Commercial real estate investors thinking about buying more property in the Chicago area might want to think again—or at least take a harder look at the fiscal crises facing our city and state governments.
That’s one conclusion of a new report that assesses the risks to investors of buying in markets burdened with public pension and budget problems. The report, by real estate research firm Green Street Advisors, raises alarm bells about the Chicago market, giving it the worst “fiscal health” score among top U.S. metropolitan areas.
“The results are most dire for Chicago, Northern New Jersey and Fairfield County (N.Y.), where fiscal death spirals, in which higher taxes lead to outmigration and yet higher taxes, are realistic scenarios,” analysts for Newport Beach, Calif.-based Green Street write in the report.
The report is a downer for a Chicago commercial real estate market that has been riding high for the past several years, as a flood of investor money has pushed up property values, generating fat profits for landlords. The favored narrative emphasizes the city’s recent success at attracting big corporations like ConAgra and McDonald’s, which recently moved its headquarters to the West Loop, and its ability to attract young, well-educated workers, whom companies need to grow.
But real estate investors could suffer here—first, as local governments raise property taxes to cover pension shortfalls, and second, as Illinois boosts income, corporate and sales taxes, according to Green Street. Rising property taxes result in a direct hit to a landlord’s bottom line, and the other tax increases nudge residents to leave the state, reducing demand for apartments, retail and other commercial space. Investors want to buy where populations are rising, not falling.
“Newly minted college graduates in the Midwest strive to establish careers in Chicago, the de facto regional capital,” the report says. “Career opportunities and lifestyle draw them in, but the effects of poor fiscal health may ultimately push them out.”
Although strong, Chicago’s commercial real estate market has slowed over the past year or so, and many investors have bypassed the area for faster-growing metro areas.
Most investors also are well aware of the city and state’s poor fiscal condition. But it’s not easy to model the risks when it comes to figuring out how much to pay for a property, aside from forecasting an increase in property taxes over an expected ownership period. Predicting migration patterns is a more complicated task.
Green Street is rolling out fiscal health scores as part of its ongoing analysis of property markets, an attempt to help investors factor in fiscal condition when it comes to making decisions about where to buy and how much to pay.
Current property values suggest that investors are not pricing fiscal risk into deals today, the report says. Investors are buying apartments in the Chicago area, Northern New Jersey and Fairfield County—three markets in “critical condition”—at an average capitalization rate, or first-year return, of 5.4 percent, not much higher than the 5.0 percent national average, according to the Green Street report. The rate should be higher to account for the added fiscal risk, Green Street argues.
“Fiscal health of states and municipalities is an inescapable threat that doesn’t appear to be priced into property market cap rates, likely because there is much uncertainty over timing and outcomes,” the report says. “But knowing the train will eventually come off the rails should be enough, and market participants would be wise to incorporate this fact into their (pricing) models today.”
Chicago and the state have already raised property and income taxes to cover budget shortfalls, and Green Street warns that investors should brace for more hikes, especially if Democrat J.B. Pritzker beats incumbent Gov. Bruce Rauner in the November election. To account for the city’s poor fiscal health, the research firm has reduced its long-term growth estimates for Chicago by 0.50 of a percentage point. The report notes that the city’s population has declined 7 percent since 2000 and cites a United Van Lines report that nearly two-thirds of the company’s recent rentals in Illinois were for out-of-state moves, the highest in the country.
Green Street also says Chicago appears to be on the same path as Detroit, a former fiscal basket case that recently emerged from bankruptcy. That’s the kind of dire message that real estate investors don’t want to hear—except maybe those prowling for distressed property.
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