State Bankruptcies Would Likely Strain CRE in the Long-Term

In recent days, there has been a fair bit of political banter about bailing out states whose finances have been further beleaguered by the economic impact of COVID-19. If states are allowed to declare bankruptcy, it would offer an as yet unseen view in the future of commercial real estate financing. Just as the Hoover administration failed to adequately address the compounding effects from the stock market and credit collapse of 1929, state bankruptcies would inject more oxygen sparking more combustion of asset values across classes in the global economy.

Preqin, a capital markets data company, estimates that as of 2018, public sector pension funds accounted for 17% of institutional capital invested in real estate. The Pension Real Estate Association, PREA, an industry trade group, estimates that 70% of pension investors in U.S. real estate originate from state and municipal pension funds, according to its 2017 investor report. These investors represent about $1.8 trillion in total invested assets and represent over 150 thousand holdings. The discussion around allowing states to declare bankruptcy first emerged when Senate Majority Leader Mitch McConnell posited that states should declare bankruptcy rather than receive federal relief funds due to the economic toll taken by COVID-19. The implications of a single state, let alone many states, declaring bankruptcy would be long-lasting and far-reaching. While we at TRA are not equipped or prepared to outline in significant detail the long-term impacts, we speculate that it would present long-term headwinds for the commercial real estate sector, gradually shrinking a major source of capital for commercial real estate development.

While states are currently not allowed to declare bankruptcy, the concept remains possible with some political maneuvering. Some municipalities have declared bankruptcy, most prominently the city of Detroit, Michigan, and one of the key hurdles was getting the retirement system on board with the city’s restructuring. In broad strokes, the agreement cut existing pension and healthcare benefits for retirees and formed two new pension plans for existing and future city workers. The city cut its pension contributions to both legacy and new pension funds and opted for a more liquid investment profile, leading to smaller and more fragmented retirement funds overall.

Public sector bankruptcies also have the effect of reducing state and local payrolls. Civil services see headcount reductions, which leads to lower long-term contributions to state and municipal pension funds. Following this trend, over the long term, public sector pension funds like CalSTRS, the Teacher Retirement System of Texas, and many others, would shrink, thus pushing commercial real estate companies to seek new or more fragmented sources of investment capital for their partnerships. The net impact of state bankruptcies is incalculable, but it would very likely put a significant amount of unanticipated pressure on commercial real estate companies in a restructured public sector pension landscape.