Dave Culver, Finance Director Doris Koo, Treasury and Budget Manager. Walter Kieser, Richard Berkson, and Ashleigh Kanat

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1 R EVISED M EMORANDUM To: From: Dave Culver, Finance Director Doris Koo, Treasury and Budget Manager Walter Kieser, Richard Berkson, and Ashleigh Kanat Subject: San Mateo Budget Forecast Review; EPS #21099 Date: September 28, 2011 The City of San Mateo s General Fund revenues increased by $5.4 million 1 in FY 2010/11 compared with the prior year, a 7.2 percent increase; City staff had projected a more conservative 3.3 percent increase. The purpose of this memorandum is to help City staff better understand the economic factors underlying the higher-than-estimated increase and the extent to which the increase represents a longer-term trend. To prepare this memorandum, Economic & Planning Systems, Inc. (EPS) reviewed national and regional economic conditions, including residential and commercial real estate indicators to understand macro-economic factors influencing the City s General Fund revenues. EPS also evaluated local factors (e.g., Measures L and M), one-time anomalies (e.g., higher than typical triple flip payments), and historical quarterly sales tax revenue through the first quarter of Summary of Key Findings Revenue increases of $6.2 million in sales tax, property transfer tax, and transient occupancy tax (TOT) revenues were offset by $800,000 of property tax and other General Fund revenue declines, resulting in a net increase of $5.4 million in FY 2010/11 compared with the prior year. Approximately $3.5 million, or 65 percent of the FY 2010/11 net revenue increase, is attributable to increased tax rates (e.g., Measures L and M). Another $1.35 million of the net increase resulted from an adjustment payment by the State to the City s sales tax receipts. Deducting these one-time anomalies accounts for all but $550,000 of the net increase from FY 2009/10, which represents less than a 0.7 percent annual increase in General Fund growth. 1 FY 2010/11 General Fund revenues reflect estimated actuals (9/14/11) and are subject to revision.

2 San Mateo Budget Forecast Review Page 2 Below is additional explanation of these changes, followed by more detailed discussion. 1. Increases in tax rates, sales tax adjustments, and minimal revenue growth in FY 2010/11 led to higher than estimated property tax, transfer tax, sales tax, and hotel tax revenues. Revenue increases of $6.2 million in sales tax, property transfer tax, and transient occupancy tax (TOT) revenues were offset by $800,000 of property tax and other General Fund revenue declines, resulting in a net increase of $5.4 million in FY 2010/11 compared with the prior year. 2. Of the $5.4 million net increase, increased tax rates accounted for approximately $3.5 million, or 65 percent of the FY 2010/11 net revenue increase. In November 2009, City of San Mateo voters approved Measure L, which established a one-quarter of one percent (0.25 percent) transactions (sales) and use tax. There are 12 months of Measure L collection in FY 2010/11 versus three months in FY 2009/10, accounting for a $3.05 million year-over-year increase. City of San Mateo voters also approved Measure M, which increased the City s TOT rate from 10 to 12 percent effective January 1, 2010, 2 resulting in a $445,000 year-over-year increase. There are 12 months of Measure M collection in FY 2010/11 versus six months in FY 2009/10. Collectively, these tax increases explain 65 percent of the FY 2010/11 net revenue increase. 3. Another $1.35 million of the net increase resulted from an adjustment payment by the State to the City s sales tax receipts. Because State estimates were off in FY 2008/09, the triple-flip /cleanup adjustment payments in subsequent years have fluctuated. The triple-flip /cleanup payment in FY 2010/11 produced additional General Fund revenues; however, this increase is not indicative of underlying economic trends and will vary year-toyear One-time anomalies such as the tax rate changes and sales tax adjustment payments noted above account for all but $550,000 of the net increase from FY 2009/10. This $550,000 increase represents less than a 0.7 percent annual increase in General Fund growth. Table 1 shows how FY 2010/11 (estimated) actual revenues compare with FY 2010/11 (revised) estimates and FY 2009/10 actuals. Figure 1 (below) illustrates the relative components of the FY 2010/11 General Fund increase (FY 2010/11 estimated actuals compared with FY 2009/10 actuals), comprising the net increase of $5.4 million. 2 Of the revenues collected from the TOT, 10 percent will go to the City s General Fund. Before January 1, 2010, 8 percent of TOT revenues had gone to the General Fund. 3 The triple flip represents a repayment of confiscated local sales tax revenues by the State in the amount of ¼ of 1 percent out of the County Education Revenue Augmentation Fund (ERAF). Because the triple-flip payment is based on an estimate, adjustment payments are usually required in the following fiscal year.

