Have you heard it said, “You’re just going to have to do more with less”? Likely you have – and you’re not alone. I don’t know about you, but when I’m told to do more with less, my question has always been, “How much less?” If we’ve got to make cuts, how can we wisely do so if we really don’t have a firm grasp of what our budget is going to be? This is a likely question for many agencies and municipalities whose budgets, fueled in part by property tax revenues, are shrinking as property assessment values continue to decline.
For the first time since 1978, a large portion of California’s property tax revenue is tied to fluctuations in the real estate market. No one, however, understands why this new reality has occurred or knows what to expect in the future. Furthermore, after 33 years of highly predictable revenue, many are scrambling for insight into what makes some assessment values fluctuate while others remain stable, whether or not there is still a measure of predictability to this revenue source, and how long budgets will be subject to market forces.
How did we get here?
With so much talk about Proposition 13 and its perceived negative implications, we thought it would be a good time to dig up some history regarding this famous proposition along with its lesser known sibling, Proposition 8. Most of us are aware of Prop 13, passed in 1978, that limits property assessment increases to 2 percent annually regardless of how much the market increases. In contrast, almost no one is aware of Prop 8, also passed in 1978, that allows for a reduction in assessed value if a property’s market value is reduced due to a natural or other disaster, but also if “[the property’s] value has been reduced by ‘other factors’ such as economic conditions.” Put simply, Prop 8 allowed for the temporary lowering of the assessed value of properties that fell below market value. This “no brainer” proposition passed without any opposition whatsoever. After all, who would deny an assessment reduction to someone whose house just burned down or washed down the side of a cliff? And besides, when was the last time values actually went down in California anyway?
True to everyone’s expectations, in the 33 years since the passage of Prop 8, economic conditions have almost never had a negative impact on assessed values, and when they did it was only regionally and for brief periods. Never has a large, statewide (or national for that matter) decline in market values occurred – that is, until now. Oh sure, during the economic slowdown in the ‘80’s, there were thousands of properties enrolled in the Prop 8 process as every assessor had a few Prop 8s on the roll due to cracked slabs, or other anomalies that would temporarily lower assessed values. But today, this little known initiative is being tested across the board in ways not seen before.
Today’s assessed valuations
To demonstrate, let’s use San Diego County as an example. Property values first starting dropping in San Diego County in the early part of 2007. At that time, the county enrolled about 11,000 of their 900,000 parcels into Prop 8 status. By 2008 that number swelled to 88,000 and by 2009 a total of 216,000 properties went into Prop 8 status!
So what does this all mean and what’s the impact? First, we need to understand the definition of ‘latent value’. Intuitively, the typical municipal finance professional understands that a Prop 8 property represents a ‘latent value’ that will only be realized as the market returns and the assessed value returns to its previous high mark (plus any additional annual CPI adjustments). We like to think of the latent value spread across all Prop 8 properties as the ‘recoverable value potential’. To make things more complex, the number of Prop 8 properties across most counties has actually DECLINED considerably since 2009. That’s a good thing, right? Herein lies the rub. These declines are NOT the result of values increasing to their previous highs, thus ‘recovering’ their latent value, but rather a result of foreclosure and ownership transfers which move them out of Prop 8 status and into Prop 13 status – which then ‘fixes’ their new base year value (which, in most cases, is well below their reference year value). With each successive roll year and as more Prop 8 properties change ownership, the maximum recoverable assessed value falls farther and farther away from 100% (or, where it was when the value first started to fall). The foreclosure phenomenon (if you can call it that) plays to the heart of the relationship between Prop 13 and Prop 8. Although many data sources show the number of new Prop 8s slowing in communities hardest hit by foreclosures, indicating a ‘bottoming out’ of the market, much of the previously realized value of these homes is now non-recoverable as they’ve converted to Prop 13 status at the new (and now much lower) assessed value. For the agency, school district or bond issue, the ability to recover latent tax revenues is now virtually impossible, regardless of the strength of the real estate market.
How different agencies are impacted
Public agencies generally see a loss in revenue proportionate to the loss in total value. For example, if the assessment values drop by 20% from the high value reference year, the local municipal’s property tax revenue will also drop by 20%. However, not all agencies are created equally. A city typically has a more diversified revenue set and may have only 25% of their overall revenue derived from property tax. Conversely, a fire district may have 90% of their revenue coming from property tax. In this case, a 20% drop in assessed values could mean a 20% drop in revenue district wide. In some affluent communities where values have dropped on homes sold during the high value reference year, one property’s decline in value can have a significant effect on an agency’s revenue. Imagine a home that sold for $2.5 Million in 2006, enrolled in Prop 8 in 2008, and decreased in value every year – resulting in a newly assed value of $1.5 MILLION. The resulting 1% Ad Valorem tax would then decrease from $25,000 to $15,000. Assuming the local fire district had a 30% share of the property tax revenue; the Prop 8 process would result in a $3,000 cut from the fire district’s annual revenue from that single property. In a district full of similar properties, staff cuts and facility closures in the midst of tremendous wealth would occur.
Where do we go from here?
It’s clear that California has entered a new chapter regarding property valuations and the impact to those who’ve historically depended upon increases to the revenue they received from property taxes. Thirty years from now, history will undoubtedly provide a sharper focus on the decisions and events that ultimately led us out of the woods (assuming, of course, that we will eventually be out of the proverbial ‘woods’). For today, however, those of us in municipal finance will have to use our experience and the tools available to pick our way through this uncharted trail. Fortunately, most municipal finance professionals are aware that Prop 8 assessments play a role in the overall decline in assessed values, albeit only a few of them are aware of the details involved. Education regarding the Prop 8 and Prop 13 process will certainly lead to better predictions about future assessed values. Information will always be a key component, and in times such as these, it’s the little things that can make the difference between disaster and success.
