- The 115th Congress is expected to see new policies and changes in the repeal/replace of Affordable Care Act, corporate and individual tax cuts and reforms, increased infrastructure spending, and trade policy and regulations.
- With increases in oil prices and rig counts, the energy sector has passed its bottom, and national, regional and local signs indicate a positive but bumpy improvement ahead.
- Gross domestic product (GDP) is anticipated to be 1.6% for 2016 and 2.1% for 2017, both slower than the 2.6% measure seen in 2015.
- U.S. employment remains steady in posting 156,000 new jobs in December, for a total of 2.2 million new jobs in 2016 (an average of 180,000 new jobs per month); though still strong, 2017 is anticipated to see a slightly lower 160,000 new jobs per month.
- Houston’s economic outlook is expected to shift from negative to a positive outlook in 2017.
- With substantially reduced demand, as measured by negative net absorption and low leasing activity, Houston’s office real estate market has likely hit the bottom of the market cycle.
- Q4 2016 posted -165,140 sq. ft. of negative net absorption, a demand for office space that is lower than average historic Q4 performance of 1,292,152 sq. ft.;
- 2016 marked the second lowest year since 2000 with negative net absorption at -65,000.
- Leasing activity of 2,393,880 sq. ft. was less than historic Q4 activity of 4.4 million sq. ft.
- Annual leasing activity of 12.7 million sq. ft. was the third lowest year since 2000.
- Vacancy continued its upward climb, now to 16.2%, with availability at 21.7%.
- The glut in office space is largely driven by the 11.9 million sq. ft. of sublease space, which represents 20% of the available market.
- Construction remains at 4.0 million sq. ft., with new deliveries anticipated in 2017.
- Houston’s office market appears to have hit its bottom in 2016, as did the oil downturn and associated impacts on Houston’s economy.
Following two years of a downturn, Houston is beginning to see some initial signs of recovery in the office market, albeit small ones. Perhaps recovery is too strong a term as the numbers show that more so than a full-blown recovery we are actually more confident in saying we have found the bottom. The deluge of sublease space that washed over Houston – particularly in west Houston and the central business district – has finally let up. In fact, the fourth quarter of 2016 was the first quarter in two years where we did not see an increase in sublease space – often cited as a barometer on the overall health of the office market. If rig counts and oil prices are any indication, then large dispositions of office space impacting the market are in all likelihood over (knock on wood).
With that said, the tune we’ve been humming hasn’t changed all that much – we are still very much in an office market “recession,” which should be music to the ears of tenants. Landlords are having to claw their way into deals as they are still very much competing with vast amounts of sublease space, more than the market can realistically absorb in the short to mid-term. Even though quoted direct rental rates haven’t seen the drastic declines as one would expect given market conditions, significant economic incentives are still being made for landlords to be competitive. The difference between quoted and negotiated rates remains substantial and other concessions including construction allowances, free rent and free parking can and definitely should move the needle for companies evaluating their current lease.
As it has been for some time now, tenants remain in a favorable position to take advantage of market conditions but the clock is ticking before Houston shifts back to a rising landlord-favored market.
As the 115th Congress began alongside a new president-elect, some new policies and policy changes that may unfold include repealing/replacing the Affordable Care Act, corporate/individual tax cuts and reforms, increased infrastructure spending, and among others trade policy and regulations. Despite a very vibrant political cycle with some clear consequences, Trump’s election is not anticipated to influence gross domestic product (GDP) in 2017, which is expected to be about 2.1%. GDP may roll in for 2016 around 1.6%, lagging behind 2.6% in 2015. Proposed tax cuts tend to mostly lead consumers to reduce their debt, rather than increase consumer spending, which accounts for about two-thirds of GDP. Consumer spending did grow by 2.8% in the third quarter of 2016.
