TABLE OF CONTENTS
LIST OF FIGURES
LIST OF TABLES
LIST OF BOXES
This chapter discusses the exogenous economic risk category. Exogenous economic risks are risks that are determined by external factors at the regional, national, or sometimes global level, and are outside the control or influence of project stakeholders. Several exogenous economic risk types exist that value capture funding for transportation may be subject to, but the three most common are: (1) macroeconomic risks; (2) real estate market risks; and (3) other local economic and demographic risks. This chapter describes each of these risk types and provides examples that illustrate how they may impact projects relying on value capture funding.
Macroeconomic risks result from the country’s economic policy and condition of the economy. Factors that influence these risks include, among others: economic growth or downturn, inflation, significant changes in the Federal Reserve Bank policy, and Federal budget deficits (10). Examples of macroeconomic risks include economic recessions that impact employment and spending by commercial and residential developers (and the public in general), or interest rate changes that impact the cost of borrowing.2 These risks may also materialize because of international geopolitical events, such as commercial treaties or trade disputes that change or disrupt supply chains, or pandemics and other catastrophic events that disrupt international trade and travel.
The subprime mortgage crisis that took place between 2007 and 2010 resulted from a rapid expansion of mortgage credit in the early and mid-2000s, a period when even borrowers who previously would not have qualified for mortgages were able to obtain them (11). This phenomenon contributed to (and was facilitated by) a rapid escalation of home prices. These high-risk (subprime) mortgages were a product available from lenders that repackaged them into new financial products called private-label mortgage-backed securities (PMBS) that were successfully sold to investors in financial markets. This situation led to a large increase in first-time homebuyer mortgages and a rise in homeownership across the country.
The resulting demand for housing led to the escalation of home prices, particularly in areas where supply was tight, which increased expectations for further price gains. Investors that had purchased PMBS benefited at first because increasing house prices protected them from losses. When borrowers could not make loan payments, they could simply sell their homes at a gain and pay off their mortgages or borrow more against the rising value of their home. However, when housing prices hit their peak, subprime mortgage losses started accumulating for lenders and investors in PBMS. In 2007, funding of subprime mortgages collapsed; lenders stopped making subprime and other risky mortgages. Demand for housing decreased, housing prices started to decline, fueling expectations of future declines, and further reducing housing demand. The resulting spiral decline in housing prices was so large that troubled borrowers had a difficult time selling their homes to fully pay off their mortgages. Mass foreclosures, repossessions and “short sales” (cases where lenders accepted limited losses if home were sold for less than the mortgage amount owed) ensued (11). The subprime mortgage crisis thus fueled a downward spiral in house prices that erased most of the gains seen during the earlier housing prices boom (11).
The subprime mortgage crisis was one of the most important factors that led to a national economic recession between 2007 and 2009. It decreased construction activity nationwide, reduced consumer wealth and spending, tightened credit markets, and made it difficult for developers and the private sector in general to raise capital from financial markets (11).
At the local government level, the sudden boom and bust in property prices was reflected in property tax revenues, and the ensuing economic recession was reflected in sales tax collections. In the aftermath of the crisis, local government revenue decreased significantly in communities across the country, affecting the delivery of basic municipal services. Value capture mechanisms that rely on land development and property values, such as TIF districts, were particularly impacted. As an example, the State of Illinois reported that revenues collected by TIFs statewide during the housing boom years increased by 382 percent, going from $5.09 billion in 2000 to $19.44 billion in 2007. The real estate market recession generated by the collapse of the subprime mortgage market in 2007 then led to a reduction in TIF district revenues statewide from $19.74 to $11.71 billion between 2009 and 2013, a 41 percent decline (12). Similar swings in property tax revenues were reported during the same period in communities across the country (13).3
To mitigate these risks, it is important to perform revenue-potential analyses before implementing the value capture technique.4 These analyses should account for the possible impact in revenues of economic recessions at the national level, changes of interest rates, and catastrophic events such as floods or hurricanes. These analyses should be reviewed before using future revenues to secure a loan from a bank or lending institution.
