The good news, of sorts, is that most of the ominous debt maturities are still a year or even several years out into the future, so this is a bomb with a long fuse. But even with time still remaining for workouts, the math is irrefutable that there will be hundreds of prominent office building financial failures in coming years.
Some desperate property owners seeing bankruptcy coming will skip making tax payments and let the liens stack up. Reports of office building sales prices of around half — or even less — of their original value are spreading, and that bodes ill for banks and other lenders. These fire sales also portend a decline in tax revenues in such once-thriving center cities as Boston, Chicago, New York, San Francisco and Seattle.
So while cities are not on the hook for the loans themselves, they have major stakes in this game. A potential solution worth exploring is to give them some skin in the game as well, using municipal bonds as their playing cards. Facing hollowed-out downtowns, they can’t wait for the capitalist approach to market meltdowns to play out — for “grave dancer” investors to step in and buy distressed properties for dimes on the dollar and hold them for eventual recovery at a nice fat profit.
That worked well for the speculators in Miami condos and apartment buildings in 2008 and 2009. Just this month in San Francisco, voters approved a ballot measure to provide tax incentives for developers to convert offices to housing. And San Diego is recalculating just how much downtown office space is even needed.
But for now at least, the question is who will bankroll the purchases of entire buildings at lower prices, when it’s still not even known how low is low enough to establish a bottom for this market.
In this financial tsunami, local governments are generally unable to plug the dike by simply offering more incentives to developers. Although local officials may find a way to work within current laws to prop up commercial real estate in limited ways, there is a path for Congress to help, one that could come just in time to get ahead of the inevitable massive wave of loan defaults coming in 2025 through 2028.
With many of the 2017 federal tax cuts expiring, congressional lawmakers will be under immense pressure to write a new tax bill next year. This will open the door for some selective tweaks in the municipal bond tax rules, especially when the net cost to taxpayers is next to nil and the result is a stronger urban economy with fewer foreclosures.
Taxpayer-Friendly ‘Bailout Bonds’
In a previous column, I lambasted the use of tax-exempt stadium bonds and private activity bonds as giveaways to the rich that serve little or no public purpose. But while advocating a 10-year phase-out of all private activity bonds, I offered up a new strategy as an alternative to phasing out stadium bonds: a profit-sharing kicker. A similar central idea is that Congress could require some upside for both the local governments that issue qualified bonds for distressed urban real estate and for Uncle Sam for providing the tax exemptions. Under this model for tax breaks, the stabilization and eventual recovery of the office tax base can provide rewards to the taxpayers by requiring profit-participation rights from the benefiting owners.
The idea of mortgages with a profit-sharing or equity-sharing arrangement for the lender is not new. There have been similar arrangements at small scale in residential finance over the years, as well as in private industry. In the case of urban office refinancing, the concept that Congress could enact is to allow sale of tax-exempt private activity bonds to provide funding for distressed urban real estate on 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 so many of the muni bond giveaways that get nothing in return for Uncle Sam, these “bailout bonds” would provide a reward to taxpayers for underwriting some of the risks of providing desperately needed capital to underwater property owners and their bank lenders in a time of financial distress.
The concept is a close cousin to the auto industry bailouts in the Great Recession era, when shares of automakers’ stock were turned over to the U.S. Treasury in return for bailout funding. In the current situation, a city would issue senior secured tax-exempt conduit mortgage revenue bonds — bonds issued without any local taxpayer guarantee of repayment — with a covenant that the property owner would be required to share in future profits or price appreciation on the subject property. This wealth-sharing provision should compensate the U.S. Treasury first and local governments second, because the interest rate subsidy is coming foremost from Uncle Sam, but it would be nice to see both levels of government benefit financially.
Access to the municipal bond market would have the added advantage of making lower-cost 30-year mortgage finance available to an industry that has often relied on much-shorter-term bank loans that require successive refinancing. That feature alone should help de-risk the urban tax base in future recessions.
An Opportunity Under Current Law
It's worth noting that current federal law might already allow a city to require a profit-sharing deal in exchange for sponsoring such a tax-exempt bailout of commercial office debt as a public purpose. With some creative legal work and a permissible deal structure, today’s private activity bond rules may be flexible enough to permit public agencies to facilitate refinancing of office properties and cut Uncle Sam out of the deal with a profit-sharing contribution by the owners not to the city but directly to a local charity or other nonprofit, such as one that provides housing for the homeless. “Two birds, one stone” for urban problem-solvers: just call it a new twist on public-private-nonprofit partnerships.
Whether any locality would be brave or crafty enough to deploy this untested strategy without legislative air cover from Congress is just the first hurdle for mayors and public financiers. As my recent column about arbitrage vampires explained, the IRS does not take kindly to clever schemes to produce otherwise taxable income from selling tax-exempt bonds, so I would argue that a direct payment of profit-sharing to the city is inadvisable presently. But a negotiated charitable contribution may be allowable. Even if it’s too dicey for timid mayors to try this in 2024, the research effort and financial modeling framework would help mightily in crafting favorable legislative and regulatory language for 2025’s inevitable tax bill.
If Congress were to insert this distressed-property provision explicitly in the tax code next year, its authority for new deals should expire after a fixed period — say, five years — so that it’s not a perpetual money tree for opportunistic real estate tycoons. Thereafter, the broader issue of private activity bonds should be addressed, to require them to include a profit-sharing feature as an integral concept. Such profit-sharing kickers could make these bonds revenue-neutral for the IRS, which would be a landmark achievement in muni-land. The challenge, of course, is framing and calibrating the lawfully required percentages of future profits or asset appreciation that would inure the federal and local governments.
Protecting the Public Interest
Any such congressional muni bond tax exemption should be applicable only to properties that are refinanced at a materially lower valuation than the outstanding debt, perhaps 75 percent or less, so that the opportunity for price recovery profit-sharing and the evidence of financial distress are both sufficient to justify the tax subsidy and public-sector intervention. The issuing municipality should be required to obtain independent fair market appraisals that become part of the bond declarations on which muni investors rely, so that any sketchy frauds committed upon issuers in that process would be subject to the Securities and Exchange Commission’s regulatory actions and criminal sanctions.
Furthermore, a stiff 80 percent loan-to-value ratio — that is, with a 20 percent at-risk capital-matching mandate for private investors — should be required. Bond-rating agencies might require even more ownership skin in the game, but that can be left to private markets to work out as long as the issuing municipality is not on the hook for future defaults.
Only time will tell whether the office real estate market meltdown continues into 2025 with enough headlines and doomsday forecasts to put pressure on congressional tax committees to consider this novel approach. But one way or another, the muni bond lobby needs to start thinking creatively about ways to rationalize the use of federal tax subsidies that predominantly benefit private investors. Stabilizing the nationwide office property meltdown seems like a worthy place to start.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment or specific issuance advice.
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