Noteware: Best to Bust: What Happens if Oil Prices Stay Down and Interest Rates Don’t?

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For the past several months, the international press has been fixated with reporting on the unexpected but dramatic slide in world oil prices – from a high of $107 per barrel in June 2014 to $47 per barrel in January 2015. The local press has been reporting the beginning of the energy industry’s expected response – layoffs, consolidations, debt restructurings, etc. Meanwhile, nearly every investment newsletter is advising investors to prepare for an increase in yields – translated to mean a rise in interest rates. This combination spells bad news for Houston.

As covered previously, the City’s property and sales tax collections have grown to record levels over the past few years. This has largely tracked the good fortunes of the energy industry. For the largest revenue contributor, property taxes, the simple chain reaction has been something along these lines: increasing energy prices create increased demand for exploration and production which directly leads to new jobs and new residents, as well as increasing incomes for both those already here and those who come in response to the higher prices. These new jobs and residents create increased demand for real estate — greater occupancy in office buildings increases the income of the existing buildings and then creates demand for additional buildings. The increases in rents and incomes lead to higher values for the existing inventory of buildings and the new buildings obviously add new value to the property tax base. This part is well understood.

There is an additional part of property value and tax growth that is not well understood, however. While energy prices were, until recently, rising, interest rates have been falling. This has contributed to the record share prices in the stock market as price-earnings ratios have increased correspondingly. Precisely the same thing happens in the real estate markets, due to “cap rates” that fall with long-term interest rates. A cap rate is industry shorthand for a measure of return on and of capital in a real estate investment – it is roughly the reciprocal of a P/E ratio. The simple conclusion is that when long rates fall, so do cap rates, all other things being equal, and values rise correspondingly.

Cap rates also measure risk: as rents rise in a rising market, investors become progressively more confident and expect ongoing increases, so their required cap rates fall further. The combination of rising rents and occupancies with falling cap rates can be dramatic – here is the market math. Consider a 100,000 square foot office building with an annual net income of $1 million. Four years ago, with cap rates of 8%, that building was worth $12.5 million ($1 million / .08). In early 2014, after several years of rising rents, its net income likely had increased to $1.25 million; meanwhile, cap rates had fallen to about 5%, valuing the building at $25 million ($1.25/ .05); a doubling. These rising values both stimulated new construction and caused the Harris County Appraisal District (HCAD) to happily increase valuation assessments for other “comparable” buildings in the market area. The revaluation of the whole inventory led directly to the record tax revenues.

A similar process has occurred in residential real estate – more, higher paying jobs increase rents for apartment owners and demand for more expensive homes. Most homeowners have been astonished at their dramatically increased assessments and tax bills. All of this has allowed political leaders to receive the benefits of increased tax revenues (record revenues most years, in the City of Houston!) without voting for tax rate increases.

With this growth comes increased spending, by both consumers and businesses, leading to record sales tax revenues. The energy industry is an especially large purchaser of materials and supplies – in fact, the State Controller’s office website estimates that $130 million annually of City sales taxes come directly from services and supplies to the energy industry.

Each recent year has brought new record property and sales tax revenues to the City. But, as these articles have noted, City expenditures have increased even faster, resulting in continuing deficits. Going forward, the City projects continuing record tax revenues, rising at approximately 3% to 4% per year, and even with these records, expenses are projected to rise even faster.

What happens when this virtuous economic growth process stops, or even worse, reverses? We are about to find out. The cutbacks and consolidations have already begun, producing immediate concern in the local real estate industry that is likely to accelerate. Because of the lag in appraisal process and tax collections, it will take about a year for the City to feel the impact of falling revenues. The direction is clear, however, and rental rates have begun to fall (“concessions” has re-entered the market vocabulary) and cap rates are now poised to rise. Watch for aggressive property tax protests by owners experiencing falling values!

Some experts warn that the sales taxes from the energy industry could fall by as much as half. Thus, unless the dramatic fall in energy prices is reversed — and I know of NO economist who is predicting this type of price recovery! — City revenues will plateau, and may well fall back to the “great recession” levels of 2008 and 2009, or worse.

In Houston, we have all seen this type of bust before. While we are, of course, concerned with our local economy slipping back into recession, we also must focus on what we will do in response. To deal with the oil slump thirty years ago, Mayor Kathy Whitmire raised property tax rates and water and sewer rates dramatically. This contributed to her loss to Bob Lanier. Mayor Lanier then tapped METRO for sales tax revenues. As the Houston economy gradually recovered through the 1990s and the prosperous 2000s, the City raised taxes and fees even further, and incurred substantial new debt.

Today, it will be much more difficult for new leaders to borrow more, and raising taxes further will simply accelerate the exodus of people and jobs to the suburbs. Because of the failures of leaders over the last decade to manage City finances in times of relative prosperity, we now, like Old Mother Hubbard, find that our cupboard is bare.

A version of this article appeared in the Houston Business Journal on February 2, 2015.

Jim Noteware
About Jim Noteware 18 Articles
Jim Noteware is a Houston-based real estate developer, focusing on suburban master-planned and urban infill communities. He also specializes in the turnaround of distressed properties, portfolios and organizations. He has served two big-city mayors, in Houston and Washington, D.C., working to improve the performance of large troubled public agencies.