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The overall vacancy rate in the Houston office market was up 20 basis points quarter-over-quarter, and up 70 basis points year-over-year.


EXECUTIVE SUMMARY

 

Vacancy rate at 21.5%

The overall vacancy rate in the Houston office market was up 20 basis points quarter-over-quarter, and up 70 basis points year-over-year. The vacancy rate for Class A properties is at 22.2%, and Class B at 22.3%. In the first quarter, overall net absorption totaled negative 207,280 sq. ft.—Class A represented positive 207,297 sq. ft. and Class B corresponded to negative 363,773 sq. ft. Of the 3.4 million sq. ft. currently under construction, about 42% of that space has been spoken for. Of the three properties completed in 2020, totaling 300,000 sq. ft., 97% of that space is leased. The overall Houston average asking full-service rent is at $29.33 per sq. ft.—down from year-end 2019’s $29.84 per sq. ft.—while the Central Business District is averaging $39.34 per sq. ft.

 

Houston economic indicators

Houston started 2020 with healthy job gains—led by leisure and hospitality, and health industries. Serviceproviding industries were accelerating, while goodsproducing sectors had slight contractions, with modest to no growth in manufacturing. However, oil and stock markets have been whirling from the impacts of COVID-19 on world economies and a flood of crude from OPEC. As noted in NAI Partners’ Houston Office Market QuickTake, these factors have cast a weighty shadow over the outlook for the region. On a year-overyear basis, Houston grew 2.3% (71,100 jobs). Houston’s unemployment rate was flat at 3.8% in February. For comparison, the February unemployment rate was 3.5% in Texas and 3.5% in the U.S. This data precedes the coronavirus (COVID-19) outbreak in the U.S.


BROKER’S PERSPECTIVE

 

As I sit here writing this from my home office, I am thinking of the best way to describe hat we are seeing in the Houston office market. Statistically speaking, the numbers ed in this report show a market that that has still not recovered from the Oil Crash of
2014, underscored by negative absorption, an increasing vacancy rate, and flat-to-decreasing rental rates. What the figures don’t show is the major crisis that has evolved over the last 30 days, and I am not just referring to COVID-19. The price war going on between Saudi Arabia and Russia is going to have far greater long-term implications on the Houston office market than the economic shutdown associated with the pandemic.

However, the combination of the demand drop associated with COVID-19 plus the supply-side issues is the proverbial “double whammy.” Job losses in the Houston area are being compared to the dirty words “the 80s”—those that have been in the commercial real estate business for 20-plus years will never forget the low-water mark for the Houston office market was that pivotal decade when oil prices collapsed and the savings and loan crises hit.

Speaking of supply and demand, I think it is important to recognize why this downturn should be different than what was experienced in the 1980s. A significant factor in the crash of the office market back then was supply-side driven. Favorable tax laws created an environment where everyone became a developer. What resulted was a supply increase in the office market the likes of which Houston has never seen. For perspective, to the right is a chart showing the amount of new office space delivered in the Houston market over the last four decades. As you can see, the Houston market added more office space between 1980 and 1989, than during the three following decades combined.


This is significant, and a major reason why we don’t see an office market comparable to the 1980s despite the demand-side issues we are facing and will continue to face in the foreseeable future. Additionally, while still heavily dependent on the energy sector, Houston has diversified its economy and as a result its base of office tenants.

With that said, the Houston office market still has some tough sledding ahead, but the conditions should not mirror what we experienced in the 1980s. I believe we will see conditions further deteriorate (higher vacancy, negative absorption, more landlord-provided concessions, and lower rental rates) for the next 18 to 24 months, or until the oil glut is behind us. Don’t expect to see any new cranes for office building construction on the horizon, as any speculative construction has no chance of being financed in this market.

The COVID-19 experience has given rise to other possible trends in the office market. Working from home, social distancing, and space design (less people in more space) will all be subjects of conversations between office brokers, developers and design professionals in the near term. Who knows, the new dirty word for office space in Houston may end up being “collaborative.” Whatever the trends/changes/innovations may be, NAI Partners is here to advise and guide our clients during the best and worst times.”

Stay safe and well.

