Is The Party Over?

Editor's note:
The rural land crash of the early '80s has moved to the larger communities, reducing commercial property values and threatening local government budgets. While larger cities throughout the Ninth District are feeling the pinch, nowhere is the problem more acute than in the Minneapolis/St. Paul metro area. Indeed, in a meeting with Twin Cities business leaders late last year Minneapolis Fed President Gary Stern heard from local officials who are concerned about the prospect of a dwindling tax base.

The following story, with emphasis on the Twin Cities metro area but with lessons for the entire region analyzes how the problem developed over the past 10 years and the prospects for the future.

Louis Frillman has been in the commercial real estate business for 16 years. He has seen good markets and he has seen bad markets, but he had seen nothing like the panic that gripped the Minneapolis office market of January 1990.

"In 30 days rates quoted by most landlords dropped an average of 20 to 30 percent," Frillman, a partner in Marquette Associates, recalls. "It was as if the owners, all at the same time, realized the market was not going to get better, so they kept cutting their prices."

The panic among landlords has not subsided. Today, however, it has spread beyond the immediate circle of developers and their lenders and has begun to grip the hearts of city officials.

Between 1980 and 1990, thanks to inflation, real estate speculation and new projects, city officials across the Twin Cities metro area could depend on double-digit growth in commercial property values. They could walk their streets or drive their highways and point to the tall, glass-sheathed office buildings, the gleaming new hotels, shopping centers and apartment buildings, many of them less than 10 years old, and deliberate about how they would spend the tax money those buildings were throwing off.

These days the buildings still look as new. The sun glints off them the same way. But inside, beneath the glass facades, the sun isn't shining quite as bright. Many of the buildings are populated, if at all, by tenants who are paying drastically reduced rents. For too many of the buildings, the phrase "return on investment" has an unreal, Alice in Wonderland quality.

Many of these buildings, particularly office structures, are no longer worth what they once were, and the decline in value has been nothing short of breathtaking. State officials have estimated that the decline in commercial values between 1988 and 1990 will result in $80 million to $90 million less in commercial property tax collections statewide within that time frame.

The bulk of that revenue will be lost in the metro area. In Minneapolis, after a decade of double-digit growth in commercial property values, a 10 percent decline in large downtown commercial values is projected for taxes payable in 1992. The decline is so large that the city's entire tax base will decline, the first time that has happened since the late 1960s.

All of this means that the metro-area cities will have less money to spend on such things as police, parks and programs. And it couldn't have come at a worse time. The state of Minnesota is facing a $197 million deficit in the current biennium and a $1.2 billion deficit for 1992-93. Governor Arne Carlson has proposed reducing state aids to cities and counties by $50 million for the current biennium, with larger reductions expected in the next.

"It's a double-barreled hit," says Steve Cramer, a Minneapolis city council member and chairman of the council's ways and means committee. "We may lose a significant amount of state aid, and the only option we have available to us to recover it is to raise property taxes. But to do so against a weakening tax base, that doesn't make much sense."

The Real Estate boom of the 1980s began during this country's last recession, when Congress passed the Tax Equity and Fiscal Responsibility Act of 1981. Among other things, the legislation expanded the tax benefits for real estate limited partnerships, enlarged the tax credits for renovating historic properties and allowed accelerated depreciation of commercial property.

Developers rushed to take advantage of these incentives, and they found a financial community more than willing to provide the money. For pension funds and insurance companies, real estate was the answer to portfolio diversification. For banks and savings and loans, real estate development was a source of high fees.

"A lot of money found real estate in the late '70s and early '80s," Frillman says. "It came from domestic and foreign sources, and it came in the form of debt or equity. If they couldn't find existing properties, they invested in new ones, even if they weren't economically feasible, because the tax benefits and depreciation schedules were so lucrative."

In downtown Minneapolis, the Class A office market through 1981 consisted of one building, the 57-story IDS Tower. By 1990, developers had added more than 9.2 million square feet of new, Class A office space to the city's skyline. In St. Paul, the Landmark Tower, Galtier Plaza and the World Trade Center opened for business between 1983 and 1987. Renovations of older buildings into office and retail uses occurred in St. Paul's Lowertown district.

