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Houston office market continues to struggle to gain foothold amid positive economic indicators
Challenging Office Market Conditions Continue
Houston’s overall vacancy rate increased to 21.4% in Q1 2018, up 70 basis points quarter-over-quarter, compared to a 150-basis-point increase year-over-year. While net absorption closed Q4 2017 at positive 238,931 sq. ft., Q1 2018 went back into negative territory at -1,245,983 sq. ft. Direct space was responsible for -441,806 sq. ft., and sublease space represented -831,015 sq. ft. Overall occupancy in the Houston office market remains below 80%—the current rate of 78.6% is the market’s lowest historical level recorded since NAI Partners began tracking office market activity in 1999. The overall average asking gross rent is up $0.14 at $28.24 per sq. ft. from last quarter, and $0.34 from a year ago.
While Office Market May be Slow, Houston Economic Indicators Are Positive
As the Houston office market strives towards a gradual recovery, current economic indicators are largely optimistic, suggesting healthy economic output and future growth. Job growth, energy-related activities, and import/export trade have recorded positive results during the first quarter of the year. Houston jobs grew at a convincing annualized pace of 4.7% over the two months ending in February (23,400 jobs), with the largest increase in professional and business services (11,000 jobs). The price of West Texas Intermediate has averaged just under $63 during 2018, and the U.S. rig count was at 993 as of March 30, up 169 rigs, or 20.5%, from 824 the same week in March 2017. In January, $16.9 billion in goods and commodities passed through the Houston/Galveston Customs District, up 8.5% from this time last year. In addition, exports totaled $9.7 billion, up 7.9%, and imports totaled $7.2 billion, up 9.5%.
After posting 239,000 sq. ft. of positive absorption in Q4 2017—the first quarter of positive absorption in the last few years—the road to recovery in Houston’s office market appeared to be underway. Alas, it turns out the road may be bumpier than imagined.
While the general attitude from our energy industry clients in 2018 appears to be that of renewed confidence and comfort, we have not yet seen the demand for office space reflect that. So far, 2018 has seen more than 1.2 million sq. ft. of negative absorption, with over 800,000 sq. ft. coming in the form of sublease space. The result is a citywide occupancy rate of 78.6%, the lowest mark recorded in the last 19 years.
It stands to reason that the Houston office market would chronologically trail the energy industry and changes in the price of oil, as it takes time for the headcounts and spending of companies in that realm to adjust to new conditions and for the corresponding office transactions to take place. For instance, the price of West Texas Intermediate crude dropped steadily from over $105 in the second quarter of 2014 to just over $46 in the third quarter of 2015, yet Houston’s office market only went from 19.5% availability to 21.5%; and while the price of crude has steadily increased from just over $46 in the second quarter of 2017 to a 2018 average just under $63, the availability rate has only decreased 0.2% in that time period.
Nonetheless, there is plenty of reason to believe that a balancing of supply and demand is on the horizon. In addition to the aforementioned increase in the price of oil, U.S. rig count is up over 20% year-over-year, and jobs in Houston grew by 23,400 in January and February. Interestingly, the average gross asking rate has increased $0.14 since last quarter and $0.34 in the last year (now $28.24). Eventually, these factors should lead to absorption of much Houston’s available space.
Other signs of a return to normalcy in the market include notable transactions by a few of Houston’s energy giants. Apache renewed its lease for more than 500,000 sq. ft. at 1990 and 2000 Post Oak Blvd.; and Williams Companies renewed its lease for more than 350,000 sq. ft. at Williams Tower. This in addition to the rumblings of Oxy purchasing the former ConocoPhillips campus in the Energy Corridor.
In the meantime, opportunities for tenants to achieve favorable terms still abound, particularly in those areas most saturated with energy industry companies. After seeing more than 500,000 sq. ft. of negative absorption this quarter, the Energy Corridor is now at 40% availability (375,000 sq. ft. placed on sublease market by Technip FMC). Downtown, Westchase, West Belt, and Greenspoint also boast availability rates over 30%.
It will take time for Houston’s office users to absorb all of that square footage. Accordingly, we expect the rest of 2018 to remain a tenant’s market, and opportunistic companies to be the beneficiaries of below-market sublease terms and/or significant landlord concession packages.
Negative Net Absorption in Q1 2018
During the first quarter of 2018, Houston’s office market had more tenants moving out of space than tenants moving in; as a result, the cumulative effect of these net occupancy losses was 1.2 million sq. ft. of negative absorption. The outcome of the slowdown in demand is vacant office space at 21.4%, or in other words, more than 49 million sq. ft. of office product sits empty.