Dan Boyles

Dan Boyles
Partner
NAI Partners


MARKET OVERVIEW

 

Negative net absorption in Q1 2020

During the first quarter, Houston’s office market saw an increase in the number of tenants moving out of space compared to the previous quarter in 2019. The aggregate effect of the net occupancy decline was just over 207,000 sq. ft. of negative absorption for the quarter, raising the vacancy rate to 21.5%. The amount of total office inventory that is being marketed for lease was unchanged quarter-over-quarter at an availability rate of 26.0%. The difference between this figure and the vacancy rate reflects expected future move-outs. Space being marketed for sublease represents 6.0 million sq. ft., or 9.6% of the 62.9 million-sq.-ft. total availability figure. The Central Business District vacancy rate is at 25.9%, up 150 basis points from this time last quarter at 24.4%, while the Energy Corridor vacancy rate is at 24.6%, down substantially from 27.3% in Q4 2019. Tenants Transocean, Bank of America, Honeywell and Engie all assisted in lowering the amount of vacant space in Houston in the previous fourth quarter to end 2019

 

Office development

Office construction is at 3.4 million sq. ft across 20 buildings, with 2.0 million sq. ft. (58%) available for lease. The Central Business District and Galleria/West Loop, account for 1 million sq. ft., or one-half of the total space available. Hines’ Texas Tower is expected to deliver in late 2021 and is 40% preleased. Outside of downtown, of the 930,000 sq. ft. underway in the Katy Freeway East submarket, the 190,000-sq.-ft. building at 9753 Katy Freeway is being built with 85% of the space available for lease. Other office buildings under construction in the submarket include Marathon Oil’s 440,000-sq.-ft. future headquarters in CityCentre, and Village Tower I & II 150,000-sq.-ft. office buildings at 9655 Katy Freeway at the former site of a Toys R Us. The Katy Freeway East market has a vacancy rate of 15.3% compared to the metro’s overall average of 21.5%.

 

Investment sales trends

Real Capital Analytics data reports quarterly office sales volume for Q1 2020 in the Greater Houston area at $414 million, down compared to this time last year at $539 million. The primary capital composition for buyers in 2020 was made up of 59.5% institutional and 33.2% private. For sellers, the majority was 36.0% institutional, 33.7% REIT/listed, and 24.6% private investors. While the pandemic has caused many deals to be placed on hold, one office investor in Houston has responded to the disaster by seizing an opportunity. CoStar reported that Belvoir Real Estate Group closed a deal in mid-March to buy a 110,529-sq.-ft. Class B office building located at 7660 Woodway Drive in the Galleria/West Loop submarket at the intersection of San Felipe Street and Voss Road. Belvoir paid about $15.6 million, or $141 per sq. ft. to the seller, California-based Commerce Realty.

 

Houston leasing two hotels as COVID-19 quarantine sites

The City of Houston approved two 90-day leases for a total of 186 hotel rooms to be used for first responders and city employees who are not able to quarantine at home. Included are those who are quarantining waiting for test results, or those exposed to the virus. The city will spend $312,765 a month for the two hotels, or about $56 per room, per night. The initial lease terms last for three months and can be extended if necessary. One hotel is located on the Gulf Freeway near Hobby Airport, and the other is off the Northwest Freeway near Spring Branch. Harris County is looking at NRG Stadium, among other sites, for a possible location to stage space for quarantine, treatment for non-critical cases and for intensive care. The city is also searching sites for treatment, including a Kindred Hospital facility in the Heights.

 

Average asking rents

The Houston overall full-service average rates are at $29.33 per sq. ft., a decrease of $0.51 from $29.84 a year ago. Asking rates for overall Class A space are $34.69 and Class B are $22.34 per sq. ft. Rent growth has varied across Houston’s submarkets. Asking rents in the Katy Freeway submarket averaged $35.49 per sq. ft., which is 21% higher than the metro average as a whole and ranked number two among Houston submarkets as of the end of Q1 2020. Houston’s office market already sits at 21.5% vacancy, with even more space—both direct and sublease—likely coming available. In Houston, office tenants will arguably have more leverage than at any other time in history with regards to negotiating rental rates, terms, tenant improvements and concessions. However, since the market was already soft prior to the current situation, the relative impact to occupancies and rents may not be as devastating as would be expected.


Leta Wauson
Director of Research
leta.wauson@naipartners.com
tel 713 275 9618

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