The coronavirus 2019 disease (COVID-19) pandemic not only caused a devastating loss of life worldwide, but also led to an economic crisis in the United States. According to the National Bureau of Economic Research, the pandemic led the country into a recession as of March 2020. Many parts of the country issued lockdown orders and travel restrictions were put in place to prevent the spread of the disease. These measures and general concern about the virus led to a large and rapid aggregate shock on demand and supply that resulted in the sharpest economic downturn the country had faced since the Great Depression (14). Unemployment peaked at 14.7 percent in April 2020. Over the course of the pandemic, Congress approved several major laws addressing the effects of the pandemic and assisting households through loan forbearance and foreclosure and eviction moratoriums, and businesses through financial incentives to retain employees. Additionally, the Federal Reserve lowered the Federal funds rate (the overnight interbank lending rate) and implemented other policies that mitigated the short-term decline in aggregate economic conditions (14). The pandemic also had a dramatic effect in the workplace. Many companies shifted to telework or work-from-home to slow the spread of the disease and protect employees. Video calls and instant messaging applications replaced in-person meetings and breakroom conversations. Many companies, particularly in the technology and services sectors, announced that they would allow employees to work from home permanently (15).
Public and private sector policies implemented during the pandemic dramatically affected the demand and supply balance in the United States real estate market. The effects of these policies, and of the pandemic in general, in the real estate market were dramatically different for the residential and commercial real estate sectors:
As a result, the impacts that the pandemic had on local government property tax rolls and sales tax revenue (and by extension on value capture techniques that rely on these taxes) were also mixed. On the residential real estate side, the growth in home values boosted municipal residential property tax appraisal rolls. This potentially benefited some value capture techniques, such as TIF districts and TRZ, special assessment districts (SADs), or land value taxes, in areas where residential real estate predominates. Increased demand for housing stimulated investment by residential real estate developers. Increased development activity may in turn boost value capture revenues from techniques such as impact fees or negotiated exactions.
Although it is too early to know what the long-term impact will be for commercial real estate, in the short term the pandemic could have a negative impact on revenues generated by value capture techniques that rely on property or sales taxes in areas where commercial property predominates. Such areas may include TIF districts or a SAD.
The mitigation strategies that many local governments are applying to deal with the short-term negative impacts of the pandemic on commercial real estate have focused on providing property owners with flexibility in payment terms. For example, Los Angeles County in California allowed taxpayers to apply for a workout plan for missed payments. In Pennsylvania, Philadelphia County moved the commercial property tax payment deadline to July to give taxpayers extra time to make their payments (19). These strategies have helped prevent a complete halt in commercial property tax revenue.
Real estate market risks are another type of exogenous economic risk affecting value capture techniques. Real estate market risk examples include regional or local real estate bubbles and boom and bust cycles that apply to specific types of property and/or specific local or regional markets, and that are not the result of broader national economic trends. In other words, these risks are associated primarily with the real estate market cycle, which are essentially related to imbalances between the supply of a particular type of property and the demand for such property (20). There are five main types of real estate property in terms of use, including residential, commercial, industrial, agricultural, and others (e.g., schools, government buildings) (21). The real estate cycle may vary across locations or geographic regions and is mainly driven by gross domestic product and employment and demographic changes.
In other words, real estate market risks refer to the position of specific property types in the real estate market cycle at the regional or local levels. The real estate cycles consist of four phases—recovery, expansion, hyper supply, and recession. In the phases of recovery and expansion, demand growth rates are higher than supply growth rates. In contrast, the demand growth rates are lower than supply growth rates during the phases of hyper supply and recession (22). These imbalances may occur because of overbuilding or shifting demand that renders the space less attractive to the market of most probable users for whom the space was developed.
These imbalances may be reflected in a temporary impairment in value as the market adjusts to a temporary imbalance, or in a permanent impairment as the space becomes functionally obsolete. This often takes place in the aggregate and is usually reflected in rising vacancy rates at a submarket or property type level. This phenomenon also disrupts real estate development and other economic activity within the community, and it is critical to understand it when planning and implementing value capture projects.
Furthermore, different property types may be at different points in the real estate cycle when compared to other property types (e.g., residential vs. commercial), and the same property type in one region may be at a different point in the cycle when compared to a different region, or to the Nation as a whole. Similarly, property subtypes may be at different points of the cycle than their broader property type classification. For example, at a particular point in time commercial retail property may appear in the recession part of the cycle, while commercial office property generally may appear in the growth segment. At the same time, it could be possible that when looking more closely into retail property subtypes, regional malls and factory outlets could be found in the recession part of the real estate cycle, while the neighborhood/community retail subtype is at equilibrium (23).
