Houston’s office market weakens over the quarter and braces itself moving forward amid $20 oil
Commentary by Patrick Duffy, MCR | President | Houston
Colliers generally uses this space to discuss the trends we see in market data and in conversations we have with our clients, prospects and friendly competitors. We take that data and attempt to project activity going forward. The bulk of the first quarter was, for all practical purposes, pre-COVID. Net “move-in” data, as well as new leases signed, were likely unimpacted for Q1 based on the virus or only marginally impacted. Our industry has a lead time of at least 4-6 months before a lease is signed or space made ready for occupancy. The real impact of this COVID crisis will not present in the data until later in Q2. Inertia will carry us for a few more weeks.
The world is focused on the COVID driven economic slowdown. Houston has two issues to watch – COVID and a collapse in oil prices. The oil issue is driven by Saudi Arabia and Russia failing to reach an agreement on production and by the severe decline of oil and gas demand driven by the COVID shutdown. Oil has been in the low 20’s since the collision of these two events. The Energy Information Administration is projecting that supply will continue to outpace demand for the balance of this year by approximately 10MM barrels per day. If that projection holds, all land-based storage (3.3B barrels) will be full by mid-May. We will likely not see much relief in oil prices for at least 18-24 months, which means the upstream and midstream companies and the companies that support them will be under a great deal of pressure to trim costs.
Houston has diversified its economy and is far less reliant on just oil and gas to drive its economy. However, when it comes to the office market, we are still very dependent on oil and gas companies, both directly in the space or businesses that are dependent on oil and gas companies as clients. These are the big space user companies historically.
If we optimistically assume that the virus-driven economic shutdown recovers quickly once the all-clear is given, Houston will still have a significant oil slow down to cope with. Most of the energy companies had already leaned up their workforces since the 2014 price crash. There is not a great deal of fat left in these players to trim. The ultimate impact on the office market will likely be a factor of a lack of new space acquisition vs. a significant increase in sublease space, which we saw after the 2014 price crash. We hope that overall occupancy will not substantially decline on a net basis by year-end. We are currently projecting less than a 2-5% decline in occupancy by year-end from Q1 2020 levels based on these assumptions. This marginal move would increase the overall vacancy rate by about 250 – 400 bps.
Another issue to watch is the tenants unable to make rent payments or to make reduced rent payments if possible and the impact on the owners of office buildings. There is a potential domino scenario where rent payments are delayed or lost altogether. Owners are then unable to cover their debt, and a loss of liquidity is created that could easily translate into owners being unable to fund tenant improvements and commissions for new leases. It is a little too early to tell how significant an impact this scenario will have.
If the US economy, followed by the global economy, recovers relatively quickly, Houston will get back to work. The energy sector will lag this recovery and will not help the Houston real estate market much in the next two years.
Historical Available Sublease Space
Of the 1,662 existing office buildings in our survey, 79 buildings have 100,000 SF or more contiguous space available for lease or sublease. There are 23 options with 200,000 SF available for lease or sublease. Citywide, 5.5 million SF of sublease space is listed as available and 2.6 million SF of the space is vacant..
Absorption & Demand
Houston’s office market posted negative net absorption of 177,916 SF in the first quarter, a huge decrease from the 837,872 SF of positive net absorption posted in the fourth quarter of 2019. Suburban Class A space recorded the largest gain, posting 463,878 SF of positive net absorption, while suburban Class B space reported the largest loss, posting 330,799 SF of negative net absorption. Since tenants typically do not move into lease space immediately after signing a lease, absorption lags and can occur at anytime after. We believe absorption numbers will trail even longer than usual in the short-term due to the “stay-at-home” orders amid COVID-19, so absorption will more than likely remain negative moving into Q2 2020.
Houston’s average asking rental rate decreased over the quarter from $29.78 per SF to $29.62 per SF, primarily due to the average CBD asking rate dropping from $40.52 per SF to $39.57 per SF. Houston’s average suburban rental rate remained relatively flat, dropping only $0.04 to $27.00 per SF. Overall, rental rates only decreased by 0.5% on a quarterly basis and by 0.3% on an annual basis. CBD Class A rates posted the largest quarterly percentage decrease of 4.2%..
Houston’s office leasing activity increased slightly over the quarter from 3.4M SF to 3.6M SF, and decreased 31% on an annual basis. Leasing activity includes new/direct, sublet, renewals, expansions in existing buildings and pre-leasing in proposed buildings. Some of the more notable transactions are listed in the table below..
Houston’s office investment sales volume decreased over the year from $704 million in Q1 2019 to $414 million in Q1 2020. The average sales price per square foot trended up from $189 to $279 per SF annually and Houston’s average office cap rate moved from 7.6% to 6.8%.
Office Development Pipeline
4.3 million SF of office space is under construction and approximately 57% is pre-leased. 2.5 million SF is spec development of which 27% is pre-leased. Below is a summary of the office buildings under construction with a GBA of 150,000 SF or greater.