Texas Office Markets: Who’s Hot, Who’s Not
From Dallas-Fort Worth’s (DFW) explosive rate of corporate relocations and expansions to Houston’s reliance on oil prices to Austin’s strong supply of tech talent, there’s very little common ground among the office sectors of Texas’ biggest cities.
And whereas the pace of sales, development and absorption for certain property types — industrial, multifamily, self-storage — are strong across DFW, Houston, Austin and San Antonio, it’s the office sectors of these metros that truly capture their differences.
The office markets of the Lone Star State’s four major metros each have a different story to tell — a narrative that speaks to their core demand drivers, as well as their projected performances for the rest of the year. In this piece, we take a closer look at the crucial factors underlying each of the Big Four’s office markets.
DFW: Slowing But Stable
The DFW office market isn’t as hot as its multifamily or industrial sectors, which are seeing record volumes of new construction and absorption, respectively. But the metro’s ability to create 100,000-plus jobs per year ensures that its strong office fundamentals can be maintained.
The metro posted year-over-year rent growth of 2.2 percent, according to CoStar Group, right on par with the national average. In addition, leasing velocity in DFW remains well above the rest of the country
The 14.8 percent vacancy rate, per CoStar, could be the problematic metric to watch. This level of vacancy can be primarily attributed to a shift in leasing activity away from stabilized, multi-tenant properties and toward newer build-to-suit assets.
As most build-to-suit product is Class A, this trend has pushed vacancies in Class B buildings upward. True, vacancy for Class A product is about 170 basis points higher than vacancy for Class B product, but there is approximately 10 times as much Class A construction underway relative to Class B. In most markets, this activity would constitute cause for concerns of oversupply.
Not so much for DFW, says Mike Ebbitt, an associate at Lee & Associates’ DFW office, who notes that market saturation is not a major concern for DFW’s office sector. This sense of security stems from DFW’s 3.1 percent unemployment rate, nearly a full percentage point below the national average.
“It all comes back to DFW’s economy,” says Ebbitt. “Office-using employment growth continues to create a need for more office space. Our unemployment rate continues to outperform the national average and pricing levels for office product remain quite reasonable compared to other markets of this size.”
All told, office vacancy in DFW is about 500 basis points above the national average, according to CoStar. With the flight to quality assets in northern submarkets like Plano, McKinney and Frisco, vacancy in the Dallas CBD has spiraled to 23.7 percent.
These market-specific forces have wielded some influence on the rising vacancy rate in DFW, but Ebbitt says the metric also reflects a national move toward more efficient office spaces.
“Companies are focusing on densification and space efficiency to save on costs and accommodate the constant changes in how people work,” he says. “At the same time, firms must reinvest in workplace enhancements to attract and retain employees. There appears to be a challenge in balancing both.”
Ebbitt adds that 2018 should be a year in which the pace of construction slows and the market absorbs space vacated by corporate relocations. Roughly half of the 9 million square feet of office product under construction is slated to be delivered during the first half of the year, according to CoStar.
Combined, the move toward higher office density and the slowdown in new construction should help the market achieve more balance over the year.
Houston: Vast Vacancies
Houston’s office market, which has delivered more than 5 million square feet of new space per year during the current cycle, entered 2018 riding a streak of 11 consecutive quarters of negative absorption. While some of the 2017 vacancy can be attributed to Hurricane Harvey, the reality is that oil prices didn’t rebound as aggressively as expected in 2017.
The price of crude oil, which was hovering around $65 per barrel at the time of this writing, rose by approximately $5 barrel in January. But there was no such luck in 2017, with concerns of oversupply and availability of cheap energy substitutes keeping price levels in check.
This activity impacted the bottom lines of oil and gas firms and precluded the possibility of a major surge of new hires. The result was overall negative net absorption of 1.4 million square feet of office space throughout 2017, according to CoStar. Houston’s overall vacancy rate closed the year at 16.4 percent, its highest level of the cycle, with vacancy of Class A product exceeding 18 percent.
The climbing vacancy rate has become the linchpin of the overall market — the factor having the strongest domino effect on sales volume and lending for new projects.
“Without question, the biggest point of concern for the market in 2018 is the sheer amount of vacancy, including the lack of high-quality subleases,” says Paul Frazier, a former executive at Brookfield Properties and the current director of the office division at Houston-based Hicks Ventures.
Though rent growth in the Houston office market nearly broke even by the end of 2017, it still remains nearly 300 basis points below the national average. Consequently, average cap rates on Houston office assets are trending upward and currently approaching the 7 percent range. Perhaps even more distressing for office landlords is the average vacancy of an office property at the time of sale, which sits at 25 percent, per CoStar.
These trends beg the question: Has the market finally hit rock bottom? According to Frazier, the answer is “yes.”
“With leasing activity set to increase due to more leases rolling in the next three years, very few new projects under construction and larger companies likely to take advantage of tenant-friendly prices, we’re now on an upward trajectory,” he says.
