Last week two debt rating agencies downgraded the creditworthiness of the State of Illinois. Moody’s downgraded the State from ‘A3’ to ‘Baa1’ while Fitch downgraded them from ‘A-‘ to ‘BBB+’. Illinois has yet to pass a budget. Fitch listed ongoing budget gaps, high unfunded pension liabilities and reduced financial flexibility as reasons for the downgrade. In Chicago, Mayor Rahm Emanuel proposed a property tax increase to address public pension shortfalls that have triggered downgrades to the city’s credit rating. That proposal passed the City Finance Committee and just recently received full council approval.
If you own real estate in Illinois, especially Chicago, how do you feel about that asset class? I found it interesting that last week’s October 26 edition of The Wall Street Journal reported that American business magnate, Sam Zell, has agreed to sell 25% of his apartment holdings to Starwood Capital Group. The article is mostly about Mr. Zell calling a top in the appreciation of multifamily rental properties like he did in 2007. It also highlights Mr. Zell’s return to city apartments away from the more saturated suburban markets.
How to Fund the Deficiency
The juxtaposition of the Illinois and Chicago credit news and Zell’s real estate asset sales made me wonder what effect unfunded public pensions could have on real estate as an asset class. Are industry insiders motivated to sell because they see a new variable in the ROI equation? Does Mr. Zell pick his cities based on their property tax outlook?
The easiest asset class to tax is property. There is virtually no chance of tax evasion and delinquencies and defaults are handled at Sheriffs’ sales or in bankruptcy where property taxes have priority over just about every other class of creditors. The decision to tax is political and while you risk reelection by taxing the hand that pulls your lever in the voting booth, the reality is that property taxes may increasingly be assessed on “fat cat” property aggregators like Zell and Starwood Capital, especially in cities where the preponderance of rental properties are owned by professional investors.
I believe we are in the first inning of a massive attempt to equitize underwater pension plans. The low interest rate and return environment are cause for concern because many unfunded plans could look materially worse if the discount rates reflect current (rather than historic) investment conditions. As long as voters don’t see the tax bill directly, they may still vote for property tax increases on “fat cats” who then pass it on to them indirectly through rent increases. You can’t love an asset class where it is so easy and effective for a public debt to be assessed privately through the action of a city council or a state legislature.
Operating Businesses and Commercial Real Estate
Direct ownership of operating businesses has some notable advantages. Operating businesses are not ideal conduits for restoring public pensions. Commercial real estate is taxed differently and its owners have the flexibility to shop for jurisdictions with low tax rates or subsidies. Even though the public perception of private equity sponsors is poor, the business model does not allow an easy transference of public pension deficiencies. You need a realization event to assess any tax on sale and few private equity owners are forced sellers due to flexibility in the business model for timing exits. Similarly, unrealized value is hard to assess because it is private and highly speculative. Yearly portfolio valuations for private equity audited financial statements are usually quite conservative.
Do Real Estate Professionals See New Risk
It would be interesting to know whether real estate professionals see public pension deficiencies as a looming threat to their business model? I do not have the experience to know whether “smart money” avoids states and cities with these pension deficiencies. If property tax increases are a new threat, the following states might be avoided. Larry Alton has written an interesting article for American Thinker (April 4, 2015) titled “Which States Have The Most Underfunded Pensions” from which I have excerpted his top ten offenders:
“1. Illinois: The most poorly funded state in America; Illinois only funds 43.4 percent of its pensions. It has an unfunded liability of $82.9 billion, with 20.7 percent going unfunded for each person.
2. Connecticut: The funded ratio for Connecticut is 55 percent with more than $20 billion in unfunded liability. The state owes each person an average of $56,000, which makes up 18.6 percent of an individual’s pension.
3. Kentucky: With a funding ratio at 53.4 percent, Kentucky is at nearly the top of the list for poorly funded pensions. The average unfunded liability for each person was more than $16,000.
4. Kansas: With only 56.4 percent of the states’ individual pensions funded, Kansas is a very difficult place to retire. They owe $9.2 billion in unfunded liability and fail to pay an average of 10 percent per person.
5. Alaska: The funding ratio for Alaska is only at 54.7 percent with more than $23 billion in unfunded liability and 27 percent of an individual’s pension going unfunded.
6. New Hampshire: At a ratio for 57.4 percent funded, New Hampshire has an unfunded liability of over $4 billion and an average of $3,000 not delivered to an individual’s pension fund.
7. Mississippi: With unfunded liability reaching nearly $50 billion and per-person unfunded liability at more than $16,000, Mississippi has a funded ratio of just 57.6 percent, a record low for the state.
8. Louisiana: The population of Louisiana is 4.65 million, but only 58.1 percent of those people receive their full pensions. The unfunded liability is nearly $75 billion with per-person unfunded liability at over $16,000.
9. Hawaii: 40 percent of pensions go underfunded in Hawaii, with nearly $40 billion in unfunded liability and a whopping average of $20,000 in per-person unfunded liability.
10. Massachusetts: Finally, Massachusetts’s funding has something to be desired with 60.8 percent of its inhabitants receiving their full pensions. Their unfunded liability totals about $75 billion.”
Mr. Alton concludes that 85% of public pensions could fail in the next 30 years.
Maybe even more important for these debtor states, is the credit effect on all other debt based state governmental operations. Illinois and Connecticut may be just a few downgrades away from serious operating problems?
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