Job growth continues to be a strength of the U.S. economy. Employment in December increased by 156,000 new jobs, with particular strengths in health care, hospitality, government and manufacturing. In 2016, there was an average of about 180,000 new jobs added per month, for a total of 2.2 million new jobs and an unemployment rate of 4.7%. Job growth in 2017 is anticipated to slow but remain strong at around 160,000 new jobs per month. Increases in job openings and turnover further suggest a tightening labor market. Nevertheless, with more people entering the labor force, unemployment is expected to drop to 4.5% in 2017. Strong employment and job growth are big contributors to the likely two-to-three interest rate hikes anticipated to occur by the Federal Reserve in 2017. Personal income also rose in every state in Q3 2016.
Core inflation, excluding food and energy, is projected to be about 2.3% in 2017, a modest increase from 2.2% in 2016. However, energy prices are likely to increase modestly in 2017, for an overall 2.5% inflation in 2017, up from 2% in 2016. The question remains as to whether OPEC’s cuts will really manifest and if so, how much they will lead to the stabilization and increase in oil prices and the energy sector. Either way the oversupply of production and stored oil still persists and needs to be burnt off for WTI prices to see substantial shifts upward. The oil markets are likely to remain volatile in 2017, possibly stabilizing some during the latter half of the year.
Business spending was largely flat in 2016, but a modest increase of 3-4% may occur in 2017. Demand for factory-produced goods continues to strengthen after a lengthy lull. The Small Business Optimism Index of the National Federation of Independent Businesses (NFIB) increased substantially by 7.9 points in December and 10.9 points in November, following decreases over the past 12-18 months. Such positive swings indicate an expected stronger economy associated with possible easing of regulations. The ISM manufacturing index rose to 54.7, a two-year high on the heels of increases in production and new orders in December. In December, the ISM non-manufacturing index was unchanged at 57.2.
Indicators such as residential construction suggest that the housing market will strengthen in 2017, despite substantial drops in housing starts in November 2016. Inventory remains low, with more people looking to buy homes than are readily available. With political headwinds in 2016 in both the U.S. and U.K. leading to uncertainty, growth in private nonresidential construction spending is anticipated to be about 7.5% in 2016. The Dodge Momentum Index of non-residential construction increased 2.9% in December after downward revisions for November.
Export prices are expected to increase with the strong value of the dollar, which in turn will produce an anticipated increase in U.S. trade deficit by 4% in 2017. Meanwhile, import prices rose 1.8% in 2016. Though all data are not yet in, it appears that international trade in 2016 will fare better than initially anticipated with the shortfall on par with that of 2015. Retail sales were weaker overall than hoped for in December, marking an increase of 0.6% in December following 0.2% in November (compared to expectations of 0.5%).
The economies of Texas and Houston appear to be poised to begin to see some positive changes in 2017, following the bottoming of the oil industry and its economic impacts. However, at both the state and local levels, we are likely to see some continued turbulence as we bounce back from the downturn. Oil prices and rig counts are moving in the right direction as the outlook begins to brighten. The Dallas Fed Energy Survey increased to 40.1 in the fourth quarter from 26.7 in the prior quarter, based on its responses of executives in the industry. Signs of recovery manifested in both employment and production.
Employment in Texas grew 2.1% in the second half of the year, compared to just 0.8% in the first half of the year. Overall, Texas employment will be about 1.5% for 2016, with a forecast of growth near 2.1% for 2017. From December 2014 through November 2016 Houston lost about 70,000 jobs in sectors associated with oil rigs. Of these jobs, 25,000 were from mining and 25,000 were from manufacturing. The outlook is getting better. Houston jobs grew 1.5% from August to November. Job growth remains weak in the oil and oil service fields, but is positive in leisure and hospitality, professional and business services, and trade, transportation, and utilities. Houston’s unemployment was 4.6%. Service sector employment in Houston grew at 2.3%, above its average of 2.0% since 2000.
The revenue index of the Texas Service Sector Outlook survey increased from 13.7 in November to 20.6 in December. Retail sales in Texas also increased according to the Texas Retail Outlook Survey, which rose from 6.0 to 19.2. Factory activity in Texas has increased consistently over the past six months, according to the Texas Manufacturing Outlook Survey. The index which measures manufacturing conditions increased to 13.8. The Houston Business Cycle Index contracted from December 2014 to November 2016 an annualized 0.4%, but has grown 1.8% over the past five months.
