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As Tailwinds Subside, Cities Set to Confront a New Reality

Nearly a year on from the Center for Disease Control's formal declaration of the end of the public health emergency from COVID-19, we find that major U.S. cities are still largely in the early stages of what we expect will be a multiyear transition. The national post-pandemic economic recovery has seen a resilient labor market and strong consumer spending propel economic growth beyond early expectations. Inflation has been stubborn, but has moderated significantly from earlier highs, and the Federal Reserve has signaled the possibility of a pivot on interest rate policy later this year. Successive rounds of federal stimulus have also provided a backstop to city finances since early in the pandemic, contributing to strong budget outcomes over several fiscal years and providing new resources to fund capital priorities.

Despite a surprisingly robust recovery so far, office vacancies continue to rise amid remote work patterns that have become entrenched. Americans are working from home roughly 30% of the time, an apparent equilibrium given that the share of paid days worked from home has changed very little over the past two years (Chart 3). And while city-by-city outcomes vary widely, downtown activity remains a fraction of pre-pandemic levels, even among cities that have seen a comparatively strong recovery (Chart 4). We reviewed 13 major U.S. cities in depth to assess the degree of credit exposure related to downtown recovery generally and CRE in particular; key findings for each are presented below.

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Lukewarm Economic Forecast Points To Cooling Revenue Growth

Contrary to widespread concerns that CRE devaluation could cause property tax revenue to plummet, in our survey only a few cities have significant direct revenue exposure to CRE. More commonly, we found that cities are poised to see sluggish revenue growth associated with weaker economic performance and, in some cases, slowing tax base growth. The median city we reviewed is projecting general fund revenue growth ranging from 1.2% to 2.7% annually through 2027 (Chart 5), below our economists' core consumer price index (CPI) projection for 2025 and just a touch above CPI projections for 2026 and 2027. Moreover, this slow-growth outlook marks a considerable decline from the 4.8% and 12.7% growth that buoyed budgets in fiscal years 2021 and 2022, respectively, and signals a more challenging budgetary environment ahead. While revenue forecasts are heavily dependent on economic assumptions that will inevitably change over time, we believe they offer an important lens on what cities could expect during a critical recovery period.

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Projection data from the 13 cities largely mirror several measures of economic performance that are also showing signs of slowing. Our current U.S. macroeconomic forecast has 2.5% real U.S. GDP growth in 2024, with below-trend outyear growth (Chart 6). We expect unemployment to edge up to 4.2% in 2025 and 2026 and consumer spending growth to soften in the interim. (See "Economic Outlook U.S. Q2 2024: Heading For An Encore," published March 26, 2024, on RatingsDirect.) While the forecast has grown increasingly favorable over the last few quarters, the outyear slowdown is notable, and budgetary balance could be even more difficult for some cities to manage if an economic downside scenario were to throw cold water on already tepid outyear GDP growth expectations.

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Big Cities Face Big Cost Challenges In Post-COVID Pivot

Slow revenue growth may not be as daunting as the possibility of sharp revenue cliffs tied to CRE devaluation, but emergent cost pressures arising from post-pandemic transition and recovery remain notable. Public safety, housing affordability, homelessness, downtown revitalization, and office conversions have achieved nearly universal emphasis in city budget narratives and are commonly the focal point of new proposals for increased operational spending, capital investment, and subsidy programs. While proactive spending targeting recovery priorities could be credit neutral--or even credit supportive if effective at enhancing recovery prospects--the practical necessity of addressing multiple concurrent issues may require difficult budgetary tradeoffs.

Potential cost challenges are compounded by several factors: higher-for-longer interest rates will increase the cost of capital for cities and present an additional headwind to a struggling office sector; increased labor costs and shortages continue to plague issuers across the U.S., and despite cooling inflation could push up wage growth for several more years (see "U.S. Local Governments 2024 Outlook: Stimulus Shelters Governments in 2024; Preventing Long-Term Leaks Requires Fiscal Focus Now," published Jan. 9, 2024); and widespread home price affordability challenges further complicate recovery by making tax increases more politically sensitive, while also reducing some cities' competitive advantage vis-à-vis less expensive cities and suburbs and increasing the number of unhoused (Chart 7).

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CRE Is Unlikely To Tank Tax Levies

Market participants are understandably concerned about the possibility of CRE valuations falling significantly across major cities and resulting in weaker tax collections and budget pressure. To date, while we continue to see real estate values increasing across the major metros that we reviewed for this report (Chart 8), it is at a slightly slower rate than in the years immediately preceding the pandemic. It may come as a surprise that San Francisco has seen average annual growth in market value of 5.8% since 2020, compared to 8.5% in the preceding five years. Like many cities, San Francisco has been helped by residential market growth that has offset declines in CRE valuations. Even commercial values have been relatively stable in many cities, reflecting CRE market segmentation that includes sectors that have not been as volatile as office real estate, such as retail, multi-family residential, and industrial.