In Bloomington, Interstate 494 was transformed into the second largest office market after downtown Minneapolis, and the Twin Cities was introduced to speculative office development on a grand scale.

Office towers were not the only things under construction. New apartment projects, anywhere from 200 to 500 units, were breaking ground across the metro area. Office/warehouse buildings were filling what had once been empty fields in Eagan, Eden Prairie and Mendota Heights.

The commercial property boom enriched city coffers and came at a time when substantial cuts were made in such programs as federal revenue sharing and community block grants.

In older cities like Minneapolis and St. Paul, a growing commercial base allowed city officials to maintain or expand services without making its homeowners—an ever shrinking number—bear more of the burden.

How important that growth was can be seen by looking at commercial and industrial property as a percentage of the city's entire tax value. In 1980 in Minneapolis, commercial property was about 20 percent of the city's taxable value. By 1990, it was 34 percent and, because commercial/ industrial property is taxed at 3.5 times the rate of residential property, it represented 58 percent of the city's tax base by the close of the decade. In part because of that growth, Minneapolis was able to get through the decade of the 1980s without raising the millage rate on homesteaded residential property.

Minneapolis and St. Paul were not the only beneficiaries. Older suburbs like Bloomington, for example, faced similar problems albeit on a smaller scale. And in newer suburbs, the taxes generated by new commercial growth helped pad operating budgets.

"For most of the '80s, we couldn't raise values fast enough," says Peter Cool, who was Brooklyn Park's city assessor until 1989, when he assumed the same post in Bloomington. "A developer would put up a building and, two or three years later, sell it at three times the price and make a fortune. It was unbelievable."

From the beginning, however, the supply of new commercial space exceeded demand. The vacancy rate in the various sectors of the metro area has fallen below 15 percent only once since 1984, but a strong economy, aggressive luring of tenants from older buildings, and as much as 18 months' free rent on a five-year lease helped developers fill those new towers.

And in truth, demand for new space was at unprecedented levels. In Minneapolis, for example, 1.1 million square feet of office space was absorbed in 1981 alone, and anywhere from 600,000 to 800,000 square feet in subsequent years. In Bloomington and the southwest suburbs, absorption was running at almost 1 million square feet a year.

As a result, land and building values were increasing far ahead of the rate of inflation, enriching developers and city treasuries alike. Trammell Crow built 6000 Clearwater Drive in Minnetonka at a cost of $8.9 million. Less than two years later, it was able to sell the building for $16.2 million to the Church of England's pension fund.

By the end of 1990, just five years after buying the property, the Church of England was in default on its loan agreement and had turned the building back to the lender.

Developers are nothing if ever-optimistic. They saw absorption rates of 1 million square feet a year and they planned accordingly, as if that absorption rate would continue ever anon. So in 1983, 1984 and 1985, developers began planning for and breaking ground on new towers that would capture their fair share of that ever-expanding pie. But by the time those towers opened, the market had changed.

The Twin Cities computer industry, built around mainframe giants like Control Data Corp. and Unisys, laid off almost 10,000 employees between 1985 and 1990. The Tax Reform Act of 1986 drastically curtailed the real estate investment and development incentives granted just five years earlier, thus rendering meaningless the economic assumptions of a number of existing projects and others in the works. The takeovers of Pillsbury and Northwest Airlines, as well as the threatened takeovers of the likes of Tonka Corp. and Honeywell, a wave of consolidation among accounting firms and advertising agencies, were just some of the factors that forced companies to more carefully consider their office space requirements.

While macroeconomic forces contributed to the changed market, overbuilding only exacerbated the conditions. Nowhere was that more evident than in the suburbs south and west of downtown Minneapolis.

Between 1986 and 1989, absorption returned to more normal levels of 500,000 square feet per year. Unfortunately, during each of those years developers brought an average of 1.5 million square feet of new space to the market. It was expensive, Class A space, built at a cost of upward to $150 a square foot and requiring average rents of $16, $17 or $18 a square foot just to cover debt service. Vacancy rates for Minneapolis' southern and western suburbs eventually climbed to over 25 percent; today they hover at around 23 percent.

