The pandemic has brought about a major shift to working from home, and no matter how hard companies try to lure workers back to city offices, office occupancy rates are unlikely to return to pre-COVID levels. As a result, owners of downtown office buildings with looming payment deadlines are staring into the abyss, as are banks and other lenders. With refinancing costs more than double what they were a few years ago, it's a struggling market searching for solutions.
The good news is that the ominous debt maturities are still a year, maybe even years, away, meaning this is a bomb with a long fuse, but the math still doesn't rule out the financial collapse of hundreds of prominent office buildings over the next few years, even if there's still time left to repay them.
Some desperate property owners, aware of looming bankruptcies, have neglected to pay taxes and allowed foreclosures to pile up. Reports are widespread that office buildings are selling for about half or even less than they were originally worth, which bodes ill for banks and other lenders. These fire sales also portend declining tax revenues for once-thriving urban centers such as Boston, Chicago, New York, San Francisco and Seattle.
So while cities are not obligated to repay the loans, they are heavily involved in this game. A potential solution worth considering is to use city bonds as a card to get cities in the game. Cities facing hollowed-out downtowns can’t wait for the capitalist approach to market collapse to come into play: “Dancer of the Graves” investors to step in, buy distressed properties for 10 cents on the dollar, hold them until they eventually recover, and make a handsome profit.
That worked out well for condo and apartment speculators in Miami in 2008 and 2009. Just this month, voters in San Francisco approved a ballot measure that gives tax incentives to developers who convert offices into housing, and San Diego is recalculating how much office space it needs downtown.
But the question is, at least for now, who will come up with the financing to buy the entire building at a cheaper price, when it's still unclear how cheap enough a price would be to establish a floor in this market.
In this financial tsunami, local governments generally cannot plug the dikes by simply giving more incentives to developers. While local officials may find ways to provide limited support for commercial real estate within current law, there are avenues Congress can help that could get ahead of the inevitable wave of massive defaults between 2025 and 2028.
With many of the 2017 federal tax cuts expiring, lawmakers will be under intense pressure next year to craft a new tax bill that would allow for selective adjustments to local bond tax systems, especially if they result in near-zero net cost to taxpayers, fewer foreclosures, and stronger city economies.
Taxpayer-friendly “bailout bonds”
In my last column, I harshly criticized the use of tax-exempt stadium bonds and private activity bonds as handouts to the wealthy with little or no public purpose. But while I advocate phasing out all private activity bonds over a 10-year period, I proposed a new strategy in lieu of phasing out stadium bonds: a profit-sharing kicker. The same central idea is that Congress could require some profit from both local governments that issue qualifying bonds for distressed urban real estate, and from the U.S. government, which provides the tax exemption. In this tax-reduction model, the stabilization and eventual recovery of the office tax base could be passed on to taxpayers by requiring beneficial owners to participate in the profits.
The idea of mortgages with profit-sharing or equity-sharing arrangements for the lender is not new. Similar arrangements have been in place for many years, on a smaller scale, in the mortgage and private sector. In the case of urban office refinancing, a concept Congress could enact would be to allow the sale of tax-exempt private activity bonds to finance distressed urban real estate, with the condition that the owners share a percentage of future rent and price appreciation with both the issuing municipality and the U.S. Treasury.
Unlike many municipal bond giveaways, which give the U.S. government nothing in return, these “bailout bonds” would reward taxpayers for bearing some of the risk of providing badly needed capital to debt-ridden property owners and their bank lenders during times of financial difficulty.
The concept is very similar to the Great Recession-era auto bailouts, where automakers handed over stock to the U.S. Treasury in exchange for bailout funds. As it stands, cities issue senior secured tax-exempt conduit mortgage revenue bonds (bonds issued without local taxpayer guarantees of repayment) and enter into agreements that obligate the property owners to share in any future profits or price appreciation of the targeted properties. This wealth-sharing provision compensates the U.S. Treasury first and the local government second, since interest rate subsidies are primarily provided by the U.S. government, but it's good to see both levels of government benefit economically.
Access to the municipal bond market would have the added benefit of providing lower-cost, 30-year mortgage financing to an industry that has often relied on shorter-term bank loans and then had to refinance them. This feature alone should help reduce risk to urban tax bases in future downturns.
Opportunities under current law
It is worth noting that current federal law may already allow cities to require profit-sharing agreements in return for sponsoring tax-free relief of commercial office debt for a public purpose. With some creative legal work and permissible contract structures, today’s private activity bond rules could be flexible enough to allow public agencies to facilitate the refinancing of office properties, removing the U.S. government from the deal, by having the owner donate profit sharing directly to a local charity or nonprofit organization, such as an organization that provides housing for the homeless, rather than to the city. That’s “two birds with one stone” for urban problem solvers. Call it a new development in public-private-nonprofit partnerships.
Whether any municipality will have the courage or astuteness to deploy this untested strategy without legislative support from Congress is only the first hurdle for mayors and public financiers. As I explained in a recent column on arbitrage vampires, I would argue that direct profit-sharing payments to cities are unwise at this time because the IRS does not take kindly to clever schemes to generate taxable income from the sale of tax-exempt bonds. Negotiated charitable contributions, however, might be permitted. Even if it is too risky for a timid mayor to attempt this in 2024, research efforts and financial modeling frameworks would go a long way in crafting favorable legislative and regulatory language for the inevitable tax bill in 2025.
If Congress were to explicitly include this distressed property provision in the tax code next year, the new transaction authority would expire after a certain period (say, five years) so that it would not become a perpetual cash cow for bandwagoning real estate tycoons. It would then need to address the broader issue of private activity bonds and mandate that they incorporate a profit-sharing feature as an integral concept. Such a profit-sharing kicker would make these bonds revenue neutral for the IRS and a landmark achievement for local governments. The challenge, of course, would be to define and adjust the legally required percentage of future profits or property value to compensate the federal and local governments.
Protecting the public interest
Congress's municipal bond tax exemption should only be applied to properties that are refinanced at valuations significantly lower than the outstanding debt, perhaps 75% or less, so that both the opportunity for profit-sharing from price recovery and evidence of financial distress are sufficient to justify tax incentives and public sector intervention. Issuing municipalities should be required to obtain independent fair market valuations that become part of the bond declarations on which municipal bond investors rely, subjecting issuers to SEC regulatory action and criminal sanctions if any suspected fraudulent conduct is committed against them in the process.
It would also require a strict 80 percent loan-to-value ratio, with a 20 percent risk-capital matching obligation for private investors. Bond rating agencies might require even greater ownership involvement, but as long as issuing municipalities are not held liable for future defaults, they could be left to the private market to sort it out.
Time will tell if the office real estate market collapse will continue into 2025 with enough headlines and doomsday predictions to pressure congressional tax committees to consider this novel approach. But either way, the municipal bond lobby needs to start thinking creatively about how to streamline the use of federal tax subsidies that primarily benefit private investors. Stabilizing the national office real estate collapse seems like a good place to start.
Governing opinion columns reflect the views of their authors and do not necessarily reflect the views of Governing's editors or management. Nothing contained herein should be construed as investment or specific issue advice.