is Losing Steam, June 29, 2023
• Could Empty Offices Lead To Empty Coffers For U.S. Cities?, June 22, 2023
• Stimulus Is A Highwire Act For China's City Governments Facing Property Go-Slow, June 21, 2023