Policy Decisions Impact Property Markets
Commercial real estate investors expend much effort underwriting the projected performance of prospective investments. Thoughtful demand and supply assumptions provide some comfort for outlooks of future rent and value levels. However, it is very difficult to see into the intermediate-term, let alone the long-term.
A focus on policy can aid property investors’ underwriting efforts. Policy decisions impacting the outlook for real estate investments include land-use regulation, taxes, fiscal health, and idiosyncratic items at the state or market-level. Green Street’s research team has heightened its attention to policy issues, often uncovering meaningful implications for the underwriting of property sectors, markets, and REIT stock-picking.
A popular private and public market property investment strategy centers around “high-barrier” metros where land and cost are perceived as constraints on new supply. But, a focus on these factors ignores the biggest impediment to supply growth: land-use regulation.
Green Street’s regulatory constraint framework considers the incentives and influences of residents and cities in an effort to separate markets that are truly supply-constrained from those that aren’t. The NIMBY (Not in My Backyard) desires of residents have greater influence in markets with high population levels relative to commercial property inventory. State and local factors exacerbate NIMBYism in California. A city’s need for and dependence on property tax revenue influences permitting. Transportation infrastructure is another consideration. Competition from surrounding areas is mitigated in metros with poor intra-market mobility.
In our framework, New York City does not merit the equivalent “high-barrier” status as other gateway markets. The rezoning of wide swaths of the city under Mayor Bloomberg is likely underappreciated and contributed to near-record levels of inventory growth across most property types in recent years. By contrast, West LA's high barriers are daunting.
Regulatory Constraint Scores (Office Markets)
Source: Green Street Advisors, "Regulation - The Barrier that Matters."
Property investors mindful of major land-use regulation inflection points will possess an underwriting edge. For example, about a year ago the New York City Council approved legislation that makes it prohibitively more difficult to build self-storage facilities in Industrial Business Zones. As a result, the outlook for new self-storage supply growth in that market has improved.
Fiscal Health Risk
As uncertainty in the distant future is high, property investors understandably pay less attention to seemingly far-off issues. However, fiscal health is one of those problems that is so large and has such strong odds of mattering that it is arguably just as or more important than the near-term outlook.
Unfunded government pension liabilities have quintupled over the last decade, and the problem is far greater if realistic return targets are used and health care liabilities are included. Perhaps because the issue of fiscal health is complex, the effects not clearly imminent, and the distribution of liabilities uneven, it does not appear to be priced in to property markets. As such, opportunities exist for investors to steer clear of the markets in the worst shape.
Our fiscal health scores assess both short- and long-term measures of state and local conditions. The results are most dire for Chicago, Northern New Jersey, and Fairfield County, where fiscal death spirals, in which higher taxes lead to outmigration and even larger tax bills, are realistic scenarios. Elsewhere, a distinct gap exists between high-tax coastal markets, for which recent changes to state and local tax deductibility are an incremental headwind, and major Sun Belt markets, which spend less and enjoy favorable demographics.
Source: Green Street Advisors, "Fiscally Unsound."
Fiscal health and land-use regulation are interconnected as local governments that are in poor health and highly dependent on property tax revenue will be incentivized to allow more construction.
The Shifting Federal Tax Burden
We and property market participants monitored the federal tax reform process closely in 2017. The commercial real estate industry breathed a sigh of relief as threats such as the elimination of 1031 exchanges were avoided.
Fiscal Health vs. Change in Tax Burden
Source: Green Street Advisors, "Fiscally Unsound."
But the impact of the change to state and local tax (SALT) deductions bears watching and could lead to migration. Poor fiscal health might exacerbate this issue as high-tax states like Illinois, New York, and Connecticut have suffered from outmigration as individual tax burdens have ballooned. The reduction of the SALT deduction will likely induce further strain on high-income earners in those areas.
The California Ballot Box
California is home to idiosyncratic policy initiatives more often than other states as its direct democracy leaves much decision-making to voters. Last year, residential landlords dodged a bullet as the state’s voters shot down Proposition 10. The ballot initiative looked to repeal Costa-Hawkins and allow individual municipalities to amend current rent control legislation. With Costa-Hawkins remaining in place, the scope of rent control throughout California is dramatically limited. However, affordable housing will remain a hot button issue in California, and it would not be surprising to see changes proposed again in the coming years.
A greater and more imminent threat is the 2020 ballot initiative on Proposition 13. Owners of California real estate have enjoyed below-market property taxes since the state’s residents voted in favor of the landmark amendment in 1978. Prop 13 capped property tax increases such that owners of assets that haven’t changed hands in recent decades now have very low property tax bills.
A sufficient number of verified signatures was recently collected to put a Prop 13 “split roll” initiative on the ballot in 2020. It would tax commercial real estate based on fair market value, as opposed to the current assessment of the purchase price plus a maximum increase of 2% per year, and it would retain Prop 13 protection for all residential owners, including apartments and single-family homes. Handicapping the outlook for Prop 13 is challenging, but an educated guess is that a 50% likelihood exists that the property tax protection for California commercial properties is lifted next year. It is doubtful that REIT and private market property investors currently ascribe odds that high. The impact on asset values would be significant if assessments are marked to market. Some tenants may feel the pain over the near-term. Existing owners would ultimately bear the brunt of the burden and many would experience a meaningful reduction in NOI over the long run.
Awareness is the Best Policy
Policy items ranging from land-use regulation to fiscal health to federal tax reform all carry important implications for commercial real estate investment professionals evaluating potential acquisitions and developments. Investors with awareness of government policy will have an underwriting edge over those who ignore its impact. As such, policy will remain a focus of Green Street’s research efforts.
Green Street’s research provides thought leadership on real estate valuation, disruptors and more to arm investors to make better decisions.
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