Real estate market risks are clearly one of the most important risks to consider in planning and implementing value capture projects. Imbalances in the real estate market directly affect revenues generated by value capture techniques relying on property taxes, such as SADs, BIDs, land value taxes, and TIF. These risks may also delay new development, making the use of value capture category techniques such as joint development and developer contributions impossible. Fortunately, a significant amount of data sources and research is available for practitioners to use to develop a better understanding of real estate market risks in a particular location. Data sources that can be tapped into range from local appraisal district and municipal building permit databases to more specialized databases that aggregate market trends at the local, regional, and national level for different property types and subtypes. An example of the latter is the Real Estate Market Cycle quarterly report published by Dr. Glenn Mueller at the University of Denver, which analyzes occupancy movements in five property types in 54 metropolitan statistical areas (22). The examples that follow illustrate how real estate market risks may affect different value capture techniques and suggest potential mitigation measures.
Interstate 670 (I-670) is a major transportation corridor that connects I-70 with I-270 across downtown Columbus, Ohio. I-670 was constructed in the 1950s and has acted as a barrier isolating the Short North Arts District and the Italian Village and Victorian Village neighborhoods from the downtown. One consequence of this barrier was that two very different real estate markets developed over time, despite their proximity. One neighborhood south of I-670 was relatively thriving as the central business district and the location of a convention center. The other, north of I-670, was struggling with much lower real estate values.
During the 1990s, different revitalization initiatives were implemented in the Short North side. As a result, the area became a vibrant place with numerous shops and restaurants. This urban renewal success was one of the main drivers for the City of Columbus to embark on a project called The Cap at Union Station (The Cap). The project commenced in 1995, when transportation agencies were seeking to widen I-670, which community groups opposed, and the City began looking for ways to reconnect the Short North with the neighborhoods north of I-670 using a hard “cap.” Although other cities had built convention centers and/or parks over urban highways (e.g., Seattle, Kansas City), what made The Cap project unique is that it was conceived as a pedestrian and retail space.
A local developer approached the City of Columbus and expressed interest in investing in the project. In 1999, the developer signed an agreement with the City to lease the ground above The Cap and build the retail space as soon as the City could acquire the air rights above the highway after obtaining permission from the Ohio Department of Transportation (ODOT) and FHWA. Construction of The Cap over I-670 began in 2002. The developer started construction of the retail space in 2003, and the project opened to the public in October 2004 (24).
Source: Hyde Park Restaurants
Figure 3. Restaurant Facade at The Cap
Source: Wikimedia Commons
Figure 4. The Cap from Above
In terms of project funding, ODOT paid approximately $1.3 million for the construction of The Cap, and the City of Columbus paid around $325,000 to provide The Cap with access to utilities. The developer assumed the costs of building all the improvements on top of The Cap, which represented an investment of $7 million, and was financed as follows (1):
The project was very successful commercially as well as in terms of spurring development and revitalization on both sides of the highway due, in part, to the increase in accessibility and walkability in the area. As a result, and after securing more tenants, the developer was able to refinance the project using a $7 million conventional loan in more favorable terms.
From a risk perspective, the City of Columbus and the developer faced significant real estate market risks associated with the project because of its unique characteristics. The Cap at Union Station presented unique challenges from a property subtype perspective because it was one of the first speculative retail projects built over a highway in the United States (25). Therefore, there was no market data or information to assess the potential demand for the property subtype and where in the real estate cycle it would likely be upon completion. Additionally, the unbalanced nature of the real estate on both sides of the highway raised concerns about the commercial attractiveness of the retail strip which could negatively impact leasing prices and increase vacancy rates, reducing the developer’s leasing revenue.
Nevertheless, the City of Columbus and the developer implemented several measures that successfully helped mitigate these risks. The City conducted thorough feasibility studies to confirm that the location and nature of the project had potential to attract demand for retail space and potential qualified developers, and to ensure that the value capture technique proposed was appropriate. On the other hand, the developer conducted its own market and financial feasibility analysis, assessing the risks associated with such a unique retail property and carefully considering potential occupancy rates and the price that retail tenants would be willing to pay. Furthermore, recognizing the challenges and uncertainty associated with such a unique property, the City provided the developer with a 10-year, 100 percent property tax abatement, which helped mitigate project risks by improving the project’s economics.
The last type of exogenous economic risks are other local economic and demographic risks. These risks are defined as economic shocks to a particular location or region that are the result of broader structural changes to the economy and/or employment mix, natural disasters, or other causes. These risks bear a significant consideration in value capture projects because they can directly impact the value of real estate assets in considerable ways. This is because real estate assets have a fixed location and are relatively costly to alter and are therefore relatively static. Conversely, the forces that drive business decisions of commercial and industrial tenants and other space users are subject to dramatic changes, including new technologies or logistical models, or global market forces that impact capital flows, business location, and ultimately the labor force (20). For example, the structural shift from manufacturing to services as employment drivers that has gradually taken place in the U.S. and other developed nations over the past several decades and has generated pockets of unemployment in sectors of the workforce across the country. Although some communities and their labor force have been able to adapt to these challenges and new labor market demands, others have struggled. This has resulted in migration and other socioeconomic problems that have hindered economic activity and impaired real estate development as the example below illustrates.
