Decimated Government Coffers

The State, cities and counties in California are in deep financial crisis once again. The shutdown of the economy and the ‘stay-at-home’ orders has caused a collapse of tax revenue at the same time there is a growing demand for government services. Governor Newsom has spent more than $2 billion in taxpayer money in just one month to combat COVID-19. Sales tax revenue is way down and income tax revenue is declining and will fall further as unemployment rises. Many counties and cities rely heavily on meetings, conventions and tourism for tax revenue which has ceased due to travel restrictions.

California’s tax structure is heavily weighted toward high wage earners and their capital gain taxes. A significant percentage of the tax revenue generated from these individuals is based on their capital gains which were over $15 billion in 2019. Those gains are volatile and with the recent plunge in the stock market they become capital losses.

As a result of the collapse in tax revenue lawmakers will be forced to make decisions about spending cuts and tax increases. At the same time tax revenue is steeply declining, some government costs are escalating higher like unemployment insurance and medical care. In four weeks over 3 million filers for unemployment have been processed. Currently the budgets of 12 out of 15 largest cities in the state are underwater. In addition, the state owes over $1 trillion in pension obligations. In the Great Recession of 2008/09 California ran out of money to pay benefits and had to borrow money from the Federal Government to cover unemployment coverage.

In San Diego the Mayor recently told the City Council to prepare for deeper cuts for the fiscal 2021 budget due to massive revenue losses. Estimated losses for the city are more than $300 million and for fiscal year 2020 the estimated tax revenue loss from sales tax and transient occupancy tax is $109 million. Already large regional events have been cancelled in San Diego; the Del Mar Fair, Comic-Con, Padres baseball. The largest loss to the city is transient occupancy tax (TOT) for hotels and vacation rentals, $83 million. The second biggest loss is sales tax revenue, $26 million so far. The projected regional occupancy rate for hotels for 2020 was approximately 77%, in April it is 0%.

In Los Angeles the City Controller stated a revenue shortfall of $231 million for fiscal year 2019/20. For 2020/21 fiscal year tax revenue may decline by approximately $600 million. Much of the loss is due to the decline in hotel transient occupancy taxes. The County Board of Supervisors is forecasting a $1 billion decline in sales tax revenue between March 1 and June 30 the end of the fiscal year. They believe that number could double next year.

In addition to the significant declines in sales and income tax revenue IG forecast a sharp decline in property tax revenue over the next few years as both residential and commercial real estate is priced lower. In these economic times it’s important for property owners to have their tax assessments reviewed annually.

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Normalcy Bias

It appears the U.S. economy will start to reopen gradually as the quarantine is lifted in some states during the month of May. However, it will not be a simple matter of flipping a switch and life resumes as it was prior to the ‘lock-down’. Many are talking about a ‘V-shaped’ economic recovery and we go back to normal, this condition is commonly referred to as Normalcy bias.

Wikipedia: Normalcy bias is a tendency for people to believe that things will function in the future the way they normally have functioned in the past and therefore to underestimate both the likelihood of a disaster and its possible effects. This may result in situations where people fail to adequately prepare themselves for disasters, and on a larger scale, the failure of governments to include the populace in its disaster preparations. About 70% of people reportedly display normalcy bias during a disaster.

The normalcy bias can manifest itself in various disasters, ranging from car crashes to world-historical events. It is hypothesized that the normalcy bias may be caused by the way the brain processes new information. Stress slows information processing, and when the brain cannot find an acceptable response to a situation, it fixates on a single and sometimes default solution. This single resolution can result in unnecessary injury or death in disaster situations. The lack of preparation for disasters often leads to inadequate shelter, supplies, and evacuation plans. Thus, normalcy bias can cause people to drastically underestimate the effects of the disaster and assume that everything will be all right. The negative effects of normalcy bias can be combated through the four stages of disaster response: preparation, warning, impact, and aftermath. Normalcy bias has also been called analysis paralysis.

Here are some new trends we believe will create a ‘New Normal’ for the operation and lower valuations of Commercial Real Estate:

• Travel restrictions and bans – hotels will continue to experience dramatic drops in occupancy and reduced RevPAR.

• Supply Chain disruptions - businesses that utilize Asian supply chains will experience shortages and delays, many will be forced to curtail or close their operations. This will reduce the need for space, increasing supply and lowering rents.  

• Social Distancing – will severely impact most offices, hotels, restaurants, gyms, retail stores, entertainment venues, etc. There will be increased cost incurred by owners and tenants in order to comply with the new rules. Many operations will not be able to operate profitably leading to closures.

• Depression Level Unemployment – decrease in consumer spending and changes in consumer behavior will force many businesses to cease operations.

