Two quarters into 2016 and we have already seen a turbulent year, with January and February lows replaced by some rebalancing in March and April, only for volatility to return at the end of the second quarter with Brexit. While Q1 2016 was likely the bottom of the oil commodity downturn, we have again in recent weeks seen WTI prices fall. This is likely a short-term result of Brexit and the value of the dollar, but nonetheless presents further concern for local and national economies. Projected U.S. GDP for 2016 has now been revised down from 2.4% to 1.8%, with the latest revision for Q1 at 1.1%. Consumer spending and consumer credit remain strong points, fueling about two-thirds of GDP. Recent changes in national employment further underscore the volatility of the first half of the year, dropping to only 11,000 new jobs in May and then bouncing back to 287,000 new jobs in June. Brexit will likely have minimal effects on the U.S., and the world as a whole, as the United Kingdom only accounts for about 4% of global GDP. Yet, Brexit could actually catalyze U.S. commercial real estate investors to remain in the U.S. rather than Central London, where many have previously sought opportunities. The economic outlook for Texas and Houston economies is uncertain, sitting on the edge of further declines or mild to modest growth for the remainder of 2016.
Net absorption and leasing activity in Q2 2016 were among the lowest since 2000. Net absorption comes in at low 72,000 sq. ft. in Q2 2016, a demand for office space that is a substantial and significant decrease below its historic Q2 performance. Likewise, leasing activity of 2.23 million sq. ft. in Q2 2016 was significantly lower than its historic Q2 average. Vacancy ticked up above 15% for the first time since 2005, while availability continued its upward climb to 20.8%, being driven by further increases in available sublease space of 11.4 million sq. ft. Nearly 2.5 million sq. ft. of deliveries occurred in Q2 2016, leaving 4.3 million sq. ft. still under construction. As Houston’s office market continues to move through the falling phase of its market cycle, attention turns to a favored tenant market and increasing landlord concessions.
The overall economic outlook has again declined for Texas and Houston, despite some intermittent positive signs. Brexit has increased volatility in financial markets, but could lead to increased CRE spending in U.S. as investors shift from Central London. The oil and gas downturn is now manifesting throughout Houston beyond just those direct businesses. The hopes are that the oil industry will swing back up before the national economy slows, which remains solid despite some mixed numbers and slowdowns.
Economic data in recent weeks and months are sending mixed messages for second quarter performance, leading many to further debate whether the economic expansion will continue or reverse course and slide downward. The Leading Economic Index (LEI) declined by a slight 0.2% in May—its third drop in six months—but overall this looks to be short lived. The U.S. gross domestic product (GDP) is now projected to be 1.8% for 2016, a modest decrease from 2.4% in 2015. GDP was revised up to 1.1% for Q1 2016, and is expected to come in around 2.4% for Q2. Strong consumer spending, which accounts for about two-thirds of GDP, will continue to fuel economic growth. Consumer credit further strengthened in May, and strong consumption in April and May will likely account for growth in Q2 2016. Consumer confidence increased 7.6 points in June, though some concern remain in the job market. International trade will continue to decline and hamper GDP with the strong dollar (up nearly 20%). Greater import growth in May led to a wider trade deficit, which is likely to increase by 4% in 2016, following a 6.2% increase in 2015.
At the center of the mixed messages in economic data are numbers on employment. Job growth in May dropped to only 11,000, but bounced back higher than expected to 287,000 new jobs in June, resulting in a three-month trend of 147,000 new jobs. With the unemployment rate remaining below 5%, the labor market continues to tighten. However, recent growth in jobs has been in industries with high and low wages, leaving middle-class wages to lag.
