New California laws designed to alleviate the state’s housing shortage, combined with structural changes to working life unleased by the pandemic, have the potential to transform land use patterns and alter the tax structures underpinning local governments.
Legislation approved by state lawmakers in September incentivizes converting underutilized retail space to housing.
Lawmakers passed and Gov. Gavin Newsom signed Assembly Bill 2011, which requires ministerial, by-right approval for affordable housing on commercially zoned land, and also allows such approvals for mixed-income housing on commercial corridors.
The commercial corridors targeted by the bill could provide up to 2.4 million new homes, including up to 400,000 affordable to low and moderate income households across the state, according to an analysis by the consulting firm UrbanFootprint.
“I love AB 2011. It’s sheer genius,” said Christopher Thornberg, founding partner of Los Angeles-based research and consulting firm Beacon Economics. “But will everyone do it?”
He noted that the downside to housing over retail is that it requires more intensive infrastructure. He added that what he would love to see state lawmakers do is provide more funding for cities to build infrastructure like water, sewer and roads that support housing.
“Construction in this state has been death by a thousand cuts,” Thornberg said. “They have made building more expensive. They need to lower the cost to builders, not lump additional expenses on them. There are a lot of different ways of properly incentivizing construction housing at the local level.”
California YIMBY, an organization that lobbied for the bill, described it as “legalizing multi-family housing.”,
That’s what California needs, Thornberg said.
“We want urban density,” he said. “Urban density is how you make the greatest use of infrastructure. You can reduce the human toll on the system. Japanese cities are more efficient, because they are dense at the core.”
The wonderful train systems in European and Asian countries work because there is a dense population making use of them, he said.
“We have to subsidize our infrastructure, because we don’t have the population density,” he said.
For local governments, a shift to residential from retail will be result in a significant change in the sales tax system.
The South Dakota v. Wayfair decision by the Supreme Court in 2018, allowing states to collect sales taxes on online orders from out of state, meant that city and state coffers were protected as even more shopping moved online.
Most cities experienced a jolt from sales tax revenues, and that trend has not slowed as people returned to offices.
The fear that sales tax revenues for cities and states would drop off a cliff during COVID-19 related restrictions of in-person shopping was never realized, said S&P Global Ratings analyst Tim Tung.
“During the pandemic, people were buying goods,” Jerry Nickelsburg, director of the UCLA Anderson Forecast, said during a briefing Tuesday about traffic at the Port of Los Angeles. “We were sitting at home, working online and hitting the purchase button and having goods shipped. Now that we can all avail ourselves of services, there has been a shift away from goods to services.”
But Nickelsburg said the trend line of purchasing goods has not reverted to pre-pandemic levels.
“We are still buying more goods, but spending on services has been added back,” he said.
Generally, California cities came into the pandemic in a reasonably healthy position after 10 years of economic expansion, said Karen Ribble, a Fitch Ratings director. “Some have continued to do well.”
In addition to the boost from sales tax revenue, cities have been cautious about how they spent federal relief money from the federal American Relief Plan Act, recognizing it wouldn’t last, she said.
“I think most have been cautious about how they are using money and how they are forecasting the recovery,” she said. “They have been conservative by and large, but that’s not to say that there aren’t some cities that will struggle.”
The trend over the past year has been to revise the outlook on individual cities to stable from negative, Ribble said.
“There has been so much talk about the recession over the past few months,” Ribble said, “but by and large that has been factored into forecasts and city budgets.”
Nationally, while states and local governments face increased costs and potential budget challenges because of higher inflation, rising sales tax revenue from price hikes will provide a partial hedge against fiscal stress, Moody’s Investors Service analysts wrote in a June report.
“The extent of the relief will vary depending on the importance of sales taxes to a government’s overall revenue and the breadth of goods and services taxed,” Moody’s analysts wrote. “The benefit has limits, however: higher prices mean consumers will get less for their money, while political pressure has already nudged governments to reduce or suspend certain sales taxes.”
Inflation is not a positive for issuers or for bondholders, Moody’s analysts said, but sales taxes do partially limit the negative credit impact of inflation by increasing revenue, though that’s more than balanced by the pressure governments face to pay higher salaries and more expensive goods and materials.
It is also effectively reducing the cost of debt governments have already issued, Thornberg said.
States and cities have been issuing debt at historically low interest rates for roughly the past decade, he said. So while they are paying debt back at interest rates as low as 2%, they are benefitting from inflationary prices on goods that are resulting in a boost to sales taxes.
“The diminishing debt improves the balance sheet,” Thornberg said.
The lingering structural shift from the pandemic on cities is expected to play out in the redefined structure of white-collar working life.
The shift where even employees who aren’t fully remote work from home two to three days a week is showing up in San Francisco, where the city has a 24.1% office vacancy rate, according to Jones Lang LaSalle’s third quarter 2022 report on the office market there.
Those numbers don’t account for layoffs at Twitter and Facebook’s owner, Meta, in recent weeks.
“Companies restructure all the time, particularly ones that have grown, and grown big,” Nickelsburg said. “They restructure when they have found they have moved in a direction they did not want to go, so they consolidate.”
Consolidations result in a loss of staff, but the question is “will those people be unemployed for 20 weeks or three weeks?” he said. “You can just look at announcements that big companies are laying people off, and say the sky is falling. You have to look at the data, and the data isn’t indicating the tech industry is shrinking, but quite the opposite.”
The latest data in the professional and business services sector, which encompasses the high-profile tech layoffs, has demonstrated increasing employment, he said.
“It is tough for those workers that the market is not as tight as it was, but the tech industry is not declining in California,” he said.
Nickelsburg said all over the country office space is being reimagined, and what he sees happening, particularly in the land-starved San Francisco Bay Area, is more companies taking less space, but that the vacancy level in San Francisco won’t remain high.
Another alternative is that some office space gets converted to housing, which is what occurred in now-vibrant downtown Los Angeles in the early aughts.
During the pandemic, many companies moved employees to remote work and the federal and state government provided ramped-up unemployment checks and rental assistance increasing buying power.
“What we have observed with local government is they have quite outperformed what the cities were expecting,” Tung said. “They were expecting that sales tax revenues would decline from fiscal year 2018-20 levels, and that has not happened.”
The death knell of in-person shopping and restaurants never rang, as retail stores moved to curbside pickup and restaurants provided outdoor seating and ramped up takeout services.
But “the mall is dead in traditional form,” Thornberg said. “They have to be entertainment zones to survive. Mall owners used to sneer at having a gym, but now they are happy to have them.”
The reduction in brick-and-mortar retail as a cash cow for cities made it an easier decision for lawmakers to open up so much commercial land to housing.
“It’s not what is going to happen, it is what has happened,” Thornberg said.
“Three days a week, working from home, eating at local restaurants,” he said. “All the taxable sales are in the burbs, not the downtowns.”
It doesn’t spell the end for San Francisco, because the city “has plenty of ways to make money,” Thornberg said. “The fact they sat by while there was a clear bubble in office construction going on is more of an issue. They will have a problem clearing out excess supply.”
Thornberg said he expects there will be a reset in San Francisco, as there was after the tech crash in 2000.
“People said then that San Francisco would empty out, but the tech industry came back in the next few years, even stronger,” Thornberg said.
“Keep in mind in 2000, there were 550,000 tech jobs in San Francisco before the tech market collapsed,” he said. “Everyone wondered what would happen. Ten years later, there were 750,000 tech jobs.”
The office vacancies, in part brought on by the tech industry layoffs, will be temporary, Thornberg said.
“The Bay Area has too much good stuff going on.”