Demand for office space is measured by net absorption, the change in occupied inventory including direct and sublet space. Figure 2 shows net absorption since 2000 by year and quarter for combined Class A and B office space. The last quarter of 2016 posted -165,140 sq. ft. of negative net absorption. This amount of net absorption in Q4 2016 represents decreases of -48.0% QoQ and -123.5% YoY (Table 1). The historic Q4 average (± 95% confidence interval) for net absorption is 1,292,152 sq. ft. (± 507,150). We are 95% certain that Q4 net absorption typically falls between 785,002 to 1,799,302 sq. ft. Thus, with the pullback in oil and its impacts on the office market, net absorption in Q4 2016 did decrease significantly from historic Q4 performance. Nevertheless, Q4 brings total net absorption for 2016 to -64,358 sq. ft. of annual negative net absorption for Class A and B office space. This makes 2016 the second lowest year for demand in office space in the past 16 years.
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 reports leasing activity since 2000 by year and quarter for combined Class A and B office space. Leasing activity of 2,393,880 sq. ft. occurred in Q4 2016, yielding decreases of -40.7% QoQ and -52.6% YoY (Table 1). The historic Q4 average (± 95% confidence interval) for leasing activity is 4,493,955 sq. ft. (± 553,915). We are 95% certain that Q4 leasing activity typically falls between 3,940,039 to 5,004,870 sq. ft. This indicates that current leasing activity is statistically lower than historic Q4 measures since 2000. Leasing activity of 2,393,880 sq. ft. in Q4 brings total leasing activity for 2016 to 12.7 million sq. ft., the third lowest year on record since 2000 (Figure 3). With net absorption lagging behind leasing activity, lower leasing activity in Q4 and 2016 as a whole suggests continued low absorption in quarters to come.
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 even for rent. Overall, office supply continued to increase in Q4 2016 (Figure 4). For Class A and B buildings combined, availability was 21.7%, which is flat QoQ but up a modest 13.6% YoY (Table 1). Likewise, vacancy for Class A and B space combined was 16.2%, up a modest 0.6% QoQ and 11.7% YoY (Table 1). As indicated by increases in both vacancy and availability, Houston’s office products are nearing or in the bottoming phase of their market cycle.
Figure 5 plots both gross and base (NNN) asking rents for direct and sublease space since 2000 for Class A and B buildings. Despite limitations of asking (rather than actual) rent, we can still derive information on market conditions by examining the difference between direct and sublease base rents. The greater the difference between direct and sublease asking rents, the softer the market conditions are.
Since Houston’s office market began falling in late 2014, the difference between direct and sublease base asking rents for Class A buildings has grown from $3.77 to $8.52 (Figure 5B). Historically, Class A buildings have shown an average difference of $3.52 between direct and sublease base asking rents, with a 95% confidence interval of $3.15 to $3.89. At the current $8.52, Houston’s Class A rents are way outside this expected range. For Class B buildings, the difference between direct and sublease base asking rents has grown from $0.82 to $3.82 since 2014 (Figure 5B). Historically, Class B buildings have shown an average difference of $1.97 between direct and sublease base asking rents, with a 95% confidence interval of $1.62 to $2.21. At the current $3.82 difference, Houston’s Class B rents are outside of this range. Note, Class A and Class B sublease rental rates have converged, such that the typical Class B tenant may enter the Class A market.
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. Figure 6 breaks down deliveries and construction on an annual basis by Class A and Class B products. Deliveries in Q4 2016 were 100,714 sq. ft. of Class A and B buildings, a decrease of 94.2% QoQ and 97.6% YoY (Table 1). RBA under construction remains at 4.0 million sq. ft. in Q4 2016, a decrease of -50% YoY (Table 1).
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 274 million sq. ft. for 4,004 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.