3 San Mateo Budget Forecast Review Page 3 Figure 1: Components of the FY 2010/11 General Fund Net Revenue Increase $6,000,000 $5,000,000 $4,910,000 Sales Tax General Fund Revenues (2011 dollars) $4,000,000 $3,000,000 $2,000,000 $1,000,000 Property Tax $890,000 $0 $380,000 Transfer Tax TOT Other GF Revenues Property Tax -$150,000 -$1,000,000 -$650,000 Property Tax Sales Tax Property Transfer Tax Transient Occupancy Tax Other GF Revenues Economic Background National and Regional Economic Conditions The threat of a renewed recession persists. A recent Federal Reserve press release reports that the labor market has deteriorated in the last few months, which has pushed the national unemployment rate up; household spending is flat, commercial real estate investment is weak, and the housing sector continues to struggle with falling prices and low transaction volume. 4 This release follows June declines in real GDP projections through 2013 and increases in unemployment projections through the same time period. Regionally, economic conditions are improving. As of July 2011, the job market in the City of San Mateo is stronger than the County s and much stronger than the State s. San Mateo s unemployment rate was 6.9 percent in July 2011, compared with 8.7 percent in the County and 4 Federal Reserve press release, August 9, 2011.

4 San Mateo Budget Forecast Review Page percent in California as a whole. 5 Strengthening employment numbers are a sign of improving business fundamentals and can affect personal and household incomes which often lead to higher retail sales and sales tax revenues. Additionally, the City of San Mateo is a net importer of retail sales due to the presence of major regional retail centers. Residential Real Estate Trends Real estate market conditions on the Peninsula, reflecting Statewide and national trends, remain weak. While economic conditions in the Bay Area, including job growth and real estate activity, are better than other parts of the State, they are still weak by comparison to historical recoveries from previous recessions. As of July 2011, the median sales price for all homes in the City of San Mateo was $530,000, which was down 17 percent from July In the last five years (July 2006 through July 2011), sales prices have fallen 31 percent in the City. Compared to the same period one year ago, the number of home sales decreased 25.3 percent. 6 Though mortgage interest rates have declined (improving affordability), credit remains very tight even for qualified borrowers, which continues to suppress demand. Additionally, conforming loan limits for high-cost areas (including San Mateo County) will be dropping further as of October 1, These trends along with regional and Statewide forecasts (e.g., the recently released UCLA Anderson School Forecast) indicate protracted weakness in real estate markets due to weak employment growth, oversupply of housing, and tight credit. According to the City s Planning Department (Ron Munekawa), several residential projects could be under construction in 2012 including: Bay Meadows Phase 2: 156 townhomes. San Mateo Times Redevelopment: 74 townhomes (attached single-family dwellings) South Delaware Housing: 120 units (60 moderate income, 60 below market rate units). The Verona Ridge project, which consists of 34 high-end, single-family homes, of which eight have been constructed. Further development is currently on hold because of lack of sales demand; a recent check on availability indicated that there is one home available. While any development activity in the City is encouraging, we do not expect that real estate development-related City revenues will experience significant growth in the coming year. 5 California Employment Development Department, Labor Market Information Division, July Preliminary data, issued August 19, Data extracted 08/24/11 from