Additionally, the static nature of real estate assets combined with their physical dimensions makes them vulnerable to several natural and man-made disasters. The past several years have seen increases in the frequency and severity of real estate losses related to natural disasters, such as hurricane-induced flooding along coastline communities and tornadoes in inland regions. On the other hand, man-made disasters range from disasters that affect the environment (e.g., large oil or other hazardous material spills), to terrorist threats, as well as unusual climate or weather patterns that cause flash flooding or other environmental degradation (20).These events can temporarily or permanently impair the local economy and real estate development in several ways. For example, mitigating future property damage through physical improvements raises the cost of construction, while expected future losses increase long-term insurance costs, reducing potential returns for developers. Aside from job losses linked to real estate development, significant job losses are likely in communities that depend on tourism or other visitors.
The materialization of this type of risks can delay or permanently impair development, thus significantly affecting revenues generated by value techniques that rely on property or sales tax growth such as SADs, TIFs, or STDs.
Rust Belt is an informal term used to describe a set of social and economic conditions that occurred between the 1950s and the 1970s because of a severe decline in industrial manufacturing activities in the region that extends from New York to the Midwest around the Great Lakes. This industrial decline forced the abandonment of factories that later were seen as rusty buildings due to exposure to the elements and lack of maintenance (26). The term Rust Belt currently describes communities that depended on industrial manufacturing in the past, which has almost disappeared in the present, producing a drastic economic decline.
The Rust Belt includes parts of the States of Illinois, Indiana, Michigan, New York, Ohio, Pennsylvania, West Virginia, and Wisconsin. This region experienced several booms in the coal, steel production, and manufacturing industries from the late-19th century to the mid-20th century, which demanded hundreds of thousands of blue-collar jobs. At that time, the region was known by other names such as Factory Belt, Steel Belt, or Manufacturing Belt (27). This industrial region was established in part by its proximity to the Great Lakes waterways and investments in transportation projects to create the required roadway and railway networks to satisfy economic and industrial activity needs (28).
However, the industrial manufacturing activities in the region started to decline between the 1950s and the 1970s due to the outsourcing of manufacturing jobs to other countries, which was driven mainly by the increase in the cost of labor and materials and the low productivity levels caused, in most cases, by the obsolescence of the equipment utilized (27). This new situation created unemployment and migration to other parts of the country, resulting in blight, decay, and other signs of local economic contraction in the region. In 1950, 33 percent of the population in the U.S. (not including New York City) was living in the Rust Belt. Fifty years later, in 2000, this percentage decreased to 25 percent (29). In fact, of the 15 U.S. cities that lost the most population from 1960 to 2007, 14 of them are in the Rust Belt (30).
Regarding employment, 43 percent of private sector workers, not self-employed, in the U.S. were working in the Rust Belt region in 1950. By 2000, the percentage of these workers decreased to 27 percent. The decrease in manufacturing jobs followed a similar trend. In 1950, 51 percent of manufacturing jobs were in the Rust Belt and decreased to 34 percent by 2000. Finally, this situation caused a significant decrease of the gross domestic product (GDP) of the region. The GDP in the Rust Belt represented 45 percent of the U.S. GDP in 1950 and decreased to 27 percent in 2000 (31).
Situations like these could negatively impact revenues generated by value capture techniques that rely on property or sales taxes, as it completely halted new real estate development for years. A mitigation strategy for risk of unemployment and migration could be used to conduct rigorous feasibility studies that consider local and national economic factors in the short and long term to assess scenarios and develop resilient project alternatives.
2 The 2008 housing crisis for example would be a macroeconomic risk, which we’ll differentiate from the real estate market risk and the economic growth impact risks described below.
3 For additional information, the National Tax Journal published an article that analyzed real estate prices in the States of Nebraska and Illinois (extensive users of TIFs) before and after the Great Recession produced by the subprime mortgage crisis: https://www.journals.uchicago.edu/doi/pdf/10.17310/ntj.2014.3.08
4 An example of typical contents in a Texas TRZ value capture analysis is included in the Appendix.
5 Find more information about the impact of COVID-19 on the housing market in a note published by the Federal Reserve System: https://www.federalreserve.gov/econres/notes/feds-notes/housing-market-tightness-during-covid-19-increased-demand-or-reduced-supply-20210708.htm