After a few months of growth and modest stability following lows in January and February, volatility has again returned to the financial and commodity markets, largely as a timely result of Brexit. Since the vote for the U.K. to leave the European Union, global financial markets have settled down. Effects on the U.S. will likely be minimal over the long term, but uncertainty will continue as the UK and EU begin working out negotiations on their future economic relationships. The U.K. will likely dip into a mild recession later in 2016, but this should not have a large effect on world economics, as the U.K. only represents 4% of global GDP. With uncertainty in the U.K., investors in commercial real estate from the U.S. may shift from Central London and simply remain in the U.S. with its strong CRE industry. To wit, the Dodge Momentum Index, a 12-month leading indicator of non-residential construction spending, jumped 11.2 percent in June and overall in Q2.
The ISM non-manufacturing index increased in June to 56.5, indicating that the economy continues to expand at a moderate pace. Moreover, the NFIB Small Business Optimism Index increased in June for the third month in a row. The ISM manufacturing index indicated that in June factories grew at the strongest rate since early 2015, but growth will remain modest in months to come, as shipments, orders and inventories are still declining, though at a slower rate. Given a variety of headwinds, including low May job growth, financial volatility, and reduced manufacturing, the current speculation is for only one remaining interest rate hike by the Federal Reserve Bank, likely after the presidential election.
The housing market is yet another variable producing mixed economic signals. Both the good-time-to-buy and good-time-to-sell indices increased in June, but the Home Purchase Sentiment Index dropped to 83.2. The high value of the dollar has led the National Association of Realtors to point out that home values by international buyers have decreased by 1.3%. This is leading such buyers to seek out lower-priced homes. Sales of new homes decreased by 6% in May.
Following the lows in oil prices of Q1, the initial months of Q2 saw prices swing up as global inventory stock piles slowed. Then Brexit and the value of the dollar saw oil prices decline again, restarting a new set of price swings and volatility in recent weeks. Due to weakness in the energy market, banks of the Eleventh Federal Reserve District have increased their funds set aside in case of loan losses, supporting recent increases in noncurrent loans associated with oil and gas companies.
Overall, Texas and Houston have a mixed set of economic numbers. Employment in Texas, despite the energy pullback, grew 0.4% in May compared to U.S. at 0.3%, with 4,400 new jobs following 14,500 new jobs in April. Unemployment in Texas remains at 4.4%, still lower than the national level of 4.7%. To this end, the Texas Leading Index, which uses key economic indicators to forecast future employment growth, did increase across sectors, suggesting some improvements ahead. Texas retail sales previously declined, but increased modestly in June as evidenced by the Texas Retail Outlook Survey. While employment growth in Houston contracted by 1.9% from April to May—with job growth coming from government, and education and health services—Houston’s unemployment rate dropped to 5% in May. Layoffs in Houston are now trickling through the economy and manifesting in residential, retail, wages, and office markets. Housing remains strong in other cities and regions of Texas, but Houston’s housing market has weakened substantially.
With reduced demand and low leasing activity, along with higher vacancy and availability, Houston continues its dive into the falling phase of the office market cycle. The second quarter of 2016 posted an exceptionally modest 72,000 sq. ft. of net absorption, a demand for office space that is substantially lower than historic Q2 performance of an average of 907,000 sq. ft. Similarly, leasing activity of 2.23 million sq. ft. in Q2 2016 was nearly half the historic Q2 leasing activity of 4.37 million sq. ft. Leasing activity was the lowest in 17 years. Vacancy ticked up above 15% for the first time since 2005, while availability continued its upward climb to 20.8%, which has been fueled by increases in sublease space to 11.4 million sq. ft. Nearly 2.5 million sq. ft. of deliveries occurred in Q2 2016, leaving 4.3 million sq. ft. still under construction.
Demand, as measured by net absorption (direct plus sublease space), is the change in occupied stock inventory. Figure 2 shows net absorption since 2000 by year and quarter for combined Class A and B office space. Following 1.7 million sq. ft. in Q1 2016, the second quarter’s 72,000 sq. ft. of positive net absorption represented a substantial decrease of -95.8% QoQ and -91.4% YoY (Table 1). The historic Q2 average (± 95% confidence interval) for net absorption is 907,341 sq. ft. (± 567,163). We are 95% certain that Q2 net absorption typically falls between 340,178 - 1,474,504 sq. ft. Thus, a net absorption of merely 72,000 sq. ft. in Q2 2016 is significantly below historic Q2 performance.