Frazier points to several external factors as positives for Houston’s office market, including the Tax Cuts and Jobs Act, which should encourage employment growth within large energy firms, as well as the metro’s growing presence in the healthcare sector.
In addition, he notes that while attaining positive net absorption this year may be too ambitious for Houston, positive net absorption is feasible in certain submarkets. These include the CBD, Greenway Plaza and the Galleria area — submarkets that house many of Houston’s trophy assets and more newly developed properties.
Several suburban submarkets, including Kingwood/Humble, Sugar Land and The Woodlands, closed 2017 with positive net absorption, though all of these submarkets have some construction that carried over into 2018.
Austin: Rampant Rents
In 2010, Austin began seeing a major influx of tech firms, including Apple and Facebook, and the youthful employees who work at them. Since that time, office rents across all classes have increased by more than 50 percent, according to CoStar. Rents for Class A spaces currently sit at about $3.40 per square foot, compared to the national average of $2.60 per square foot and are expected to grow by 3 percent this year.
But Austin is also a market in which space for new development — at least in and around the urban core, where rent growth has been the highest — is extremely tight. The metro is also known for having a slow development process stemming from archaic bureaucratic policies. Consequently, supply has continually trailed demand in the state capital during this cycle, and rent growth has never really flattened out.
Despite this healthy appreciation in rates, the volume of investment sales in office properties could decline in 2018, says Jason Steinberg, brokerage principal with Equitable Commercial Realty.
“Investors are still bullish on office assets,” he says. “But most of the buildings on the market have already traded at least once in this cycle and many owners don’t think there are enough value-add opportunities to buy.”
Steinberg qualifies that statement by adding that newer construction is likely to be marketed for sale after it is stabilized, particularly to foreign investors that don’t typically require the same rates of return as regional players.
But it’s not just the tech firms and their soaring stock prices that have driven rents in the state capital sky-high. Healthcare and engineering firms are gobbling up space quite rapidly, as are law and accounting firms and local and state government agencies.
These companies typically have the budgets to afford spaces near the urban core. But the rising rents are problematic for smaller outfits, says Steinberg.
“The biggest point of concern Austin faces for office space in 2018 is the rising cost of rent and, consequently, operating expenses,” he says. “Large companies can absorb this, but many small businesses can’t and are being forced to relocate to the suburbs or find a space that provides greater density.”
But all bets will be off if Austin lands the ultimate prize: Amazon’s second headquarters. In addition to having the tech-savvy workforce that Amazon covets, Steinberg notes that Austin already has several spaces that would work for the e-commerce giant’s HQ2.
These include IBM’s Broadmoor campus on the north side, which has the capacity for more than 8 million square feet of office space; the former Motorola/Freescape campus in East Austin, which totals more than 100 acres; and Robinson Ranch, an 8,000-acre development located on the city’s northwest side.
SA: Development Dearth
Though the Alamo City boasts an unemployment rate that is roughly 70 basis points below the national average and is in the midst of developing large amounts of multifamily and hospitality product, its office sector is still playing catch-up to DFW, Houston and Austin.
The lag is due in part to lack of development, both now and in the past. Only once in the last six years has the market delivered more than 500,000 square feet of product on a quarterly basis.
Scarcely 1 million square feet of office space is under construction at present, nearly half of which is embodied in the 450,000-square-foot Frost Tower. Envisioned as a build-to-suit property for its namesake tenant, the project is the only real Class A development in San Antonio’s CBD. Scheduled for a March 2019 completion, Frost Tower is approximately 65 percent preleased.
The shortage of development has undermined investor confidence in the space, particularly with regard to capital from institutional sources, says Marshall Davidson, managing director at Avison Young’s San Antonio office.
“Investment sales of stabilized office buildings in our market aren’t attracting institutional buyers,” says Davidson. “While we should have more options for larger spaces moving forward, those assets are still going to have high cap rates because there just aren’t as many competitors.”
Another problem arising from scant competitive office space, Davidson adds, lies in the classification system. Properties that make the cut as Class A in San Antonio can be considered Class B product in other primary markets.
“If it’s an office building in San Antonio that was built recently, it’s Class A,” says Davidson. “If it’s on the market and not functionally obsolete, it’s Class A. Institutional investors and capital providers are placing these labels on product because they want an apples-to-apples comparison between here and other markets of similar size.”
The office market may still be finding itself, but in Davidson’s view, 2018 should bring stronger sales velocity and deal volume. Rents have been steadily rising for several years and more properties are moving toward stabilization.
In addition, development of single-story and midrise office buildings in submarkets north of town has picked up. Several such projects are set to come on line this year, including the 102,699-square-foot building at 12707 Silicon Drive in Oakland Heights and the two-building, 120,000-square-foot development at 2049 Sundance Parkway near New Braunfels. Both projects are slated for completion this year.
— By Taylor Williams. This article first appeared in the April 2018 issue of Texas Real Estate Business magazine.