Many investors have expressed concern about the impact of declining property values across the country and the effect on the credit quality of tax-backed municipal bonds. Although it is true that these declines have put pressure on many local governments and taxing authorities, history tells us that state and local governments have proven to be resilient and are likely to be so in the future.
A recent study by Fitch Ratings found that declining property values do not necessarily translate into weaker credit quality for tax-backed bonds. In fact, the impact has varied depending on several factors, including the size of the real estate “bubble” in an area, local assessment practices and how dependent governmental units are on property taxes as a revenue source.
Property values, assessments don’t necessarily move in lock step
Fitch found that the link between the rise and fall of property values and assessments are not in lock step in many states due to restrictive laws that aim to keep property taxes low. Real estate prices may have risen due to new sales and construction, but assessed values are often limited by formula for the vast majority of properties that don’t change hands very often. In fact, some of the states with the biggest real estate declines (Arizona, California, Florida, Michigan and Ohio) have implemented assessment and tax collection procedures that have slowed the impact of real estate volatility on local revenues. California’s Proposition 13, the most prominent of such limits, requires the operating tax rate to not exceed 1% of a property’s assessed value, and limits assessed values annual growth to 2%, regardless of current market value.
Fitch notes that Florida’s “Save Our Homes” and Amendment 1, for example, have capped assessments, thereby limiting property tax growth during boom years. The limits on assessed value increases for continuously held properties have also shielded local governments in another way. With diminished inflow of property tax revenue, many local governments have, over the years, sought to lessen dependence on property taxes as a revenue source. Increased imposition of user fees, sales and excise taxes, and other revenue sources, for example, now limits reliance on property taxes to less than half of general fund revenues in many Florida cities. Although still a major revenue producer, property tax limitation rules have also served to cushion local governments on the downside, just as they limited over-reliance on property taxes when property values were skyrocketing.
Tax hikes can offset decline in assessed values
A further offset to declining assessed values, Fitch found, was the ability to raise tax rates in some states to keep property tax collections close to former levels. Despite a tax revolt in Florida, local governments and special taxing districts have been doing just that.
Palm Beach County raised its rate by 15% earlier this year, and 24 of the county’s 38 municipalities also adjusted millages upward to counter falling assessed values.
Fitch reports that Nevada’s property tax abatement law actually worked to stabilize local government finances by deferring property tax increases to future years when property value growth will be less robust. By allowing future recapture of prior growth above an established limit, property taxes are less volatile than the dynamic real estate market in Nevada otherwise would have suggested.
The general stability of ad valorem property taxes and their high collection history have always made the property tax a staple revenue source at the local government level. Since the current year’s assessed valuations are used to set the coming year’s tax rate, the impact of current property value declines will be felt further into the future, giving local governments time to consider options to keep budgets in balance.
Fitch’s conclusion that declining property values will be unevenly felt in the credit quality of America’s municipalities is quite reasonable. We believe that where stresses occur, the impact will be met with counterbalancing actions to keep budgets in control and debt service paid.
While the debate will center around which services a community needs to cut to achieve budget balance, it is extremely rare that non-payment of debt service will even be considered. While communities that rely heavily on property taxes may find their bond ratings under pressure, we expect the municipal bond market’s extremely low default rate to continue.