5 San Mateo Budget Forecast Review Page 5 Commercial Real Estate Trends Office San Mateo office market conditions improved in 2010 and the first half of 2011, as indicated by occupancy gains and rent increases (see Table 2). Vacancy rates are still too high (16 percent) and rents are still too low ($2.75 for Class A space) to justify new, speculative development; therefore, the inventory has remained relatively stable in the past several years. Retail Retail conditions are tight, with vacancy rates in the City of San Mateo at just 1.7 percent as of the end of 2010, as shown on Table 3. 7 The overall vacancy rate in San Mateo County was 3.5 percent at the end of Evaluation of General Fund Revenues The City of San Mateo s General Fund revenues increased by a net of $5.4 million in FY 2010/11 compared with the prior year. This net increase consisted of $6.2 million of revenue gains and $800,000 of revenue declines. The following sections describe changes in specific revenues in greater detail and provide a near-term outlook. Property Tax Property taxes include general, voter-approved, and redevelopment property taxes. The City of San Mateo s property tax revenues decreased by $650,000 in FY 2010/11 compared with the prior year, a 2.1 percent decrease. City staff had projected a 3.2 percent decrease in FY 2010/11 over FY 2009/10 as over-valued properties were reappraised in accordance with Proposition 8 allowances. Actual property tax revenues in FY2010/11 were $30.2 million, representing a 1.0 percent increase above revised estimates but still a 2.1 percent decline over FY 2009/10 actuals. The FY 2009/10 Local Assessment Roll (which includes both secured and unsecured property) affects the City s FY 2010/11 revenues. San Mateo s FY 2009/10 Local Assessment Roll was 0.62 percent lower than it had been the previous year. The assessed value of residential properties declined by $578.6 million, affecting 17 percent of the City s residential parcels. Even if sales volumes are declining, if the homes that are selling have not transacted for many years, sales prices are likely to exceed current assessed values, which will buoy the City s assessed value. However, with Proposition 8 assessment reductions and persistent weakness in the San Mateo housing market (e.g., declining prices and low transaction volume), property tax revenues may continue to experience moderate declines in the near term. 7 Terranomics, San Mateo County Year-End 2010 Retail Shopping Centers Report.

6 San Mateo Budget Forecast Review Page 6 Transfer Tax The City of San Mateo s property transfer tax revenues increased by $384,000 in FY 2010/11 compared with the prior year, a 10.0 percent increase; City staff had projected a more conservative 4.2 percent increase. The City s revised estimates projected property transfer tax revenues to increase in FY 2010/11 following a year of declines because of declining home values and low transaction volume, but transfer tax revenues increased in FY 2009/10 (by $500,000) 8. Actual transfer tax revenues exceeded revised estimates in FY 2010/11 by 5.5 percent; moderate levels of commercial transaction volume contributed to the gains. The recovering commercial real estate sector may sustain moderate levels of commercial transaction volume, off-setting weakness in the housing market. Transfer tax revenues are likely to experience moderate increases in the near term. Sales Tax The City of San Mateo s sales tax revenues increased by $4.9 million in FY 2010/11 compared with the prior year, a 34.6 percent increase; City staff had projected a more conservative 24.7 percent increase. The City s revised sales tax estimate projected sales tax revenues to increase in FY 2010/11 reflecting a full year of Measure L revenues, but sales tax revenues are ahead of estimates even after controlling for Measure L revenues. Sales tax revenues were estimated to be $17.7 million in FY 2010/11. Actual sales tax revenues in FY 2010/11 are expected to be $1.4 million higher than the estimate, resulting in total revenue of $19.1 million. There are several explanations for the $4.9 million increase in FY 2010/11 estimated actual revenues above FY 2009/10 actual revenues, as described below. In November 2009, City of San Mateo voters approved Measure L, which established a onequarter of 1 percent (0.25 percent) transactions (sales) and use tax. Measure L is not a point-of-sale tax; rather, the tax is charged on all taxable sales that are delivered or placed into use within San Mateo. There are 12 months of Measure L collection in FY 2010/11 versus three months in FY 2009/10, amounting to a $3.1 million increase. The County triple flip was unusually low in FY 2009/10 because of an overpayment of sales tax in FY 2008/09 and unusually high in FY 2010/11 because of an underpayment of sales tax in FY 2009/10, resulting in a $1.35 million increase. In the San Francisco metropolitan area, motor fuel prices are approximately $3.80 per gallon of regular gasoline, up 19 percent from approximately $3.20 per gallon one year ago. In San Mateo, sales at services stations during the four quarters from the second quarter of 2010 through the first quarter of 2011 increased nearly 16 percent year-over-year. Comparing just the first quarter of 2011 to the first quarter of 2010, service station sales were up 26 percent. Of the $485,000 absolute increase in sales tax revenue during the four quarters from the second quarter of 2010 through the first quarter of 2011 over the prior 8 CAFR, page 8.