• Financing – Lenders are tightening their underwriting requirements, requiring additional equity, and reevaluating their risk exposure. This will lead to fewer transactions and lower sale prices for owners when selling.

Some estimates indicate that there could be a loss of several thousand CRE transactions this year and a loss of over $100 billion in volume. Markets that have the highest exposure to tourism and stricter social distancing and containment policies will experience the biggest drop in valuation.

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Supplemental Assessments

The supplemental roll provides a mechanism for placing property subject to Proposition 13 reappraisals due to change in ownership or completed new construction into immediate effect. Changes in ownership or completed new construction are referred to as 'supplemental events' and result in supplemental tax bills that are in addition to the annual property tax bill.

The increase (or decrease) in assessed value resulting from the reappraisal is reflected in a prorated assessment (a supplemental bill) that covers the period from the first day of the month following the supplemental event to the end of the fiscal year. A fiscal year runs from July 1 through June 30.

How it Works

When a supplemental event occurs, the county assessor determines the current market value of the property that changed ownership or that was newly constructed. The assessor then subtracts the property's prior assessed value from its newly assessed value, and the difference between the two is the net supplemental value that will be assessed and enrolled as a supplemental assessment. The supplemental assessment may be either a positive amount or, in the case of a reassessment that is less than the prior assessed value, a negative amount.

If the net supplemental assessment is positive, the increase in taxes will be calculated by the county auditor-controller based on the change in value. One, or possibly two, supplemental tax bill(s) will be generated and mailed by the county tax collector. If the net supplemental assessment is negative (a reduction in value), the auditor-controller will issue one, or possibly two, supplemental refund(s).

Once the new assessed value of your property has been determined, the county assessor will send a "Notice of Supplemental Assessment." This notice will show what the net supplemental assessment amount is and how it was calculated.

A supplemental reduction in value will not reduce (nor can it be used as a credit toward) the amount still due on an existing annual tax bill. The amount of tax shown on the existing annual tax bill must be paid even if the assessed value of the property was reduced by a supplemental assessment.

Supplemental bills (or refunds) are calculated based on the number of months remaining in the current fiscal year after the month in which the supplemental event occurs. A fiscal year runs from July 1 through June 30.

If a supplemental event occurs between June 1 and December 31, only one supplemental tax bill or refund check is issued. This bill, or refund, accounts for the property's change in value for the period between the first day of the month following the event date and the end of the current fiscal year (i.e., the following June 30). If, however, a supplemental event occurs between January 1 and May 31, two supplemental tax bills or refunds are issued. The second bill or refund accounts for the property's change in value for the entire 12 months of the coming fiscal year, beginning on the following July 1.

The tax or refund amount resulting from a supplemental assessment becomes effective on the first day of the month following the month in which the supplemental event took place; monthly proration factors are used to calculate the taxes owed. Taxes supplemental to the current roll are computed by first multiplying the net supplemental assessment by the tax rate, and then multiplying that amount by a monthly proration factor.

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Declining Demand for CRE

We have hit uncharted territory; the U.S. has never experienced a near complete shutdown of the entire economy so abruptly. The economic implications from the recent government imposed sanctions are far reaching for Commercial Real Estate. Not one aspect of CRE will be unaffected. The retail and hospitality sectors were some of the operations hit earliest with restaurants closed, movie theaters closed, malls and retail stores closed and hotels empty. The impact will be devastating to property owners as they experience serious cash flow stress from tenants unable to pay rent. This will lead to debt service issues for borrowers and ultimately loan defaults.

There will be longer term structural changes to all commercial space requirements. The retail and hospitality sectors are not alone in the decline in demand for commercial space. The requirements being laid out by Federal and State governments before business can reopen will impose unprecedented changes. This will lead to additional costs and many businesses will downsize or decide to not open due to the increased costs and declining revenue. Many companies are now making plans to operate with fewer people, in smaller space and becoming more efficient in their operations.

CRE prices more than doubled over the past decade since the GFC. Prices were at elevated levels prior to the virus and the economy was beginning to contract in 2019. As a result of the Fed maintaining abnormally low interest rates over the past two decades there has been a misallocation of resources and inaccurate valuation of assets.  Because of COVID-19 things have suddenly changed and the financial mistakes of the past several years are being exposed. The demand and need for all types of CRE is being reevaluated by all users.  The drop in demand and decline in Net Operating Income will mean a significant re-pricing of CRE going forward, assumptions on income growth, vacancy, lease up time and future sale prices are changing. 

