This area of the market rarely calls attention to itself, but the relentless press forecasting the death of downtowns has caught the eyes of many investors. The vast majority of our local government holdings reside in school districts, many of which enjoy added protection of state support. In contrast, our allocation toward city general obligation bonds and traditional mass transit debt is much lower—not due to credit concerns, but rather of the lack of attractive values. We understand the reasons for the negative sentiment, but we would not extrapolate them into fundamental concerns.
Local government credits benefit from durable revenue sources, of which property taxes are the largest and arguably the most stable. These taxes are based on assessed real estate values within a district. A typical local government derives over 60%1 of its property taxes from residential real estate. This provides important diversification to, and insulation from, declining commercial property values. There is a big difference between owning bonds directly backed by office buildings and those backed by the full taxing authority of a city.
Typically, there is a significant lag between property price appreciation and tax growth. Residential housing price growth over the past few years will enhance local government revenues for years to come. The lag holds true in downturns as well. When looking back at the Global Financial Crisis (GFC), real estate values peaked in 2006, but peak property tax collections did not occur until 2010.2 This lag provides time and flexibility for municipal governments to prepare and adjust.
Investors learned from the GFC that large declines in real estate values do not lead to commensurate declines in property taxes (see Exhibit I). Nationwide, inflation-adjusted real estate values declined by 27% peak to trough, while the peak to trough decline for property taxes per capita was only 8.5%.3 Local officials frequently mitigate the impact of declining real estate values by increasing property tax rates. From a credit perspective, it is important to understand any relevant property tax caps as well as periodic rate hike limitations.