Rising Pressure: How State and City Fiscal Crises Could Affect Commercial Real Estate Demand

State and municipal pension funding gaps have been growing for years and have widened further since the COVID-19 pandemic. As a result, many cities and states could find themselves in a position where they are forced to raise taxes and cut services to pay for pension liabilities. This may already be affecting commercial real estate demand.

Peter Muoio, Senior Director, SitusAMC Insights, and Russell Appel, Founding Principal, Praedium Group, have been analyzing this issue for the past 11 years, and both say it has never been more serious. In a webinar hosted by Gunnar Branson, CEO of The Association of Foreign Investors in Real Estate (AFIRE), they discussed how underfunded liabilities are tied to taxation, demographics and migration—and how these trends could affect CRE demand.

Pension Contributions Lag Liabilities

In their recent report, “State Fiscal Pressures and CRE,” Appel and Muoio document how state and municipal pension contributions have failed to keep pace with public pension liabilities, which have grown steadily since 2000. According to data from Pew Charitable Trusts and SitusAMC Insights, since the last housing crisis, state and municipal assets have increased an average of 2.7 percent per year, while liabilities grew 4.3 percent.

Nationwide, state pension funded ratios—based on a pension plan’s assets as a percentage of liabilities—fell from a healthy 103.1 percent in 2000 to 70.6 percent in 2018, the most recent year for which data are available. They are likely to have dropped even further, especially following the pandemic’s shock to municipal finances. In fact, in the second quarter of 2020, at the onset of the pandemic, corporate tax revenues fell 40 percent while individual income tax collections dropped by 30 percent, and sales tax revenues declined by 15 percent, according to U.S. Census data.

“Every year, it’s gotten worse,” said Muoio. “The pandemic came, and it was like this double whammy … the fiscal situation sort of went haywire for state and local governments.” Adding to the pressure is the burgeoning population of workers reaching age 65, who will be receiving pension payouts in the coming years, he said.

Some cities and states have tried to shift their pension obligations with little success, Muoio said, as courts have ruled in several cases that pension liabilities cannot be altered. While state and local governments have some leeway to change plans for new employees or to make minor changes to certain calculations, the only other option is to increase their pension funding. This would generally mean raising taxes or cutting services—both of which make areas less desirable. “Residents want a fair deal, and the fiscal condition impacts whether people can really get a fair deal or not,” Appel said. “And if they don’t feel like they’re getting a fair deal, they’re going to move.”

Cities and states that address fiscal issues by raising taxes or cutting services are also affecting their quality of life, Muoio noted. “People, all of us, respond to quality of life, and quality of life includes a whole slew of things,” he said. “Is the area you’re living in safe? Is it clean? Can I get from point A to point B quickly without aggravation? All kinds of other things come into play. But it’s an important ingredient in how we decide where we want to be, and if that’s changing as a result of the pension crisis.”

Migration and Growth May Shift

In recent years, real estate demand has focused on gateway markets, which attracted knowledge-based workers and experienced strong growth. The aftermath of the pandemic could see shifts in growth, not only tied to increased freedom of location because of remote work and hybrid remote-work models, but also due to people moving as pension-related tax and service changes lead to deteriorating quality of life in some areas. A higher share of growth may come not from large urban areas but places where governments are “offering the best deal” because they are in better financial shape, Appel said. “The states that are in a better fiscal situation, where pensions are better funded, can provide a better deal with respect to taxes, services and affordability.”

The long-standing trend of migration within the U.S. now looks to be “turbocharged” by the pandemic, as more people move from gateway cities like San Francisco and New York to less dense markets, said Muoio. That generally means migration away from the Northeast, Midwest and California and toward the Southeast and Southwest regions of the country. In fact, the most expensive and high-tax states, like California, New York, New Jersey and Connecticut, have seen the biggest population outflows.

The rapid normalization of remote work has also fueled this trend, Muoio noted. “If you live in Silicon Valley, it’s expensive and congested. Suddenly you’re told you can work anywhere,” he said. “With that shift from the Bay Area to Austin, or to Raleigh-Durham, or Boise, Idaho, these kinds of places are suddenly seeing a bigger uptake than they already have been.”

The rising fiscal pressures caused by the pension crisis make a real estate investor’s job “harder and more interesting at the same time,” Muoio said. “[Investors] can’t just throw money into a certain type of property or a certain kind of market. You really have to do a lot more research and diligence in terms of the specifics of what’s happening and consider markets and segments and subsegments that you haven’t considered before.”

Peter Muoio is head of SitusAMC Insights, providing research, tools, data and perspectives on real estate markets. For more information on SitusAMC Insights, click here.