7 San Mateo Budget Forecast Review Page 7 four quarters, sales tax revenue from service stations comprised more than $200,000, or 42 percent (see Table 4). The heavy industry and furniture/appliance segments also posted significant year-over-year gains in sales tax revenues; however, in absolute dollar terms, the restaurant segment contributed larger gains. Leasing activity contributed to significant sales tax revenue increases in the first quarter of Despite a slight decline in personal income in 2010 (per capita personal income fell from $43,981 in 2009 to $43,825 in ), sales may have increased in part due to pent up demand. For the last couple of years, many purchases had been deferred as consumers waited for stronger economic conditions to take root. As noted previously, retail vacancy rates are very low in San Mateo. Though there has not been any recent new retail development in the City, some vacancies have been filled. Since the closure of Mervyn s, the 80,000 square foot-space at the Hillsdale Shopping Center has been subdivided into smaller spaces, which are now fully leased. One-time increases and unpredictable sector-specific anomalies aside, sales tax revenues are likely to stay relatively flat in the near term. Though unemployment is low in San Mateo relative to the County and the State, consumer confidence needs to increase before a sustainable rise in discretionary spending occurs. Transient Occupancy Tax The City of San Mateo s TOT revenues increased by $890,000 in FY 2010/11 compared with the prior year, a 30.8 percent increase; City staff had projected a more conservative 12.6 percent increase. The City s revised estimates projected TOT revenues to increase in FY 2010/11 reflecting a full year of Measure M revenues (versus six months in FY 2009/10), but TOT revenues are ahead of the City s revised estimates by about 16 percent, or $525,000. TOT revenues were estimated to be $3.25 million in FY 2010/11. There has been no new hotel development in the City of San Mateo; rather, growth in TOT is attributable to rising occupancy rates and rising room rates, indicators of increased demand. This growth is consistent with national trends. PKF Consulting reported that after two years of declining profits, the average U.S. hotel experienced a 9.8 percent increase in bottom line revenues in In the first half of 2011, the San Francisco/San Mateo market experienced above average gains in occupancy and average daily room rates. Contributing to rising demand is a general strengthening of the Silicon Valley economy, which has led to an increase in business travel. San Francisco International Airport passenger counts were up 4 percent in FY 2010/11 from FY 2009/10, reflecting a rise in business and leisure travel (both domestic and international). 9 City of San Mateo. 10 PKF Consulting: May 17, 2011 press release.

8 San Mateo Budget Forecast Review Page 8 The City periodically checks in with its largest hotel, the Marriott San Mateo, which is located near the San Francisco International Airport. The Marriott reported that occupancy rates were 70 percent or less in 2010 with room rates averaging approximately $100. In 2011 (through August), occupancy rates improved to above 70 percent with room rates up approximately 25 percent from the year before. Even after controlling for Measure M revenues, TOT revenues paid by the Marriott increased 10.8 percent year-over-year, between FY 2009/10 and FY 2010/ There are no immediate plans to develop new hotel rooms in the City as the planned remodel of the Ben Franklin Hotel is on hold since building permits for hotel renovations expired. A new property owner is considering options for the property; future plans and timelines are uncertain. As the economic recovery takes hold and the local tech sector continues to expand, TOT revenues are expected to increase in the near term, in line with previous projections. Outlook While General Fund revenue increases in FY 2010/11 provide some optimism for an economic recovery and Silicon Valley s tech sector appears to be strengthening, recent indications of persistent economic weakness (e.g., still-high national and state unemployment, the debt ceiling debate, the downgrade of our national credit ranking, global political and economic instability, steep stock market declines, and very shaky consumer and business confidence) point to the possibility of a renewed recession, or a protracted recovery. Though San Mateo s stable population of wealthy, older households and diverse economic base help to insulate the City from further declines, the residential real estate market remains weak and the commercial real estate market, though stable, is not yet strong enough to justify new construction. Other revenue fluctuations (e.g., sales tax revenue increases due to rising gas prices) are unpredictable and do not necessarily reflect a sustainable trend. Looking forward, modest General Fund revenue increases are expected (with increases in transfer tax, sales tax, and TOT revenues off-setting near-term property tax revenue declines); thus, continued caution and fiscal prudence is warranted. 11 City of San Mateo calculation.