More than one-quarter (25.8% or 59.5 million sq. ft.) of the total office inventory is being marketed for lease. The difference between this figure and the vacancy rate reflects expected future move-outs. Space being marketed for sublease represents 9.2 million sq. ft. (4%) of the 59.5 million-sq.-ft. total availability figure. Although vacant sublease space is still economically occupied because rent is being paid, it is available to tenants, and therefore competes with both direct and new space.
Metro Houston will need to start absorbing more of the vacant supply to create less risk for new developments. Houston’s office market will continue to struggle through decreased absorption until increased economic growth returns long enough to stimulate ongoing demand.
Construction Pipeline at Record Lowest Level
The Houston office market development pipeline is at 1.2 million sq. ft., the lowest amount documented since 1999 when NAI Partners began recording historical data. The metro reached its peak during Q4 2014 at 11.7 million sq. ft. under construction in 52 projects. Currently there are five buildings underway, with the majority of space in Capitol Tower at 800 Capitol St. The 35-story, 778,000-sq.-ft. building, includes anchor tenant Bank of America obligated to 210,000 sq. ft., plus future availability of 495,115 sq. ft., with a delivery date in mid-2019. Also under construction is City Place 2, at 1701 City Plaza Dr. in the Woodlands, a 4-story, 326,800-sq.-ft. office building, at 93.9% leased with a scheduled delivery date of October 2018.
Deliveries during 2018 include The Post Oak at 1600 West Loop South, a 36-story, 104,579-sq.-ft. building, at 67% leased; and the completion of Building 4 in Grandway West at 2322 W. Grand Parkway N., a 2-story, 72,045-sq.-ft. office property, at 93% leased. Developers have shown control over the last few years as the construction pipeline has grown smaller and most spec developments have been put on hold, as the Houston office market attempts to stabilize.
Investment Sales Down Year-Over-Year
Real Capital Analytics data reports year-to-date office sales volume for 2018 in the Greater Houston area at $1.1 billion, resulting in a year-over-year change of -34.0%. The buyer composition is made up of 62% private and 31% institutional. A recent top transaction in the Houston office market is the acquisition by Griffin Partners of Loop Central at 4848 Loop Central Drive in the Bellaire submarket. The three-building, 600,000-sq.-ft. office complex was sold by TIER REIT and was 84% occupied at the time of the sale by tenants Universal American, Service Link LP, Terra Energy Partners, and Easter Seals Of Greater Houston.
Leasing Activity Down from Last Quarter, but Way Up in Galleria
Leasing activity during the first quarter of 2018 was at 3.7 million sq. ft., down 27% quarter over quarter, although equal to the amount of activity year-over-year. Class A space fulfilled 2.5 million sq. ft., while Class B space realized 1.2 million sq. ft., with direct space representing 91% of all transactions.
The Galleria/West Loop submarket got a big boost during the first quarter of 2018 with Apache renewing their 524,342-sq. ft. lease. The oil and gas exploration and production company will continue to occupy all of the 24-story, 396,432-sq.-ft., Class A office building at 2000 Post Oak Blvd., and will also continue its lease of 127,910 sq. ft. at 1990 Post Oak Blvd. The 60-month renewal extends the Apache lease through 2024 in the Post Oak Central complex. In addition, namesake tenant Williams Companies renewed their 353,944-sq.-ft. lease at Williams Tower. The energy company’s subsidiary, Transcontinental Gas Pipeline, has been lead tenant in the 1.5-million-sq.-ft. building since the tower was developed in 1983, and is currently 92.3% leased.
The Galleria/West Loop was only one of two Houston office submarkets with noteworthy positive net absorption during Q1 2018. Lonza Houston Inc. completed construction on a biotech facility for viral and immunotherapy development and manufacturing in Pearland’s Lower Kirby District. The project, which broke ground in March of 2017 along Kirby Drive south of the Sam Houston Tollway, has been expanded by 150,000 sq. ft. for a total of 250,000 sq. ft.
Despite Slower Leasing and More Available Space, Average Asking Rents Rise
The market saw overall full-service average rates increase $0.14 per sq. ft. quarter-over-quarter to close Q1 2018 at $28.24 per sq. ft. Sublease rates increased to $20.48 per sq. ft., up from Q4 2017’s $20.29. In addition, year-over-year asking rents grew by 1.2%—although concessions such as free rent and tenant improvement allowances make posted rents less meaningful as a market indicator. Brokers report net effective rents, what a landlord ultimately gets to keep from a deal, dropping significantly once negotiations begin.
Director of Research
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