Although there is considerable uncertainty on the economic recovery with the virus, I can tell you with 100% certainty you will see an increase in Colorado taxes as states burn through cash. At the end of the day someone has to pay and unfortunately you and I will be holding the bag. What does this mean for real estate? How will this impact the recovery?
We all know that regardless of what the politicians say, there is no free lunch, you can’t just print money as some suggest to solve the economic crisis. At some point you have to pay the piper through either reduced spending which never happens or higher taxes. I can guarantee higher Colorado taxes will be the answer if past performance is any indication.
States burn through cash:
Not only is the federal government burning through cash, but states are also facing a cash crunch. There are two primary drivers. First revenue is down substantially from declining tax collections like sales tax and income taxes. At the same time expenses have increased substantially due to preparations for the pandemic as well as the sudden huge increase in unemployment claims that far outpace any collections. Taxpayers will have to pick up the shortfall via higher taxes.
Property taxes increase:
Coronavirus has caused the Federal Reserve to drastically cut rates to almost zero due to the Coronavirus fallout. This is great news for borrowers from mortgages to cars, but there is a huge unintended consequence. Savers are getting pummeled due to the lower rates. One group will get pummeled as rates remain low and you, the property owner, will be on the hook for 3.8 billion annually!
The pension bomb on the horizon!
U.S. institutions managing trillions of dollars in retirement savings — including the California Public Employees’ Retirement System — have been ratcheting down return expectations. Japan’s Government Pension Investment Fund, the world’s largest, has warned that money managers risk losses across asset classes. Almost every major pension plan in the US is using much higher expected returns than the market is now allowing.
Pensions are reeling from the swift declines in rates in both the United States and other parts of the world where rates have turned negative. This loss in returns will transform the Pension market and taxpayers will be on the hook for billions.
A case study: Colorado’s Pera
Colorado PERA provides retirement and other benefits to nearly 1 out of every 10 Coloradans who are current and former teachers, State Troopers, snowplow drivers, corrections officers, and other public employees who provide valuable services to all of Colorado. It is very similar to other plans in States/Cities throughout the country.
Pera has under management approximately 48.1 billion dollars. Over the last 10 years, they have averaged a 10.4% return, last year the return was 4%, what happens when the return is even lower or negative? Below is a chart with the expected change in revenues. As 10 year treasuries plummet and returns on other “safe” asset classes follow suit revenues will decline sharply. As you can see, with a 2% return, revenue is 3.8 billion dollars less each year. Taxpayers will be on the hook for this huge deficit in revenue.
| $ under management | $ 48,100,000,000 | |
| Return | Expected income | Loss of Revenue |
| 10% | $ 4,810,000,000 | |
| 4% | $ 1,924,000,000 | $ 2,886,000,000 |
| 2% | $ 962,000,000 | $ 3,848,000,000 |
Sustained period of lower yields
The Pension apocalypse is just beginning. Low rates of returns are here to stay. In many parts of the world investments in government securities has turned negative. Essentially you are paying the government a fee to hold your money so for every dollar you give it at the end of the year you have 2 cents less (98 cents in your account). As a result, investors are hunting for yields in other parts of the country. For example, the US government (Treasuries) is one of the most desirable “safe” assets. With all the new demand this has pushed US returns to record lows. Many pension funds are required to keep a portion of their assets in safe securities like US government bonds. These investments are now returning paltry returns and will likely go lower.
The clamoring for yield has pushed other returns down as well. For example, class A commercial real estate is also showing lower returns due to the large demand for high quality assets. We are in for a sustained period of lower yields as the world “hunts” for higher returns in the US and other locations
3 options to stem the crisis
The pension bomb is already upon us with the prevalence of low returns become the norm not the exception. This will force pension plans like Pera to take drastic steps. There are basically three options to help resolve the crisis.
- Cut benefits: not only will future benefits have to be pegged to the return of the investment fund, but current benefits will have to be pared so that the fund does not run out of assets. This is a political hot potato
- Increase property taxes: This is the most probable solution as property taxes pay the salaries of public employees while also contributing to the pension. As returns decrease, public employers will have to pay larger amounts to the pension fund to help shore up the finances. Taxpayers will be on the hook for the higher payments and property taxes will have to be increased
- Chase higher yields: To increase returns, pension plans can take more risk by investing less in government bonds and more in other higher yielding asset classes like private company debt, stocks, real estate, etc… Unfortunately with higher returns there is more risk for capital loss due to investment decisions. For example what if pension funds had invested large sums in mortgage backed securities (basically pools of residential and commercial loans) in 2006 which were viewed as safe assets; when the real estate market imploded pension funds would have lost billions in assets. This will be a very fine balance of trying to increase yields while mitigating the risk.
This is just the beginning of the problem.
Unfortunately, we are at the beginning of a nasty cycle of lower yields that will likely be sticking around for a while. Pension plans and other investors will have to adapt to the new reality of lower rates. Unfortunately, governments rarely cut benefits after granting them which leads to only two options: increased property taxes and more risk taking by the funds. These two solutions will long term be unable to prevent the pension “bomb” as property taxes will not be able to grow fast enough to compensate for the sharp decline in returns and more risk taking will inevitably lead to losses in asset value. Without any structural changes in the pension program, the increased property taxes will merely kick the can down the road. In Colorado alone, the loss in revenue could be 3.8 billion a year. What do you think the best solution to this crisis is? Are you ready to pay substantially taxes?
Resources/Additional reading
- https://www.timescall.com/2020/04/11/historic-demands-on-colorado-unemployment-trust-fund-caused-by-coronavirus-pose-risk-of-payroll-tax-hike/
- https://www.wsj.com/articles/states-burn-through-cash-for-unemployment-payments-11587412810
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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