Challenging Market Conditions Continue for Foreseeable Future
Houston’s overall vacancy rate continued to rise to 20.8% in Q3 2017, an increase of 30 basis points quarter-over-quarter and 210 basis points year-over-year. Net absorption remained negative at 633,666 sq. ft. as of the quarter’s end, adding up to 2.38 million sq. ft. of negative absorption year-to-date. Presently, overall occupancy in the Houston office market remains below 80%, situated at 79.2%, continuing to surpass its historical lowest levels. Both the Houston metro’s overall rent and leasing activity are down from last quarter, with an even deeper gap from a year ago. However, despite the uphill battle, the amount of sublease space as a percentage of the total amount of available space decreased to 16.8%, compared to 18.4% at the end of Q2 2017, while the total amount of available sublease space stands at 10.1 million sq. ft. Average asking rents fell by 1.0% year-over-year, while concessions such as free rent and tenant improvement allowances continued.
Hurricane Harvey Alters Economic Activity
The Houston economy sustained moderate growth, but at a slower pace through August. The business-cycle index and employment data were softer, and the energy industry provided less of a helping hand to Houston over the summer. Striking at the end of August, Hurricane Harvey was not included in the jobs data for August, however, a breakdown by the Dallas Fed suggests that while Harvey’s impact will be felt deeply, Houston and the Texas Gulf Coast are expected to recover quickly. Houston’s unemployment rate was 5.0% in August, up from a revised 4.6% in July. The August unemployment rate for Texas was 4.2% and 4.4% for the U.S. After the storm, the shutdown of refinery capacity drove the price of West Texas Intermediate crude oil (WTI) down, and also pushed motor fuel prices up. WTI has traded between $45 and $55 over the majority of the past year, while the weekly retail price of regular gasoline rose 36 cents per gallon in Houston. Overall, while the outlook for the immediate future is unsure, prospects for the next few years remain positive.
On behalf of the entire NAI Partners team, our thoughts and prayers go out to those affected by Hurricane Harvey. Like most every organization in Houston, we had employees and associates that have had to deal with the devastation this storm brought to our region. Regardless of the impact, we are all very confident that Houston will come back stronger than ever. I am already amazed by how quickly rebuilding is taking place.
Speaking of Harvey, I have been asked quite often about the impact the storm has had or will have on the office market. Although the statistics are not yet available, our general consensus is that there were some positives coming from companies needing space after being displaced; however, most of these needs were short-term in nature and therefore will have no sustainable impact on the market. The ability to work remotely, along with the deployment of temporary power solutions for those buildings that went down, are two major factors that allowed landlords and tenants to get back to work quickly following the storm.
The Houston office market continues to be a tenant’s market in almost every submarket across the city. The vacancy rate now stands at 20.8%, with overall availability in excess of 26%. On the demand side, absorption has been negative for the fifth quarter in a row, and we will likely see negative net absorption for the year in excess of three million sq. ft. As a result, landlords will continue to feel the pressure to drop rents and increase concessions for those few tenants in the market looking for space.
The good news is that there has been activity in the market. However, much of that activity has been for smaller tenants needing space of less than 10,000 sq. ft. It is impossible to make up for the millions of square feet dumped on the market as a result of the energy downtown in 5,000- to 10,000-sq.-ft. chunks. At that rate, it would take 50 years for the market to return to any type of equilibrium. The good news for landlords is that historically speaking the office market has cycles of 7 to 8 years in Houston. As such, we should begin to see some light at the end of the tunnel sometime in 2018. However, I believe we have a way to go before the pendulum will swing back in the landlords’ favor.
Average asking rents continue to fall, but that statistic does not tell the real story. Landlords have a tendency to hold advertised asking rents, only to drop them significantly once they have a strong prospect to lease space. We have seen rental rates decrease by as much as 30% during the negotiation process, while concession packages will increase by that same percentage. The amount of negotiation can vary from submarket to submarket and even building to building, so it is important for tenants to consider all their options to find the best lease terms.
The overall office market continues to face new challenges. M & A activity has left companies with more excess space which has been placed in the sublease market. Examples of this include Ensco’s acquisition of Atwood Oceanics and Spectra Energy’s acquisition of Enbridge. Both transactions resulted in large blocks of space being put on the sublease market. The former in the energy corridor and the later in the CBD.
The rest of 2017 will likely continue with more of the same: not enough positive influences to outweigh the results of the downturn in the energy business which started roughly three years ago. However, history tells us that 2018 should be a year in which the office market will see signs of life that will lead to a gradual recovery.
