Rick Goings, JLL
The real estate capital markets are a funny thing — one minute you’re up and the next you’re down. The debt market starts making investors bring more equity to the table, reserves tied to energy-related tenancy are mandated, the four-letter word “recourse” is thrown around and more scrutiny is placed on every detail.
No one wants to be laughed out of a committee meeting for trying to push through a multi-million dollar loan on an office building in the Energy Capital of the World.
The same holds true in the equity market. Return requirements that fluctuate along the risk/return spectrum haven’t changed, but underwriting scrutiny has. Market rent growth has been scaled back or even gone negative, energy-related tenancy is being given a lower retention ratio or being downsized, downstream tenancy is more favorable than upstream tenancy, mark-to-market value-add strategies have been replaced with income preservation strategies, etc.
Individually, these various reactions in the debt and equity market don’t have a huge impact on values. Combined, they have a material impact. You would think that this environment would bring about great opportunities for investors with a long-term, bullish view on Houston’s office market.
Instead, most owners will be patient, electing not to sell, as they search for clarity. We are not going to see any distress — Houston’s office buildings are primarily owned by large institutional funds, private equity funds, REITs and other well-capitalized entities.
Not the 1980s
The Arab Oil Embargo in 1973 quadrupled oil prices in just three months, sparking real estate and drilling speculation that lasted a decade. Oil prices collapsed in 1982, and oil and mining jobs fell by 57 percent, leading to total job losses of nearly 222,000 by 1987. Despite negative demand indicators, Houston’s office inventory had become dramatically overbuilt.
To put it in perspective, today that would be the equivalent of Houston adding 200 million square feet of office space, while losing 450,000 jobs. Houston’s energy and real estate industries today are not what they were in the 1980s. There are higher barriers to entry, and the industries are savvier, well-capitalized, lower leveraged and more resilient.
A December 2014 Goldman Sachs report noted that the Houston economy is highly diversified, and jobs directly tied to oil extraction represent just 4.2 percent of the total. It’s estimated that 38 percent of Houston’s GDP is tied to the energy sector.
That number was 75 percent in the 1980s. The Goldman Sachs report goes on to say that, “Houston is more than just a play on oil pricing, and results from the last major price decline prove this.” The benchmark average West Texas Intermediate price in 2008 of $100 per barrel declined 38 percent to $62 per barrel in 2009. During this timeframe, Houston lost 2.9 percent fewer jobs than the U.S. average and GDP outperformed the U.S. average by 3.1 percent.
In retrospect, a lot can be learned from the last major oil price decline in 2009. At that time, the nation was in the worst economic recession since the Great Depression, and Houston was the last in and first out.
The Houston MSA lost 4.1 percent of its total non-farm employment, or just over 106,000 jobs. Houston recovered all jobs lost in less than two years. We added more than 430,000 jobs from 2010 to 2014, a compound annual growth rate of 3.25 percent, which was the best in the nation in that time frame.
Houston’s six primary office submarkets remained resilient during this time. Combined with approximately 4.5 million square feet of new office construction in 2008 and 2009, the 4.1 percent decrease in total employment in 2009 contributed to the primary submarkets’ first year of negative net absorption since 2003, taking Class A and B occupancy from a high of 92 percent (2008) down to a still-healthy 88 percent in 2010.
In the five years since, nearly 11 million square feet of office space has been absorbed in spite of 7.7 million square feet of new deliveries coming onboard. This equates to approximately 2.2 million square feet of positive net absorption per year, and overall Class A and B occupancy ended 2014 at approximately 92 percent in the primary submarkets.
Sublease Market Effect
When the economy is in question, all eyes are on the sublease market. Throughout this energy cycle, there will be a lot of different stats thrown around by people questioning the Houston office market’s stability. Approximately 2.7 million square feet of sublease space has been added to the supply since to the beginning of 2015, and this sublease space is primarily concentrated in the central business district (35 percent) and west Houston (Energy Corridor with 26 percent and Westchase with 15 percent).
Landlords, however, are still faring well. Nearly all of that sublease space is coming from tenants with investment-grade or otherwise high-quality credit profiles. This sublease space includes several global oil and gas companies. Combined, the 2.7 million square feet of sublease space that has been added to the market has a weighted average remaining lease term of nearly six years, and every building with one of these sublease spaces is more than 85 percent leased.
Generally speaking, this means that these landlords don’t have to be concerned about existing vacancy competing with sublease space since their buildings are substantially leased. Additionally, these buildings have six years, on average, before having to worry about whether their tenant or subtenant will vacate the premises.
By that time, the space may be backfilled by another company that will want to sign a direct deal with the landlord, or the sublessor may once again need the space due to changing market conditions. Moreover, the overall Houston office market vacancy is still a very healthy 12.7 percent, up from 11 percent at the end of 2014.
The effects of the sublease market are somewhat exaggerated, but not entirely unfounded. Rent growth in the hardest hit submarkets will flatten out or go negative, and the older, less competitive buildings within these markets won’t automatically follow the success of the Class A buildings like they have in recent memory. Instead, they’ll have to offer increased concessions to attract and retain quality tenants.
The interesting statistic to watch for isn’t how much sublease space is on the market right now, it’s how much of that sublease space gets absorbed. As that begins to happen, there will be an uptick in market vacancy and a more abrupt reduction in rental rates. The energy commodity market will always be volatile.
Houston is well diversified, but there is no debating that we are closely tied to the energy industry. Companies will cut spending and downsize in the short-term, but the demand for energy, and with it, the demand for Houston office product, will remain. Today, the office investment market slowdown is a result of market perception taking precedent over market fundamentals.
— By Rick Goings, capital markets associate, JLL. This article originally appeared in the May 2015 issue of Texas Real Estate Business magazine.