Houston’s office market continues to see tenant demand for new construction, increasing supply in older product
Commentary by Blake R. Virgilio, CCIM, SIOR | Vice President | Houston
If you asked most experts if Houston’s stagnant office market is a result of supply or demand, most would say demand, due to five years of lower oil prices. Looking at the numbers over the past five years, and trying to determine whether Houston office market woes have been more supply or demand-driven, most would be surprised by what the numbers tell us. The market sentiment “feels” like there’s been a severe contraction on the demand side. However, Houston office tenants are still occupying more space than they were in 2015, a nominal 2% increase; it’s still an increase nonetheless.
However, when oil retreated in late 2014, new construction still continued and the effects of that additional space have been as much of a detractor to a healthy office market than the demand issues. At the peak of the office market from 2011-2014, 14.2M SF of new inventory delivered. Since 2015, there’s been an additional 23.1M SF delivered and currently there is another 3.6M SF under construction. Houston’s office market added more inventory during the contraction phase of the cycle than the expansion phase. Most of this is caused by the “flight to quality” trend of new tenants’ demand for new Class A+ projects in order to attract and retain talent. While reduced footprints have been prevalent, tenants have also shown an appetite to move into a newer project that garners a higher rate than the one they’re vacating. The “pre-lease” effect sees a building break ground on a new building that is only 40-50% pre-leased, leaving an additional 50% vacancy to hit the ground in a market that is already struggling. This has had a pronounced negative effect on the fundamentals.
For example, a tenant signs a 250,000 SF pre-lease in a 400,000 SF proposed project. The tenant’s current footprint is 340,000 SF, so the “net-net” of this large pre-lease is effectively negative absorption of 90,000 SF (a 340,000 SF vacancy at the old project). This same scenario has been repeated multiple times throughout the market, and unless a city’s dominant occupiers are expanding, then this cycle is great for that developer and tenant, but the effects to the rest of the market are much more staggering. Long term, Houston will benefit from the quality of the new office construction, but the near term effects that have been repeated over this most recent contraction have made for an extended recovery.
Historical Available Sublease Space
Of the 1,672 existing office buildings in our survey, 73 buildings have 100,000 SF or more contiguous space available for lease or sublease. There are 21 options with 200,000 SF available for lease or sublease. Citywide, 6.4 million SF of sublease space is listed as available and 3.3 million SF of the space is vacant. The largest sublease space currently listed is in the Greenway Plaza submarket. The space is available in April 2020 and is occupied by Oxy.
Absorption & Demand
Houston’s office market posted positive net absorption of 1,656,883 SF in the fourth quarter, a much needed positive change from the negative net absorption posted in the second and third quarters. Houston’s office market closed out 2019 posting 1,278,549 SF of positive net absorption. Suburban Class A space recorded the largest gain, posting 1,152,824 SF of positive net absorption, while suburban Class A space reported the largest loss, posting 204,311 SF of negative net absorption. A large portion of the positive absorption can be attributed to McDermott International’s move in December to Energy Center V in the Katy Freeway submarket. McDermott leased the entire building (524,000 SF) last year and several news articles indicated the company will be vacating several different locations. We believe the net absorption caused by this tenant may be overstated as we could not verify the exact amount of space the tenant has vacated. Looking forward, our forecast indicates positive absorption in the first quarter, but much less than what was recorded in Q4.
Houston’s average asking rental rate decreased over the quarter from $29.89 per SF to $29.82 per SF, primarily due to the average CBD Class B asking rate dropping from $30.95 per SF to $30.64 per SF. In contrast, Houston’s average Class A rental rate rose from $35.30 to $35.35 per SF and the average CBD Class A rate increased from $45.64 per SF in Q3 to $45.67 per SF in Q4. Looking ahead, rental rates should remain flat over the next quarter.
Houston’s office leasing activity decreased over the quarter from 3.3M SF to 2.7M SF. 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 quarter from $656M in Q3 2019 to $447M in Q4 2019. The average sales price per square foot trended up from $253 to $316 per SF over the quarter. Houston’s average office cap rate is 7.3%, while the average U.S. cap rate is 6.6%.
Office Development Pipeline
3.6 million SF of office space is under construction and approximately 42.8% 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 100,000 SF or greater.