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Tax assessments tend to lag changes in market value, and the protracted nature of the office sector recalibration--given vacancy rates that are still climbing, the long-term nature of office leases, etc.--means that it may still take several years before we know the magnitude and implications of a reset in office valuations. While this is an area we are tracking closely, there are several considerations that will frequently either limit or reduce exposure to CRE devaluation.

Limited reliance on property taxes

Several cities in our sample either do not rely heavily on property taxes or collect only a small share of their property taxes from office properties. The New York city comptroller reported last year that under a "doomsday scenario" of office properties declining by 40% in value, the city would stand to lose about $1.1 billion in revenue by 2027 (due to a statutory five-year assessment phase-in). This amounts to just 3% of its property tax levy and 1% of total revenue, which, the comptroller notes, is within the range of typical tax collection variance. Among cities we reviewed in this report, Denver, Philadelphia, and Phoenix are also minimally reliant on property taxes or taxes collected specifically from CRE.

Institutional framework

State laws governing how tax levies operate and how assessed value (AV) is calculated can effectively decouple city tax levies, partially or entirely, from real estate values. Some examples: Chicago, Atlanta, Seattle, and Boston have the statutory ability to adjust levies upward each year regardless of changes in AV, subject to some limitations. Another example is California's Proposition 13, which provides cushion for the market value of properties to fall before AV is affected.

Economic development and offsetting valuation growth

Economic growth prospects, demographic and employment trends, and tax base composition are key variables that will support economic and revenue stability for some cities. This is especially true for those seeing rapid growth and for whom a CRE reset may only mark a temporary blip in AV as opposed to the beginning of a long-term downward spiral.

City Case Studies

The following case studies focus on three key areas for each city: credit exposure related to the downtown recovery, revenue sensitivity to falling CRE values and revenue underperformance generally, and post-COVID spending initiatives. These 13 cities were selected for size and geographic diversity to highlight the different recovery paths cities face nationally. While the return-to-office challenges cities face are broadly shared, credit sensitivities are not uniform and depend on economic context, tax base composition and growth prospects, revenue composition, and statutory taxing flexibility.

Atlanta (AA+/Stable)

• Atlanta exceeded its pre-pandemic employment levels late in 2021 with annual growth projected to be around 1%, in line with broader state and national trends. The city has a diverse commercial sector highlighted by the long-standing headquarters of Fortune 500 companies. Commercial property makes up 41% of its tax base, of which 10% is office space that is under pressure and exposed to potential real estate devaluations, but stability is provided by growing residential values.
• Atlanta levies ad valorem taxes through a millage rate imposed on tax digest AVs and sets the tax rate annually, which allows flexibility to address any changes in AVs. While property tax is the largest single revenue source (37% of general fund revenue), local revenue streams that are insulated from broader macroeconomic trends and did not experience material declines during the pandemic provide additional revenue stability. Slowing growth across the state and Atlanta's reliance on business travel, which has had a slower recovery relative to rebounding leisure activity, is unlikely to materially affect the city's central operations and services.
• Atlanta has enhanced efforts to address housing affordability and public safety through increased spending, coupled with public-private partnerships and other incentive programs. Recent new initiatives through the city's Invest Atlanta program include a $380 million conversion of downtown office space into a mixed-use development, including 400 residential units (200 affordable and 200 market-rate); four new programs to provide grants and low-interest loans to assist small businesses with acquiring or improving commercial property; and a proposal to build or preserve 20,000 units of affordable housing across the city.

Boston (AAA/Stable)

• Property taxes accounted for 70% of Boston's general fund revenue in fiscal 2023, approximately 60% of which was generated by commercial taxpayers and 40% from residential taxpayers. Because of Proposition 2-1/2, the city has limited exposure to tax losses from falling office valuations but could see a significant shift in the tax burden to residential taxpayers if commercial values deteriorate markedly.
• Commercial-industrial properties account for just 33% of Boston's AV but make up 58% of the total tax levy because the city taxes them at a higher rate than residential. Under Proposition 2-1/2, the city can raise its tax levy by 2.5% annually, subject to a maximum levy that is equal to 2.5% of market value. Because the current tax levy is considerably below the 2.5% maximum, we expect that Boston will continue to be able to increase its tax levy as allowed under Proposition 2-1/2 even if commercial property values decline dramatically. Such a scenario, however, would mean that residential payers could face a significant tax hike. To prevent this, the mayor has filed a home-rule petition that would temporarily shift a larger share of the tax levy to commercial properties in a move that echoed a similar plan approved by the state legislature in 2004.
• Acting through the Boston Planning & Development Agency, the city launched a pilot program in the fall of 2023 that provides payment-in-lieu-of-taxes (PILOT) agreements to developers who convert offices into residential units. The city has received interest from several developers of Class B and C office space and has received six applications for the program that are in various stages of the approval process.