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Mortgages-The Life Blood of Real Estate

History repeating itself, the Great Financial Crisis exposed the lack of sound underwriting and oversight in the mortgage industry prior to the collapse in 2008. Since the GFC, the majority of residential mortgages have been provided by ‘non-bank’ lenders. These lenders have not been well regulated and are under-capitalized; many have already requested federal assistance. Many of the same issues encountered in the mid-2000’s are prevalent today, such as down payments as low as 3% not uncommon.

Mortgages are difficult to obtain now that lending requirements have tightened. Several major banks recently announced they are requiring 20% down payments and a credit rating of at least 700 for new mortgages. Several have also stopped making HELCO loans. Recently several large banks reported their financial results and have now set aside over $20 billion in reserves anticipating a surge of defaults and a devaluation of collateral. They see what’s coming and are attempting to reduce their risk exposure to the real estate market. They are hoping to avoid a repeat of the GFC when they were exposed to huge write-offs and required taxpayer bailouts.

Moody’s is forecasting that as many as 30% of US mortgages could stop paying their mortgages if the economy remains closed for a few more months, that’s approximately 15 million. Many economists are predicting increasing unemployment numbers that will exceed 20% of the workforce. One report shows that 45% of Americans employed prior to the government forced shutdown are either unemployed or working fewer hours. Once again the market will experience rising foreclosures and borrowers unable or unwilling to continue making payments on a property when their equity has vanished. In the near term private lenders will reappear to fill the void left by banks and ‘non-banks’ as they exit the market. They will offer first or second trust deeds but at significantly higher rates as they price in the new perceived risk. There will be financing but at a premium for buyers.

Demand Stops

As a result of the economy shutting down the pool of potential buyers has dropped precipitously. Some of factors creating this sudden drop in demand include: uncertainty of employment; increased underwriting requirements and high rates for financing; move-up buyers unable to sell their existing homes. These are a few factors that will put pressure on re-pricing. As values decline more buyers will delay purchases until they see price stabilization at reduced levels.

The real estate market is now in the early stages of experiencing a market upheaval that will lead to re-pricing at much lower levels than the recent all-time highs.  

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Housing Markets Financial Burden

Are we on the cusp of another major decline in housing prices?

As a result of historic low mortgage rates and weak (if not fraudulent) underwriting abetted by the Feds work in creating bubbles, home prices are almost 20% higher than they were in 2006 prior to the previous bubble bursting. According to the Case-Shiller home price index home prices declined approximately 35% between 2006 and 2009 nationwide.

As reminder Former Federal Reserve Chairman Ben Bernanke quote from 2005-06 when asked about a potential bubble in the housing sector, “We’ve never had a decline in house prices on a nationwide basis. I do think this is mostly a localized problem, and not something that’s going to affect the overall economy.” His models and forecasting severely missed what was obvious to many.

Since the Feds began to aggressively reduce the cost of borrowing around the turn of the century creating debt bubbles many home buyers have viewed purchases of a home the same as they have done for many decades in buying vehicles. Not considering how much the total costs are but what I can afford to pay monthly, many not even thinking about the costs outside of debt service such as HOA fees, Insurance, Maintenance and Property Taxes. With the sudden shut-down of the economy and tens of millions unemployed and many others with reduced income the financial burden is increasing quickly.

In a recent survey conducted 30% of home dwellers with mortgages reported having less than one month savings to cover one month of mortgage payments. Many are beginning the process of asking for some form of forbearance from their lenders. Due to the inflation in asset prices far exceeding any increase in working wages over the past decade there is an affordability issue and now a sudden change in demand. Once the forbearance periods cease there will likely be a flood of homes hitting the market coupled with the process of lenders foreclosing. Also adding to the supply will be investors of houses and condos with remaining equity looking to dispose of rental properties.

This anticipated supply of residential properties coming to the market along with a major slow down in demand and tightening of lending requirements will bring about a nationwide housing decline, possibly greater than the 35% decline a decade ago.

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REIT Valuations Collapse

The sudden shutdown of the economy has created immediate uncertainty in forecasting CRE property valuations. As a result of the shutdown property sales have come to a halt and property values will certainly decline as a result. According to Green Street Advisors the value of publicly traded REITs fell 34% between February and March.

There are many unique issues suddenly hitting real estate and it will take some time before we understand the full impact on valuations. REIT pricing may be an initial indicator of how much CRE values may fall. As Green Street reports the sudden decline in REIT valuations suggest a 20% decline in property prices. We forecast that many property CRE types will experience a fall in excess of 20% as effective rents decrease due to increased concessions; vacancies and collection losses increase; net operating incomes decline and capitalization rates rise.

