Pity the City

Urban areas having a not great time

America’s largest urban areas have faced massive challenges in recent years. There are many centrifugal forces out there pulling people away from the center. That’s a problem for cities, the appeal of which rests upon: 1) a lot of people in close proximity to each other and to amenities, neither of which is great during a pandemic, 2) abundant shopping opportunities, which matters less in the Amazon, Instacart, Door Dash world; and 3) access to higher paying jobs, a perk that faded with the proliferation of remote work. Add to that the additional space needs required to work from home, and it’s obvious why a lot of households have fled cities since 2020.

Losing residents is bad. Losing rich residents is even worse. This EIG report released last week indicates that the people who fled cities during the pandemic were, relatively speaking, extremely rich.

In Baltimore, for instance, the average person who left the city 2020 and 2021 earned an annual income of $73,000. The average person who moved into the city over that span was associated with an average income of about $56,000. With roughly 2,400 fewer people filing tax returns in 2021 than 2020, net migration caused a $504.9 million decrease in citywide adjusted gross income.

Manhattan had it even worse (at least in absolute terms). People who left the city had an average income of nearly $240,000, close to twice the $123,000 income of Manhattan’s newcomers. With 37,000 fewer tax returns filed in 2021, AGI declined by more than $16 billion. Cook County, home of Chicago, lost $7.6 billion in AGI. Los Angeles lost $8.7 billion.

Even some of the cities thought to be big winners lost income. Mecklenburg County in NC, home of Charlotte, lost close to $100 million in AGI. Fulton County, home to Atlanta, lost more than $640 million.

Of course, the major cities in Florida gained wealthy residents, led by Miami and it’s $6.4 billion increase in AGI in 2021. The same can be said of Austin and Nashville, though those two added wealthy residents at a slower rate than surrounding counties.

A quick note on demographics

Part of the exodus of higher incomes from cities is due to demographics. It’s probably right to think about this as an acceleration of a pre-pandemic trend—Millennials growing up, starting families, and heading to the burbs—rather than an entirely new phenomenon.

The most common age in the U.S. right now is 32, and the second most common age is 31. There are about 3 million (or 4.3%) more Millennials—currently aged 25-40—than Gen Zers, meaning they wouldn’t backfill Millennials’ presence in cities even if they flocked to urban areas.

And there’s evidence the Gen Zers aren’t flocking anywhere. An estimated three in ten Gen Zers between the ages 18-25 still live at home or with relative, according to this survey conducted by Credit Karma.

(This post isn’t about what’s going on with Gen Z. On the one hand, they’re graduating into arguably the best labor market in living memory. On the other, they’ve emerged from a pandemic into a high-inflation, high interest rate world. Maybe we’ll try to make sense of them later.)

Tax implications: not great

Losing tax base is bad for cities, obviously. Let’s look at Baltimore City (for no reason other than I’m most familiar with these data), where income tax revenues increased just 2.2% from 2019 to 2022. During the three years before the pandemic, Baltimore City’s income tax revenues increased by about 27%, or about 12x faster than in the three years after the start of the pandemic. AND THAT’S BEFORE ACCOUNTING FOR INFLATION. In real terms, Baltimore City’s income tax receipts were lower in 2022 than in 2019.

Over that same three-year period that Baltimore City income tax revenues increased by just 2.2%, state-level income tax receipts increased by 51.3%. At the risk of sounding dramatic, that is atrocious, horrific, sound the claxons, DEFCON 1 bad.

Will property taxes save cities?

Hahaha, no.

Large cities depend on the property taxes generated by large office buildings, and the assessed value of those have been devastated by work from home. In San Francisco, a building that sold for $395 million in 2015 just sold for $60 million. Blackstone just offloaded an $82 million office park for 36% less than they paid 9 years ago. Principal Financial Group just sold a building in New Jersey for $14.3 million; they bought it for $42 million in 2008.

In Baltimore, an office building proximate to the Inner Harbor that sold for $66 million in 2015 just sold for $24 million. That building currently has an assessed value of $51.4 million, meaning it pays more than $1 million in property taxes every year. Or it did, anyway. Not only will the assessed value of that building decline, but that kind of transaction will carve away at the assessed value of other large office buildings.

And—here’s the kicker—that building is 95% occupied!!! Office vacancy rates in the city are currently hovering around 20%. This is not a great sign for the rest of the city’s office market.

Rising home values will help to bridge some of the gap here. Home prices are up about 40% since the start of the pandemic, and that will eventually translate into higher property tax receipts (and very sad homeowners) as the assessed values rise.

But losing income and CRE tax revenues and replacing it with residential property taxes is not a winning formula.

Can we save cities?

First, big cities aren’t going anywhere. About 80% of Americans live in urban areas, and that won’t meaningfully change anytime soon.

Second, we can’t save cities from the pain of this current period, but they can save themselves.

Cities are currently (and literally) built around large office buildings, but that’s going to have to change. The demand for office space isn’t gone, but it’s down bad, and a lot of those towers will have to be converted into housing with the kind of amenities that attract young people (pre-kids) and retirees (post-kids). Of course, not all office towers can be converted, as developers rush to tell us.

This will be an extraordinarily painful transition for a few reasons. First, it’s physically and politically difficult to convert office space into residential (this WaPo story nicely outlines some of the challenges, as does this episode of the Odd Lots podcast). Even when it’s possible, it probably won’t be profitable, and cities will have to incentivize developers to take on these costly conversions.

A few already have:

Boston announced a pilot program that will use public-private partnerships to accelerate the conversion of underutilized office space. “The program would offer owners of commercial office buildings Downtown reduced property tax rates in return for immediately converting their buildings to residential uses. Based on studies prepared for the City as part of PLAN: Downtown, a rate reduction by up to 75% of the standard tax rate for residential for up to 29 years could provide a strong incentive to encourage conversion.”

Chicago is using tax increment financing to spur on office-to-resi conversions on historic LaSalle street, and D.C. and California have launched similar programs.

Final thoughts

Cities are neither dead nor dying—the combination of unmatched convenience and leisure amenities and world class healthcare (big for retirees) is not going anywhere—but they are going through a difficult transition. In the short term, this is going to cause fiscal shortfalls that range from painful to excruciating, depending on the city.

Ultimately, the cities that are best able to transition from an office-based economy to a leisure/housing-based economy will enjoy the most rapid recoveries.

What’s next

Week in Review tomorrow. That’s for paying subscribers only. If you want that to be you, just click the button below.