St. Paul faced problems of a different sort. New, speculative office development ended with the completion of the World Trade Center in 1987. Unfortunately for the city and the project's developer, BCE Development, absorption of Class A office space had peaked at almost 400,000 square feet two years before. By 1987, there was "negative" absorption and the vacancy rate climbed to 17 percent, where it hovers today. Late last year, the lender on the World Trade Center agreed to write down approximately 50 percent of the project's debt.

The St. Paul Port Authority, which backed the revenue bonds issued on behalf of a number of commercial developers between 1984 and 1989, was forced to repossess a dozen of those projects between 1987 and 1989.

The downtown Minneapolis office market held out a little longer, and on the surface appeared to be doing somewhat better. The vacancy rate of Class A space fell from almost 15 percent in 1983 to a healthy 7.5 percent in 1986, before climbing back up to 15 percent in 1987. Those relatively low vacancies, at least by the standards of the suburban market, came at the expense of older Class B buildings, whose tenant rosters were plundered to fill the new buildings.

By the end of 1989, however, there were strong indicators that the potential tenant base for the downtown towers had been exhausted. The major financial institutions, law firms and accounting firms had made long-term lease commitments, and the vacancy rates in older buildings had climbed to over 30 percent. By the end of the year, only 275,000 square feet of space had been absorbed, less than 50 percent of the historic average and only one-third of 1988's total.

As bad as things seemed to be, it only appeared that the market would get even worse. Four new towers containing a total of 3 million square feet of leasable Class A space are under construction. BetaWest Properties Inc. and the Frauenshuh Cos. are building a 30-story, 470,000 square foot office tower at Ninth Street and Hennepin Avenue. Brookfield Development is building a 32-story, 500,000 square foot office tower on top of a five-story, 250,000 square foot shopping center on the Nicollet Mall, between Fifth and Sixth streets. Ryan Construction Co. is building a 34-story, 600,000 square foot tower at the corner of Marquette Avenue and Ninth Street; and IBM is developing a complex with a 53-story building and one of 18 stories, totaling 1.3 million square feet, at Sixth Street and Second Avenue.

Tenants have been found for about half of the space in the four towers, but those tenants will be vacating existing space in downtown Minneapolis or the suburbs. The remaining 1.4 million square feet—equal to the current total of vacant Class A space—is unclaimed. It was that realization, Frillman says, that caused landlords to panic and slash their rental rates in January of 1990.

Dave Bernier is Minneapolis' city assessor. He oversees a staff of six appraisers, and their job is to find a value for more than 25,000 property parcels in Minneapolis. They use three approaches in combination by assessors to place a value on commercial and industrial property.

The cost approach is the most straightforward and is particularly appropriate for new buildings that have yet to reach full occupancy. The market approach, favored by the state of Minnesota, can be problematic because it is used when the property, or sometimes a comparable one, has been sold. The income approach, how much a building is worth based on its net operating income and market capitalization rates, tends to be the more dominant determinant of value; it is the method used by the tax court.

Bernier's job is never an easy one, but it has gotten considerably more difficult since 1988. "Nobody knew for sure how bad the market was until those four towers broke ground," Bernier recalls. "Then everybody realized things were going to get pretty serious. Rents began slipping quite a bit, and the vacancies started to go up fast."

As a consequence, the market approach to value essentially disappeared because no properties were sold. For older buildings, then, that left only the income approach to value.

Landlords show Bernier their leases, and what he has seen isn't pretty. Space that used to rent for $10, $12, even $16 a square foot is now under lease without charge, with the tenant paying utilities and taxes.

Bloomington's assessor, Peter Cool, faces the same challenges as Bernier. In the last 16 months, lenders have accepted deeds in lieu of foreclosure on at least three premium Class A office towers. A fourth, Trammell Crow's 8300 Tower, was sold for $27 million, $7 million below its mortgage and $15 million less than what the city had valued it for taxing purposes.

Bernier's "famous zero rents," as he calls them, are the main reason he projects that Minneapolis' 1991 commercial values for large downtown properties (for taxes payable in 1992) will fall 10 percent after increasing 15 percent in 1989 and 3 percent in 1990. That reduction means the city's total market value will fall from $13.3 billion to about $13 billion. Minneapolis' tax value, the amount the city levies against, is projected to fall from $391.5 million to $374.6 million.