9 Table 1 City of San Mateo General Fund Revenue Sources City of San Mateo Revenue Forecast Analysis; EPS #19110 Item A B C C - B FY % of Actual Total GF FY % of (Revised) Estimate Total GF FY (Estimated) Actual C - A Change B - A Change Change % of Total GF Number Percent Number Percent Number Percent Property Tax [1] $30,839,211 41% $29,863,720 39% $30,185,454 38% $321, % ($653,757) -2.1% ($975,491) -3.2% Sales Tax [2] $14,210,683 19% $17,723,000 23% $19,123,408 24% $1,400, % $4,912, % $3,512, % Property Transfer Tax $3,837,735 5% $4,000,000 5% $4,221,831 5% $221, % $384, % $162, % Transient Occupancy Tax [3] $2,886,000 4% $3,250,000 4% $3,775,527 5% $525, % $889, % $364, % Other $22,668,061 30% $22,089,000 29% $22,522,979 28% $433, % ($145,082) -0.6% ($579,061) -2.6% Total, General Fund $74,441, % $76,925, % $79,829, % $2,903, % $5,387, % $2,484, % [1] Property tax includes secured, unsecured, Homeowner Property Tax Relief (HOPTR), Supplemental, and Property Tax in lieu of VLF revenues. [2] Sales tax includes the 0.75 sales and use tax, the county triple flip, Measure L, September clean up (if applicable), and public safety revenues. [3] TOT includes Measure M. Sources: City of San Mateo (9/14/11); Economic & Planning Systems, Inc. Economic & Planning Systems, Inc. 9/20/2011 P:\21000s\21099SanMateo_RevenueReview\Model\21099model_ xls

10 Table 2 San Francisco Peninsula Office Market Indicators, 2Q2010-2Q2011 City of San Mateo Revenue Forecast Analysis; EPS #19110 Item 2Q10 3Q10 4Q10 1Q11 2Q11 San Mateo Net Rentable Area (Sq. Ft.) 6,823,743 6,838,199 6,840,747 6,859,410 6,859,410 Vacancy Rate 20.6% 19.0% 18.0% 17.1% 16.0% Average Asking Lease Rate 1 Class A $2.50 $2.50 $2.50 $2.60 $2.75 Class B $2.15 $2.15 $2.35 $2.35 $2.45 Under Construction (Sq. Ft.) Central County 3 Net Rentable Area (Sq. Ft.) 20,800,247 20,814,703 20,952,535 19,547,803 19,305,443 Vacancy Rate 19.7% 17.8% 17.0% 13.9% 13.7% Average Asking Lease Rate 1 Class A $2.72 $2.72 $2.74 $2.85 $2.90 Class B $2.20 $2.20 $2.33 $2.39 $2.45 Under Construction (Sq. Ft.) San Francisco Peninsula 4 Net Rentable Area (Sq. Ft.) 43,395,174 43,368,033 43,541,979 42,676,415 42,444,052 Vacancy Rate 15.5% 14.4% 14.7% 12.0% 11.8% Average Asking Lease Rate 1 Class A $3.32 $3.28 $3.38 $3.48 $3.75 Class B $2.81 $2.82 $3.06 $3.14 $3.30 Under Construction (Sq. Ft.) ,500 40,500 30,500 [1] Full service gross. [2] Includes office space expected to be completed within six months. [3] Includes San Mateo, Foster City, Belmont, San Carlos, and Redwood City/Redwood Shores. [4] Includes Daly City, South San Francisco, Brisbane, San Bruno, Millbrae, Burlingame, San Mateo, Foster City, Belmont, San Carlos, Redwood City/Redwood Shores, Menlo Park, Palo Alto, and East Palo Alto. Sources: CB Richard Ellis; Economic & Planning Systems, Inc. Economic & Planning Systems, Inc. 8/31/2011 P:\21000s\21099SanMateo_RevenueReview\Model\21099model_081911_adapted from 19110model_ xls

