It looks like the good old days. Robust expansion in the oil and gas sector, producing shortages of space in the vibrant Energy Corridor on Houston’s west side, is driving a new development cycle. It’s an old refrain, now sung by Studley, Inc. in its second quarter report on the local market: “As Houston’s energy sector rally continues, developers are scrambling to catch up with the robust demand for office space.” Overall market vacancy is declining and growth has returned to average rents, both asking and effective.
The profile this time around, however, includes a somewhat unfamiliar element. While a substantial construction cycle has gotten underway, it proceeds with relative prudence; it is unlikely to pose the specter of severe overbuilding such as the market suffered in the past when the energy sector and local economy took a turn for the worse, leaving huge volumes of inventory, both existing under construction, with poor prospects for timely absorption. Indeed, while energy sector expansion is a major factor, other factors cut the other way. “The region,” continues Studley, Inc., “is not completely sealed off from the broader economy.” A slowing since January has cost “several hundred office-using jobs.” With leasing trailing off in second quarter, net absorption, by Reis’ count, slowed along with it—and should stick to the slower pace over the remainder of the year. Too, rent growth, while positive, remains modest alongside what this market produced in previous periods of expansion. All said, however, the general good health of the market does not appear to be in jeopardy.
The relative resiliency of the energy sector during the recession and its sluggish aftermath, despite active development, prevailed against severe increases in the vacancy rate. Indeed, the 18.0%-plus rates seen as a result of the recession of the early 2000s were nowhere to be found post-2008. The latest upward trend in the vacancy curve reached its peak in the third quarter of 2010 at just 15.4%. With construction slowing (albeit not disappearing) and demand strengthening, the rate had declined to 14.3% by the end of the second quarter of 2012, a loss of 20 basis points for the quarter alone, a decline of 100 year-over-year. At 23.3 million square feet, the volume of vacant stock reported as of mid-year was down 1.6 million from a year earlier. The easing up of demand along with and increase construction activity expected to bring a substantial volume of space on line by the end of the year should result in little change in the occupancy level in the period ahead.
Despite the slowdown in leasing, meanwhile, Studley, Inc. reports further depletion of the supply of large blocks of vacant space, an effect of several recent large deals in downtown Houston and in the Energy Corridor area on the west side. While “flight to quality” is a trend common to markets stressed by excess supply, Houston’s growing shortage of large Class A blocks and the related increases in rents imposed by landlords on upper-tier spaces have produced a contrary effect. Thus, notes Studley, Inc., “a few tenants that were in Class A space [recently] opted for Class B space when their renewals came up.” Still, the strength of demand overall has been sufficient to bring virtually equivalent rates of descent in vacancy to both the upper and lower tiers. Reis put second quarter Class A vacancy at 12.9%, down 120 basis points year-over-year; at 15.9%, the quarter-end Class B/C rate was down 90. Studley, Inc. reports 40 blocks of Class A space 50,000 square feet or larger available metrowide as of mid-year, down from 42 a quarter earlier. The same number and the same reduction are indicated by the firm for Class B/C.
SUPPLY AND DEMAND
Measured by the year, the latest recession produced only one instance of negative net absorption of office space—2009’s minus 532,000 square feet, a modest loss, moreover, compared with annual losses seen in previous downturns. Unfortunately, that year’s loss coincided with the delivery of 4.9 million square feet of new construction. While new supply volumes continued to run ahead of same-year net absorption, the latter turned positive in 2010 and remained so in 2011. That, along with a reduction in the existing inventory count by more than 1.3 million square feet in 2011, helped stabilize the market.
The year 2012, meanwhile, is expected to see the first instance of net absorption in excess of same-year new supply since 2007. With only 12,000 square feet of competitive general purpose, multi-tenant office space arriving on line, net absorption for first half 2012 ran at nearly 1.1 million square feet. That favorable number, however, conceals an internal trend—a slowdown in demand during the second quarter. Net absorption for the latter, accordingly, was counted by Reis at only 310,000 square feet. Citing a slowdown in job growth in 2012 and the evacuation of some spaces as a result of office-using job losses, Studley, Inc. reports a related 28.4% decline in leasing during the second quarter, to 3.3 million square feet, from the quarter before. Still, the slowdown does not seem a cause for concern. Reis expects about 530,000 square feet of positive net absorption for the remainder of the year. While the construction completion total expected for the same period is slightly greater (see below), the small differential does not appear to threaten the health of the market. Indeed, the advantage is expected to fall to the demand side in 2013. Indeed, notes Studley, Inc., “the region has recovered 92.2% of the 45,531 office-using jobs shed during the recession.”
“In another tell-tale sign of the region’s rebound,” explains this source, “many of the area’s primary employers in energy and engineering are once again vying with each other for top talent. Leasing or building a marquee property is another way for a company to gain a competitive edge in these recruiting efforts.” According to this Observer, moreover, eight of second quarter’s top nine leases, including the top five, were executed by energy and related companies. The total for the eight combined was approximately 870,600 square feet (see Submarkets for more information).
Factoring in the growing shortage of attractive large spaces and the general strength of the energy business sector, the increase in construction activity now seen is not surprising. Competition among tenants for the diminishing quantity of large blocks of quality space is a major factor in the increase in construction. Developers are “running to get new properties up and running,” remarks Studley, Inc. Reis’ mid-August 2012 report on individual projects cites four competitive general purpose buildings with a combined total of 437,000 square feet as the 2012 completion total (one, with 12,000 square feet, had delivered year to date). Five such projects with a combined total of 1.1 million square feet, meanwhile, were underway per report date for delivery in 2013. Others still in planning stages could join them. Indeed, two with a combined total of 360,200 square feet are scheduled to start by the end of the year. And the 546,000 square foot Energy Center III project scheduled to break ground in the Energy Corridor this September currently is assigned a September 2014 completion date (see Submarkets).
Although the recovery of the market following the recession has been decisive, rent growth has not matched that seen in previous periods of market strength. Lingering issues in the post-recessionary economy and tenant base, as suggested by Studley, Inc., may be factors in Houston’s relatively moderate post-recession rent growth. At $24.51 psf and $20.62 psf, asking and effective averages for the second quarter were up 0.3% each from the quarter before and were up 1.0% and 1.3% since year-end—in the wake of gains of 2.0% and 2.4% in 2011. Continuing moderate growth is expected for the remainder of the year. At $29.30 psf and $18.94, second quarter Class A and B/C asking averages were up 1.2% and 0.7% for the first half of the year.
“The delta in rents between the classes has spread enough that many tenants facing sticker shock are opting for the value-play of Class B offerings,” reports Studley, Inc. “This is most apparent in the Central Business District (CBD) where landlords have reigned in concessions and aggressively ratcheted up rents.” Indeed, the general shift in favor of the landlord should continue as owners continued to pare back concessions. Tenants prepared to make short-term commitments “continue to have leverage,” observes Jones Lang LaSalle in its second quarter report on the local market, “but the window of opportunity to secure attractive long term rental rates and quality space will soon begin to close.”