Available Sublease Space Represents 4.4% of the Market
The overall availability rate, which measures the total amount of space being marketed for lease, remains over 26% as of third quarter 2017. Direct available space sits at 60.4 million sq. ft., while sublease space is at 10.1 million sq. ft. Although the amount of sublease space has declined from its highest point of 12.0 million sq. ft. as of third quarter 2016, it still represents 4.4% of the market. More than 3.3 million sq. ft. of this sublease space is slated to be returned to property owners in the next 24-36 months, foreshadowing financial problems for landlords who have loan payments to make. Many local experts believe subleases less than two years aren’t really subleases at all, but in fact direct space. Landlords are more concerned with the 24-36-month range subleases, with tenants that aren’t in a position to buyout the lease, or particular restrictions in the loan agreements. Of the 3.3 million sq. ft. scheduled to be returned to landlords between September 2019 and September 2020, 2.5 million sq. ft. is Class A space, and 800,000 sq. ft. is Class B.
Net Absorption Remains Unenthusiastic
Net absorption continued in negative territory for the fifth consecutive quarter, seeing 633,666 sq. ft. of net move-outs in the third quarter, representing 0.3% of Houston’s total office inventory. Direct space represented negative 373,958 sq. ft. of that total, and sublease space was responsible for negative 256,224 sq. ft. Accounting for some of the Class A positive absorption activity, tenants moving into large blocks of space in the third quarter of 2017 include Kirkland & Ellis moving into 104,025 sq. ft. and Orrick, Herrington & Sutcliffe taking occupancy of 56,666 sq. ft. at 609 Main St. in the CBD; and Crestwood Partners occupying 114,870 sq. ft. and Thompson & Knight moving into 60,655 sq. ft. of sublease space at 811 Main St.
World-Class Construction Pipeline in CBD
Buildings underway with more than 100,000 sq. ft. of available space in the Houston CBD 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 fall of 2017; and Capitol Tower at 800 Capitol St., a 35-story, 778,000-sq.-ft. building, with anchor tenant Bank of America committed to 210,000 sq. ft., and a completion date projected for the second half of 2019. As for future construction, at a recent office market event, the rumor mill was abuzz with plans for a potential new skyscraper in downtown Houston. Speculation has the high-amenity project starting by the end of next year. Currently, there is about 2.31 million sq. ft. under construction in the Houston office market, with about half of that space available for lease. Production remained basically unchanged from this time last quarter, with only 110,000 sq. ft. delivered to the market.
Investment Sales and Leasing Activity Optimistic
Real Capital Analytics data reports year-to-date office sales volume in the Houston area at $2.134 billion, resulting in a year-over-year change of 196%. The buyer composition is made up of 31% cross-border, 27% institutional, 26% private, and 13% public listed/REITs. Another positive sign for the Houston office market is the Lincoln Property Co. and H.I.G. Realty Partners acquisition of Greenspoint Place, a portfolio of six office buildings and three adjacent retail centers from Northwestern Mutual Life Insurance Co. The North Houston properties are located at Interstate 45 and the Sam Houston Tollway and were built between 1978 and 1992. The portfolio went into foreclosure after Exxon Mobil, the largest tenant, vacated the buildings in 2015 and consolidated at its Springwoods campus. The six office buildings on Greenspoint and Northchase drives total more than 2 million sq. ft. and the three retail properties total more than 80,000 sq. ft.
Leasing activity slowed during the third quarter with a total of 2.45 million sq. ft. leased in the overall Houston market. Direct space fulfilled 1.78 million sq. ft., while sublease space realized about 640,000 sq. ft. These amounts are down significantly from 4.41 million sq. ft. at this time last year. On a percentage basis, transactions declined quarter-over-quarter by 34.3%, while the year-over-year drop was at 44.4%. Even so, NRG Energy sealed a deal subleasing 431,037 sq. ft. from Shell Oil Co. at One Shell Plaza – 910 Louisiana in downtown Houston. NRG will occupy 18 floors within the 50-story, 1.1 million sq. ft. high-rise in the Houston CBD. This transaction marks the city’s largest sublease deal since the oil slump began more than two years ago, with a term through Dec. 31, 2025, when Shell Oil Co.’s lease expires.
Average Asking Rents Soften
The market saw overall full-service average rates fall $0.09 per sq. ft. quarter-over-quarter to close Q3 2017 at $27.91 per sq. ft. Sublease rates increased at $20.74 per sq. ft. compared to Q2 2017 at $20.72 per sq. ft. In contrast, year-over-year asking rents fell by 1.0%, while concessions such as free rent and tenant improvement allowances continued.
Director of Research
tel 713 275 9618