Chicago (BBB+/Stable)

• Chicago has seen a strong revenue recovery since the height of the pandemic, though new spending on public safety, migrants, and other areas is generating an increasingly large outyear structural budget gap that may prove difficult to manage without new revenue.
• As a home-rule city, Chicago levies ad valorem taxes at a flat dollar amount, meaning that changes in AV do not affect the amount of taxes it can levy and collect. The large relative size of the residential payer base compared to commercial will most likely limit the per-household effect of tax-shifting from falling commercial valuations. An analysis by the University of Chicago and Mansueto Institute for Urban Innovation found that a 10% decrease in commercial property value would result in a $43 (0.8%) increase in the average resident tax bill, while a more substantial 40% decrease in commercial value would result in a $479 (9.1%) increase in residential tax bills.
• Recent new-spending proposals include a program to provide low-interest loans and grants to downtown businesses; a plan to use tax dollars from expiring tax-increment districts for debt service on general obligation (GO) bonds issued to fund housing initiatives; and the "LaSalle Reimagined" plan to provide tax-increment subsidies to developers to convert downtown offices into residential units.

Denver (AAA/Stable)

• Denver's tourism trends and sales tax collections have fully recovered from pandemic-induced declines, but the city faces cost challenges related to affordable housing, homelessness, and a growing migrant population.
• Sales taxes are Denver's largest revenue source, making up over half of general fund revenue. Sales tax revenue grew 4%-7% annually through 2019 and fell 10% in 2020 at the height of the pandemic before rebounding, growing 22% in 2021, 13% in 2022, and 2% in 2023. Monthly collections in 2024 indicate softening growth, which could be partially due to lower office occupancy downtown and reduced spending on dining out during the workday. Property taxes make up just 11% of general fund revenue, and a strong residential real estate market should limit the potential effects of fluctuating office valuations on the city's budget.
• Between 2015 and 2023, median home values in Denver rose 120% and grew by 35% in 2023 alone. The city created the Department of Housing Stability (HOST) in 2019 to address affordability. HOST oversees programs addressing housing opportunity and homelessness that are funded through a 0.5-mill property tax levy, a 2% special marijuana sales tax for affordable housing, and a 0.25% sales tax for homelessness resolution. Officials continue to prioritize and proactively budget for these programs, along with providing temporary shelter and services to an influx of migrants during the past 18 months through the city's Newcomer Program.

Houston (AA/Stable)

• Houston's post-pandemic revenue trends, particularly for sales tax revenue, have been strong, and tax rate flexibility provides some insulation to exposure from commercial property value declines. Rising costs related to inflation, public safety, and higher interest rates could moderate operating results compared to the two most recent fiscal years, when the city reported large general fund surpluses.
• Houston's ad valorem tax rate is limited statutorily, but the city has room under this limit to offset potential AV declines. Property tax revenue growth is also limited by the city's charter, which reduces budgetary flexibility, particularly if other revenue sources decline. The majority of the tax base is residential, limiting the potential effects of declining commercial property values on general fund revenue and per-household tax burden shifts.
• Houston has one of the nation's highest office vacancy rates and several office conversions are happening in the city. Officials are currently gathering information on how potential incentives for future conversions could function, but no decisions have been made. Houston continues to focus on reducing homelessness, allocating funding in its capital improvement plan and annual budget.

Los Angeles (AA/Stable)

• Los Angeles saw only a modest revenue effect during the pandemic, and we believe that near-term budget exposure specifically tied to potential decreases in CRE valuations is limited. Budgetary balance, however, is vulnerable to potentially slower-than-anticipated revenue growth and inflationary expenditure growth, including general personnel and public safety costs, introducing the risk of outyear budget gaps. In fiscal 2024, we understand that revenue has lagged the city's initial projections, which, in combination with various sources of overspending, could result in reserve draws this year.
• Proposition 13 creates some headroom for commercial market value to decline without affecting AV and the city's tax base is largely residential, both factors that we believe provide substantial protection to its tax levy from falling office values.
• Spending priorities for the city remain public safety and efforts to reduce its unhoused population. In recent years, initiatives to reduce homelessness in Los Angeles have included bonds issued under Proposition HHH, passage of Measure ULA, and spending to launch the city's "Inside Safe" program. In addition, efforts are underway to transform downtown Los Angeles (DTLA 2040) by creating nearly 100,000 additional housing units across the downtown area.