David Shulman, senior economist at UCLA Anderson school of Business recently stated:

“No one knows what pricing is right now. How do you value a home right now? How do you value a regional mall right now? The market is very uncertain at this time and no one knows how to value anything. On the topic of mortgage forbearance, “If it was an individual bank lending to an individual borrower, it would be easier. In a securitized world, it becomes very hard to do forbearance. Freddie and Fannie said they would do forbearance, but I don’t know how the investors expecting interest payments get paid on the other end. That is what happened in 2008 and 2009, so we are dealing with the same issues.” Servicing debt will strain many property owners.

Going forward the demand for many types of commercial property space will not bounce back to levels seen prior to the pandemic. The historic low capitalization rates the market has experienced over the past several years due to low cost financing has expanded the debt level of many properties. As capitalization rates begin to rise the reevaluation will significantly impact price levels.    

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Key Indicators to Re-Opening

Governor Newsom unveiled six key indicators that will guide California’s thinking for when and how to modify the stay-at-home and other orders during the COVID-19 pandemic.

The Governor noted that the progress in flattening the curve, increased preparedness of our health care delivery system and the effects of other COVID-19 interventions have yielded positive results. However, these actions have also impacted the economy, poverty and overall health care in California. Any consideration of modifying the stay-at-home order must be done using a gradual, science-based and data-driven framework.

“While Californians have stepped up in a big way to flatten the curve and buy us time to prepare to fight the virus, at some point in the future we will need to modify our stay-at-home order,” said Governor Newsom. “As we contemplate reopening parts of our state, we must be guided by science and data, and we must understand that things will look different than before.” For example, restaurants will have fewer tables and classrooms will be reconfigured.

Until we build immunity, our actions will be aligned to achieve the following:

• Ensure our ability to care for the sick within our hospitals;

• Prevent infection in people who are at high risk for severe disease;

• Build the capacity to protect the health and well-being of the public; and

• Reduce social, emotional and economic disruptions

California’s six indicators for modifying the stay-at-home order are:

• The ability to monitor and protect our communities through testing, contact tracing, isolating, and supporting those who are positive or exposed;

• The ability to prevent infection in people who are at risk for more severe COVID-19;

• The ability of the hospital and health systems to handle surges;

• The ability to develop therapeutics to meet the demand;

• The ability for businesses, schools, and child care facilities to support physical distancing; and

• The ability to determine when to reinstitute certain measures, such as the stay-at-home orders, if necessary.

There are sure to be many questions and issues around these conditions, however, the condition of businesses to modify floor plans to support physical conditioning will have a costly immediate impact on businesses and commercial real estate valuations.

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Winning The Appeal

Presentation of the Opinion of Value is critical to winning your case. The property tax appeal process is based on the expressed “fair market value” as of the lien date. The development of this value must be supported by market knowledge and the taxpayer/consultants analysis and conclusions. Many appeals are lost due to the applicant failing to clearly state their opinion of value. As a result of the imprecise nature of property appraisal and valuation usually the appraiser provides value conclusions that are in a range. The Assessment Appeals Boards take a dim view of value ranges, applicants typically fail if they do not state specifically their position on value. 

The opinion of value must take into account the law and it’s limitations regarding the admission of supporting evidence. Quite often the applicant is advocating an opinion of value 12 or 24 months after the lien date for which the assessment was set. With this delay in processing the appeals the market can shift dramatically. During economic downturns this can limit the taxpayer’s relief. In California, sales comparables that occur more than 90 days after the lien date are not admissible

The applicant must also be prepared to challenge the assessor’s evidence and stated position. Often the assessor’s case will include many comparables that are not truly comparable to the subject property. The applicant must question these comparables and the adjustments that are required.

Common adjustment issues:

• Rental Rates

• Vacancy and Collection

• Operating Expenses

• Reserves for Replacement

• Capitalization Rates

• Size, Age and Quality

• Time Adjustment

A thorough convincing case demonstrating your knowledge of valuation principles and a solid conclusion is the most effective way to have success.

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Economic Freeze Creates Uncertainty

Will the Commercial Real Estate market decline more precipitously than it did during the Great Financial Crisis?

Will the Housing market collapse the way it did during the GFC?

These questions are just now being seriously asked as lenders and real estate investors attempt to adjust their financial valuation modeling. Assumptions being used in these models drastically changed in a matter of weeks. As potential buyers of income producing property adjust their analysis to include:

• lower effective rents

• increased vacancy and collection loss

• increased operating expenses (rigorous cleaning)

• additional equity requirement by lenders

• increased cost of debt service

Lenders for all property types have increased their rates and underwriting is significantly more conservative with stronger debt covenants on CRE loans. For certain property types like hotels and retail, lenders have stopped making loans until there is a better level of certainty with price discovery. Many lenders are also preparing for the onslaught to come of borrowers requesting forbearance on their payments as a result unable to pay rent.

This will lead eventually to a reevaluation of all real estate.  

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