Those reductions reflect Bernier's decision to drop or, best-case scenario, hold steady the values of many commercial and industrial properties in Minneapolis. But that hasn't stopped landlords from filing formal appeals of their assessments. In 1986, there were 788 property tax appeals in Hennepin County. By 1990 there were over 1,800 protests filed with the county.

Last year, for example, City Center Associates Limited Partnership won a reduction of about $414,000 on both its 1989 and 1990 taxes. In 1985, the property was appraised at $160 million and its taxes totaled $7.6 million. By 1989 the property - the Multifoods Tower and City Center (not including the Carson Pirie Scott department store) was appraised at $194 million and its tax liability was $10.2 million. The owner succeeded in getting the appraisal reduced to $186 million, which dropped the tax bill to $9.8 million.

A $414,000 reduction doesn't seem like a lot, especially when that money is split among the county, the city and the school board. But it's important to note that Bernier's estimate of a 10 percent decline in commercial values does not include the potential impact of hundreds of such appeals.

"I don't have a feel for whether a 10 percent drop is a conservative estimate or not," says Minneapolis Councilmember Steve Cramer "A lot of that depends on how successful building owners might be pulling us into court and challenging us on valuations."

As Cramer said earlier, the property tax revenue decline has to be seen as part of a bigger, even less attractive picture. He estimates that Minneapolis will lose $4 million in state aid that was already budgeted for 1991. The city has prepared for that, he says, by instructing department heads to go back into their budgets and find places to cut.

"The big question is what happens in 1992 and beyond to the fiscal relationship between state and local governments," Cramer says. "I don't think the prognosis is good." A proposed $200 million cut in state aid for 1992-93 could mean a $44 million reduction for Minneapolis," Cramer notes. "That would be 17 percent of our operating budget," he adds. "To suggest it can be gotten rid of without losing basic services is ludicrous."

For cities like Minneapolis, the options are limited. The easiest solution would be to raise the mill rate enough to offset the decline in values. Not only would such a move risk incurring the anger of homeowners, but Frillman points out that in the current market it would only further lower the value of a building by lowering the income stream to the landlord. He explains: "Taxes are a fixed cost of doing business that is passed on to the tenant. If you raise taxes, you are essentially raising the rent, and in today's market you can't do that. So the landlord is forced to lower his rent even further to compensate for the increase in taxes."

If the landlord doesn't make the reduction, the tenant finds another landlord who will. Maybe that landlord is in another city, where the taxes are lower. So, the end result is that the landlord receives even less income from the tenant, or no income at all from the lost tenant.

"I think this crisis is going to force city governments to make calculations they may not want to make, to look at their operations in ways they may not want to look," Frillman says.

Even Cramer thinks increasing property taxes would be shortsighted and ultimately destructive for most cities. Instead, he sees cities banding together to get the state legislature to grant them the authority to raise revenue by other means, including a city income tax or sales tax surcharge. "Right now, our only source of revenue is property taxes," he says. "l think it's clear that we're going to need more flexibility in the future."

Indeed, especially in the near future. Governor Arne Carlson has said that reduction of the commercial and industrial property tax rate in Minnesota is a priority, though probably not until the 1992 legislative session. A successful rate reduction will only reduce even further the property tax revenue on which cities like Minneapolis depend.

The problems confronting Minneapolis and other metro cities are expected to worsen before they improve. Vacancy rates continue to hover at historically high levels throughout the entire Twin Cities metro area. Absorption of existing space has fallen to a fraction of its levels in the mid-1980s, and that was before the current recession set in. Office buildings continue to be turned back to lenders, and once high-flying, speculative developers are now in retreat—or Chapter 11. Most lenders have drastically curtailed all real estate financing activities, and a number of national lenders have closed their local offices.

Frillman, for one, does not expect to see any appreciable increases in commercial values for 2.5 years, maybe longer if the recession is deeper than expected. "The Twin Cities is experiencing a real estate decline of massive proportions, the likes of which we have not seen in my lifetime," he says. "We saw it happen in Denver, we saw it happen in Houston. We never thought it could happen here."