Miami (AA/Stable)

• Miami tax revenue increased throughout the pandemic, including 11% growth between fiscal years 2022 and 2023, reflecting population increases and strong residential demand. Furthermore, Miami outpaced other major cities in return-to-office, mitigating the effects of material and long-term commercial space vacancies. The average asking rent for office space increased by nearly 50% between 2019 and 2023. While we expect the rate of increase to moderate, we do not expect it to materially affect city revenue.
• Property taxes constitute 50% of the city's total operating revenue and demonstrated a steady growth trajectory between 2017-2023, although there was some deceleration in 2024. Residential and commercial properties account for 47% and 25% of the Miami's total AV, respectively, which we believe somewhat limits budgetary effects from potential commercial property market volatility. With the recent valuation growth, Miami's millage rate has declined, providing slightly improved financial flexibility.
• Miami's primary spending priority remains public safety. However, housing affordability has been a growing focal point. Miami voters approved $400 million in GO Miami Forever Bonds in 2017, including $100 million dedicated to affordable housing, for which the city has declarations of intent totaling $55 million. In 2019, it also announced a goal of creating or preserving 12,000 affordable housing units by 2024 and has adopted an affordable housing master plan.

New York (AA/Stable)

• Supported by a diverse economy, with employment surpassing pre-pandemic levels, and the return of tourists to the city, New York City's revenue has recovered well from the pandemic. However, office vacancy rates remain stubbornly high (over 20%) and weekly office occupancy peaks at around 60%, putting pressure on office valuations.
• Overall, office property taxes account for only about 5.5% of total fiscal 2024 revenue and the city's assessment process spreads the full effects of new valuations over five years, which we consider potentially mitigating factors. However given the city's return-to-office challenges, we monitor how lower office valuations could affect its finances; pressure is most pronounced on Class B offices that account for 1.3% of revenue, but we are also paying attention to whether stress extends to Class A and Trophy properties. Residential values remain strong, with AVs on the fiscal 2025 tentative assessment roll 14% higher than for fiscal 2022. At the same time, personal income and sales taxes--which together accounted for 25% of New York's general fund revenue in fiscal 2023--have shown solid recovery and are now, respectively, 27% and 29% higher than in fiscal 2020.
• In 2023, New York City's Mayor Adams proposed his "City of Yes" initiative, a three-pronged initiative with a focus on carbon neutrality and economic and housing opportunity. The latter two initiatives, if passed, would facilitate job creation and small business growth, as well as growth in housing units through zoning changes that make office-to-residential conversions easier and encourage higher density, mixed-use, and transit-oriented development.

Philadelphia (A/Positive)

• Philadelphia experienced significant revenue loss during the height of the pandemic but bounced back quickly; by 2022, all major general fund revenue exceeded pre-pandemic levels, given strong economic recovery as well as inflation. We view expenditure demands as the more pressing credit risk for the city, as inflation and a tight labor market put upward pressure on personnel costs.
• The city has very little exposure to revenue loss related to declining CRE values. Property taxes make up only 14% of the budgeted fiscal 2025 general fund revenue, of which only 16% comes from commercial and industrial; therefore, even declines in CRE valuations would only have a small direct effect on revenue. At the onset of the pandemic, the city experienced substantial losses in its wage and earnings tax revenue, its largest revenue stream (32%). Total wage and earnings taxes are now well above pre-pandemic levels, despite rate cuts, and the city is projecting 4.7% growth in fiscal 2025. However, commuter taxes make up roughly one-third of the city's wage and earnings taxes and are heavily influenced by return-to-office trends. Philadelphia's 2023 budget included a 25% reduction in its commuter wage tax revenue, which carried forward to lower revenue assumptions in 2024 and 2025. The city assumes this loss is permanent due to changes in commuter behavior.
• The mayor's 2025 budget priorities include public safety, initiatives to improve sanitation and vacant properties, workforce development, housing, education, and reducing complexity for businesses working with city government.

