Have we reached the bottom of the office market in Houston? While many seem to be in agreement that the worst is now behind us, the city is still very much in an office market slump. Houston’s overall vacancy rate rose to 20.0% in Q1 2017, an increase of 100 basis points quarter-over-quarter and 260 basis points year-over-year. Net absorption stood at negative 778,758 sq. ft. as of the quarter’s end—on the heels of the more than 1.4 million sq. ft. of negative absorption for full-year 2016. In addition, both Houston citywide overall rent and leasing activity are down from last quarter, as well as from Q1 2016. However, despite some market sluggishness, available sublease space is down 3.5%, and the amount of space in the construction pipeline has declined by 40.0%, quarter–over-quarter.
The Houston metro area reported 125,005 new residents from July 1, 2015 to July 1, 2016, and Houston ranks fifth in the 10 most populous metro areas in the country. Houston job growth increased by 6,200, with Government (led by colleges and school districts) and Professional and Business Services responsible for the lion’s share. Trade, Transportation, and Utilities had the largest drop. All told, the unemployment rate ticked up to 5.9%. The Greater Houston Partnership forecasts one more soft year in 2017, albeit with an encouraging job forecast of adding 30,000 new jobs. More than 7,300 of that total are expected to come from the Professional and Business Services supersector, and 2,200 in Financial Activities.
Other positive indicators are the Houston Purchasing Managers Index, which came in at 54.2 in February, signaling economic expansion in metro Houston for the fifth consecutive month; the closely tracked Baker Hughes U.S. Rig Count at 809 rigs; and the NYMEX WTI Spot Prices, closing at $47.97/barrel. Although 2017 may not be an exceptional year for the Houston-area economy, it should be a boost on the path back to robust growth.
In the first quarter of 2017, the Houston office market showed some encouraging signs as it began to lift itself out of the soft environment that has lingered in many of its submarkets. During the two years prior to 2017, we witnessed an onslaught of sublease space being added to the market, totaling more than 12 million sq. ft. Today, we are on our way down from that mark and closing in on 11.1 million sq. ft. citywide. This is due in part to the rising rig counts (nearly double that of Q1 2016), rising oil prices, other non-energy related industry growth, and natural lease expirations.
While I won’t go so far as to forecast what I think will happen going forward, by recognizing trends in the market one can position oneself to take advantage when opportunity arises. Market indicators such as sublease availability, vacancy rates, and absorption rates are all critical data points when evaluating the future strength of the office market. Looking at the trends seen in 2016 and thus far in Q1 2017, I feel comfortable saying the market softening has “bottomed out.” Tenants in the market for space now or over the next few years can take advantage of landlords taking an increasingly aggressive approach when vying for prospective tenants. These aggressive incentives often come in the form of rental rate reductions, large concession packages, additional free rent periods, free parking, and greater building amenities.
As the trend continues for tenants to take on new or additional space, or renegotiate existing leases, the market will once again shift back to favor landlords. A very realistic prediction of when this shift might happen is over the next 14 to 18 months (think Q2 to Q4 2018). This begs the question: why do many companies only seem to renew on high points? Based on where we are in the current market cycle—the Houston commercial real estate market historically operates in seven- to eight-year cycles—office tenants today have tremendous negotiating leverage. To that end, on average we are now seeing longer lease terms signed, even for smaller companies, who wish to capture the favorable market terms for as long as possible. Timing, as they say, is everything.
Houston ended the first quarter of 2017 with negative 778,758 sq. ft. of net absorption. Direct space represented negative 936,272 sq. ft. of that total, and sublease space was responsible for positive 157,514 sq. ft.
Largely contributing to the direct negative absorption was Freeport-McMorran’s 355,908 sq. ft. of sublease space at 717 Texas Avenue that was released prior to the August 2018 term date, moving it over to direct space. In addition, 500 Jefferson had approximately 277,424 sq. ft. of sublease space with a lease expiration date of 2030 that was dropped when the property was recently sold, adding to the amount of direct space available. Also, 92,637 sq. ft. of direct space at 1401 McKinney became vacant in Q1, resulting in additional negative absorption.
Availability and Vacancy
The overall availability rate, which measures the total amount of space being marketed for lease, rose to 25.7%, an increase of 70 basis points from the previous quarter’s 25.0%. Available sublease space has dipped from a peak of 12.0 million sq. ft. in Q3 2016 to 11.5 million sq. ft. at the end of 2016 and now settling at 11.1 million sq. ft. as of the first quarter of 2017. Before 2014, available sublease space in Houston had been averaging about 3.3 million sq. ft. Since the oil downturn began to manifest in the office market in 2014, available sublease space in Houston has more than tripled. With everything considered, the sublease market seems to have reached its bottom; however, there is more than 4.5 million sq. ft. of sublease space that will be returned to landlords in the form of direct space through 2019. The large sublease market is a critical element in regaining positive momentum and could be viewed as beneficial as the big blocks become more competitive.
The five largest blocks of contiguous sublease space currently available are 820,853 sq. ft. in One Shell Plaza; 510,502 sq. ft. in Two Allen Center (both in the CBD); 378,209 sq. ft. in West Memorial Plaza; 370,397 sq. ft. in Three WestLake Park; and 534,098 sq. ft. in Four WestLake Park (each in the Energy Corridor).
The market saw overall full-service average asking rates, which include real estate taxes, insurance, maintenance and any fees typically included in a lease agreement, fall $0.07 per sq. ft. quarter-over-quarter to finish at $27.76 per sq. ft. at the end of Q1 2017. Sublease rates remained steady at $21.06 per sq. ft. quarter-over-quarter, although they were down 16.3% from a year ago when average asking rates were at $25.17. The difference between quoted and negotiated rates remains substantial and makes a significant difference in lease negotiations. While leasing activity slowed by 34.6% quarter-over-quarter and 31.5% year-over-year, tenants took advantage of quality sublease space at bargain rates.
Construction & Deliveries
There is currently about 2.0 million sq. ft. under construction in the Houston office market, with about half of that space available for lease. Buildings underway with more than 100,000 sq. ft. of available space include 3200 Kirby, a 13-story, 200,000-sq.-ft. Class A office building that is part of the Kirby Collection mixed-use development in River Oaks scheduled to deliver in the summer of 2017; One Grand Crossing, a three-story, 170,000-sq.-ft. Class A office building at the southwest corner of I-10 and Grand Parkway planned for completion in early 2018; and The Post Oak at 1600 West Loop South, a 38-story mixed-use tower, with more than 100,000 sq. ft. of boutique office space in the Galleria/Uptown area, scheduled to deliver in the Fall of 2017. Currently, overall occupancy in the Houston office market is at 80.0%, the lowest level since NAI Partners began tracking occupancy in early 1999.
As leasing activity has slowed, a total of 2.2 million sq. ft. was leased in the overall Houston market during Q1 2017. Class A space fulfilled 1.2 million sq. ft., while Class B space realized about 917,000 sq. ft. Overall activity was down quarter-over-quarter from 3.4 million sq. ft., and year-over-year from 3.2 million sq. ft. The average sq. ft. leased per quarter over the last ten years is approximately 4.4 million sq. ft. Notable tenants that signed lease agreements this year include HP, with 378,000 sq. ft. at City Place Drive in The Woodlands; Targa Resources, with 127,734 sq. ft. at 811 Louisiana St.; and Crestwood Partners taking 54,215 sq. ft. of sublease space at 811 Main. The latter two transactions occurred in the CBD submarket, where almost 25.0% of all leasing activity took place.