Crisis in Concrete: Navigating the Ripple Effects of Commercial Real Estate on Municipal Bonds

Executive summary

A decline in commercial real estate (CRE) prices is causing some investors to worry about the potential impact on their municipal (muni) bond holdings. In this publication, we dig deeper into the issue, and share some of the factors the Franklin Templeton Fixed Income (FTFI) muni credit research team considers in our security selection process. To answer the most pressing question first: We do not currently expect declining CRE valuations will lead to a wave of defaults among muni issuers, and we still believe in the sector’s fundamental strength. In our view, balance sheets currently look strong. Federal COVID-19 aid gave rainy-day funds a significant boost. Budgets significantly expanded through strong revenue increases during the post-pandemic recovery and have been maintained with conservative budgeting and fiscal discipline.

In our view, falling CRE values will not escalate into a sector-wide crisis. While we anticipate some ratings downgrades over the near to medium term, we believe they will be idiosyncratic in nature. In determining the overall impact decreased CRE valuations will likely have on specific muni issuers, our dedicated credit research team looks at a wide range of factors on a case-by-case basis.

First, revenue sources, tax bases and primary service areas differ significantly across issuer types (cities, counties, school districts, hospitals, etc.), which leads some issuers to be more sensitive than others to changes in property prices. Second, property valuation changes do not have an immediate revenue impact, but rather, trickle through into tax collections with a lag, allowing time for issuers to react and offering them a wide array of options to address declines. Fundamentally, municipalities can reshuffle expenditures in their budgets, raise revenues or tap reserves if needed to incorporate lower property tax receipts. Additionally, they can change policies to encourage development or other activities that result in more revenue to the city. Lastly, muni bonds often have additional protections, such as insurance, oversight programs and legal provisions, which can help mitigate against potential default events.

Despite the headwind CRE valuations pose on issuers, we continue to believe that attractive opportunities can be found regionally and nationally across the credit spectrum. Robust, bottom-up research and strong security selection will remain crucial in our view going forward.