Leasing activity is another measure for the demand of office space, representing the total amount of space for direct leases, subleases, renewals, and pre-leasing. Figure 3 shows leasing activity since 2000 by year and quarter for combined Class A and B office space. Q2’s 2.23 million sq. ft. of leasing activity represented decreases of -21.7% QoQ and -38.1% YoY (Table 1). The historic Q2 average (± 95% confidence interval) for leasing activity is 4.37 million sq. ft. (± 535,462). We are 95% certain that Q2 leasing activity typically falls between 3,830,626 - 4,901,551 sq. ft. This indicates that current leasing activity is statistically lower than historic Q2 measures. In fact, Q2 leasing activity was the lowest on record of all prior quarters since 2000. With net absorption lagging behind leasing activity, lower leasing activity in Q2 suggests low absorption in quarters to come. This is not only indicative of the change in Houston’s oil economy, but also the shift to a falling phase of the Houston office market cycle.
Vacancy and availability measure the supply of office space, and as such are key indicators of shifts in the phase of the office market cycle. Availability better measures total supply because it includes vacant, occupied, and sublease space. Vacancy better measures empty space on the market, whether or not that space is leased or for rent. Overall, office supply increased in Q2 2016, continuing into the falling phase of the office market cycle that began in early to mid-2014 (prior to the manifestation of the oil downturn) (Figure 4). For Class A and B buildings combined, availability was 20.8%, up 3.5% QoQ and 12.4% YoY (Table 1). Likewise, vacancy climbed to 15.1%, up 5.6% QoQ and 12.7% YoY (Table 1). As indicated by increases in both vacancy and availability, Houston’s office products march forward in the falling phase of their market cycle.
Figure 5 plots asking rent for direct and sublease space since 2000 for Class A and B buildings. In Q2 2016, both Class A and B space showed stable direct asking rents, with Class A asking rent at $35 and Class B at $21. However, Class A direct rents tended to be about $5 higher than sublets, which continued to decline in asking rates due in part to the glut of sublease space on the market. Note, sublet rather than direct asking rents tend to be more indicative of a softening market, as evidenced in Figure 5 over recent quarters.
Construction of new stock inventory shapes the growing supply of office space. “RBA Delivered” refers to completed construction, while “RBA Under Construction” refers to space under construction that has not yet been completed. Deliveries in Q2 2016 were 2.49 million sq. ft. of Class A and B buildings, an increase of 33% QoQ but a decrease of 30% YoY (Table 1). RBA under construction is now down to 4.35 million sq. ft. in Q2 2016, a decrease of -34.1% QoQ and -64.7% YoY (Table 1). Figure 6 breaks down deliveries and construction on an annual basis by Class A and Class B products.
Figure 7 depicts changes in the inventory of Class A and Class B buildings since 2000, both in terms of RBA and the number of buildings. Stock inventory for Class A and B office space included 272 million sq. ft. for 3,910 buildings (Table 1).
The quarterly report for the office market includes information and data for Class A and Class B buildings, but excludes Class C buildings. Buildings are not excluded on the basis of single vs. multi-tenancy, owner occupancy, or building size.
Information and data within this report were obtained from sources deemed to be reliable. No warranty or representation is made to guarantee its accuracy. Sources include: U.S. Bureau of Economic Analysis, CoStar, Council on Foreign Relations, Federal Reserve Bank of Dallas, Greater Houston Partnership, FiveThirtyEight.com, Houston Association of Realtors, Moody Analytics, NAI Global, National Association Realtors, Texas A&M Real Estate Center, Well’s Fargo, University of Houston’s Institute of Regional Forecasting, U.S. Bureau of Labor Statistics.