11 Table 3 San Francisco Peninsula Retail Market Indicators, City of San Mateo Revenue Forecast Analysis; EPS #19110 Year- End Item City of San Mateo [1] Total Centers Total GLA 2,151,944 1,926,944 1,926,944 Vacancy 2.4% 4.7% 1.7% Average Asking Rate [1] $28.29 $29.99 $24.92 Market Rent Range [1] $ $42.00 $ $36.00 $ $36.00 Central County Total Centers Total GLA 2,432,345 2,432,345 2,432,345 Vacancy 2.9% 4.9% 2.6% Average Asking Rate [1] $26.46 $26.56 $23.54 Market Rent Range [1] $ $42.00 $ $51.00 $ $36.00 San Mateo County Total Centers Total GLA 10,125,678 10,125,678 10,125,678 Vacancy 2.5% 4.5% 3.5% Average Asking Rate [1] $30.41 $ Market Rent Range [1] $ $45.00 $ $54.00 $ $45.00 [1] NNN lease rates per year. Sources: Terranomics; Economic & Planning Systems, Inc. Economic & Planning Systems, Inc. 8/31/2011 P:\21000s\21099SanMateo_RevenueReview\Model\21099model_081911_adapted from 19110model_ xls

12 Table 4 City of San Mateo Sales Tax Revenue [1] San Mateo Revenue Forecast Review; EPS #21099 Economic Segment 2Q2010 through 1Q2011 % of Total 2Q2009 through 1Q2010 % of Total Absolute Change Percent Change % of Total Absolute Change Restaurants $1,919, % $1,823, % $95, % 19.7% Misc. Retail $1,779, % $1,719, % $60, % 12.5% Department Stores $1,956, % $1,949, % $7, % 1.5% Service Stations $1,497, % $1,294, % $203, % 41.9% Apparel Stores $1,064, % $1,128, % ($64,184) -5.7% -13.2% Food Markets $725, % $709, % $16, % 3.4% Bldg. Matls-Retail $671, % $659, % $12, % 2.5% Furniture/Appliance $718, % $644, % $74, % 15.3% Auto Sales - New $591, % $555, % $36, % 7.5% Leasing $249, % $200, % $49, % 10.2% Auto Parts/Repair $413, % $380, % $33, % 6.8% Drug Stores $308, % $310, % ($2,262) -0.7% -0.5% Office Equipment $287, % $302, % ($14,636) -4.8% -3.0% Light Industry $254, % $235, % $19, % 3.9% Recreation Products $242, % $235, % $6, % 1.3% Heavy Industry $130, % $57, % $72, % 15.0% Auto Sales - Used $146, % $143, % $2, % 0.6% Liquor Stores $133, % $148, % ($14,889) -10.0% -3.1% Florist/Nursery $106, % $138, % ($32,148) -23.2% -6.6% Health & Government $61, % $69, % ($7,337) -10.6% -1.5% Business Services $69, % $87, % ($18,107) -20.6% -3.7% Bldg. Matls-Whsle $67, % $94, % ($27,329) -28.8% -5.6% Misc. Other $56, % $70, % ($13,970) -19.7% -2.9% Electronic Equipment $8, % $16, % ($8,672) -51.7% -1.8% Misc. Vehicle Sales $9, % $11, % ($1,894) -17.2% -0.4% Food Processing Equipment $1, % $ % $ % 0.2% Chemical Products $1, % $1, % $62 4.5% 0.0% Closed Acct-Adjustmt $ % ($423) 0.0% $1, % 0.3% Energy Sales $ % $ % ($336) -57.3% -0.1% Total $13,475, % $12,990, % $484, % 100.0% [1] Sales tax revenue does not include Measure L revenue. Source: MuniServices; City of San Mateo; Economic & Planning Systems, Inc. Economic & Planning Systems, Inc. 8/31/2011 P:\21000s\21099SanMateo_RevenueReview\Data\SM_SMU Q1 Hist Amt by Qtr.xlsx