Phoenix (AA+/Stable)

• Phoenix has experienced a swift recovery from the height of the pandemic, as reflected in healthy consumer spending, labor market expansion, robust economic development, and tax base growth. The state's property tax valuation framework requires all property taxes to be levied against limited net AV, providing substantial insulation from a sectoral decline in commercial property values.
• Currently, Phoenix's 2024 full cash value (market value) is 18x larger than its limited value (AV), providing significant cushion from any valuation losses. The city's operating budget is largely funded by sales-tax and state-shared revenue, neither of which deteriorated during the height of the pandemic. And although sales tax is the city's largest revenue source, only 7% of collections were derived from commercial real property rental in fiscal 2023. We also expect that the city's positive net migration trends and strong business climate will support job creation and overall economic growth, even as the post-pandemic telecommuting trends leave it with comparatively high office vacancies.
• Phoenix will be directing capital funds to key post-pandemic recovery priorities--including housing affordability, homelessness, and public safety--as part of its $500 million GO bond program approved by voters in November 2023.

San Francisco (AAA/Negative)

• San Francisco continues to see a very slow post-pandemic recovery, with one of the country's highest office vacancy rates among major cities exacerbated by changing remote work patterns that seem to be here to stay. While growth in the tax base has not completed stalled, declining CRE property values stemming from vacant office buildings and shuttered retail spaces are a growing pressure on the city's tax base. Property tax revenue, its largest revenue stream, is projected to remain nearly flat, contributing to projected budget deficits.
• Despite declines in certain residential and commercial property values, the city's overall tax base remains bolstered both by strong home prices and by California's Proposition 13, which provides a substantial cushion for tax base growth even when the market value of properties declines. While we expect commercial and retail valuations to remain pressured, we believe the losses will be partially mitigated by growth in residential value. Business tax revenue, San Francisco's second-largest revenue stream, fluctuates based on the number of employees who physically work in the city and has declined from its pre-pandemic peak, further pressuring the city's budget.
• San Francisco has implemented several initiatives to strengthen the recovery of its downtown corridor, such as increasing safety and cleanliness and attracting recreation, retail, and entertainment businesses to diversify away from traditional offices. It has also recently relaxed certain zoning restrictions to make it easier to convert empty offices to retail and residential uses. In March 2024, voters approved a measure to exempt the sale of properties converted from commercial to residential uses from the real property transfer tax.

Seattle (AAA/Stable)

• Property tax revenue is Seattle's largest revenue stream and is insulated from valuation declines because state law allows property tax revenue to grow by 1% (plus new construction) annually, regardless of any changes in AV. The city has seen a healthy post-pandemic revenue recovery and a slow, but steady, return-to-office trend, which is projected to continue.
• Seattle collects most of its revenue from property, sales, and business and occupation taxes, all of which have shown a strong recovery from the pandemic. The city also collects a payroll expense tax that became effective Jan. 1, 2021 and is assessed on payroll for employees who live within city boundaries. The payroll expense tax can be volatile and is generally restricted to affordable housing, local business and workforce support, community development, and projects supporting a transition to clean energy.
• Recent initiatives to revitalize downtown Seattle include a focus on improving safety and cleanliness, the reopening of City Hall Park, and regulatory changes that make it easier to convert empty office space into housing. The city's Downtown Activation Plan was announced in 2022 and focuses on filling vacant commercial spaces in existing buildings, including those in the city's downtown corridor. The mayor has also proposed land use code changes that would provide more flexibility in allowable uses for commercial spaces, making it easier to fill vacant commercial properties.

Washington DC (AA+/Stable)

• Washington DC maintained stable finances through the height of the pandemic and retains significant revenue-raising flexibility to address budgetary gaps. However, the District also faces budgetary pressure from competing expenditure priorities and revenue pressure, particularly from commercial property taxes. Officials recently came to terms with two professional sports teams to improve the city-owned arena downtown and make additional improvements in related facilities, which, along with other proposed investments, could stabilize the downtown core.
• Commercial property valuation fell about $11.5 billion over the past two years and will likely decline further, but growth in residential valuations led to total valuation growth of about $10.2 billion to $254.6 billion over the same period. Property taxes are the second-largest operating revenue, with commercial property accounting for about 40% of total taxable value. The District's February 2024 revenue forecast notes current-year revenue rising higher than prior projections but also notes a likely slowdown ahead, largely reflecting revised downward projections in future-year property tax collections. Total revenue projections continue upward due to income tax growth, but slowing revenue growth coupled with growing expenditures is likely to result in increasingly difficult budgetary decisions.
• The mayor's office has released several plans targeting downtown revitalization, including a $515 million arena proposal, a $400 million plan for investing in quality-of-life improvements, and $41 million in tax incentives for office-to-residential conversions.