Texas Office Owners: Sell or Hold?

by Taylor Williams

While rumors of a looming recession dot the mainstream media landscape and pervade conversations at bars and water coolers, Dallas-Fort Worth (DFW) and Austin are humming along with the kind of healthy job growth that reduces that talk to little more than a whisper. 

Growth in office-using sectors like tech, finance, engineering and business services in both the state’s capital and largest metropolis continues to fuel demand for space, push rents to new levels and drive price  appreciation on office assets.

According to CoStar Group, the Dallas area has added about 90,000 new jobs over the last 12 months, and currently boasts a 3.4 percent unemployment rate, which is lower than both the state and national averages. And based on the most current data from the Austin Chamber of Commerce, payrolls in the state capital grew by about 23,000 between June 2018 and June 2019, while unemployment currently sits below 3 percent.

While strong population growth is enough to jumpstart development and absorption in the multifamily, industrial and retail sectors, it’s pure job growth that drives the office space.

So it’s not a bad time to be an owner of core properties in desirable submarkets in both cities. But these owners  face tough decisions on whether to quit while they’re ahead or let it ride.

DFW: Time to Sell

Although the economies of both markets are almost certainly diverse enough to weather a recession, office owners in DFW and Austin are approaching their respective investment markets in opposite manners.

Investment demand for trophy office assets is strong in both markets, but particularly in DFW, where more listings are hitting the market after a period of relative calm. CoStar recently reported that more than 1,000 properties were listed for sale as of mid-October, a five-year high. In addition, the average asking price across all office assets in the metroplex has risen by 12 percent in 2019, eclipsing the mark of $170 per square foot.

Demand from foreign capital sources that see the metroplex as an insulated market with exceptional economic diversity has contributed to this demand, as has a sustained environment of low interest rates. Price escalations in markets like New York and San Francisco have also pushed more investors in search of better yields away from those areas and toward markets like DFW, which has become a magnet for corporate relocations and regional workforce consolidations.

Many of the relocation/consolidation deals in DFW, which run the gamut of industries from pharmaceutical giants like McKesson Corp. to consumer service providers like FedEx, come with a prerequisite for quality space. With the biggest users targeting the finest office buildings, deal velocity and price appreciation in the Class A submarket have become especially robust.

“Because DFW was a secondary market for many years, it had a lot of runway in terms of rent growth and compression of Class A cap rates,” says Brett Merz, senior vice president and asset manager at California-based investment firm KBS. “Two years ago, a price north of $500 per square foot was a big deal; now you’ve got trophy assets like 1900 Pearl and The Union that are trading for record highs of $700 per foot.”

Merz adds that although there is a healthy volume of office product on the market, buyer depth is not as strong as it was earlier in the cycle. Yet real estate investment in DFW as a whole remains a very capital-rich playing space. As such, the smaller buyer pool — even when paired with investor concerns about slower economic growth on the horizon — has not really impacted pricing.

Examples of Class A office assets in the metroplex that have traded recently include Fourteen555, a 250,000-square-foot building in north Dallas that was purchased by New York-based Admiral Capital Group; Citymark at Katy Trail, a 226,000-square-foot property that was acquired by local investment firm Harwood International; and Legacy Place, a 300,000-square-foot complex in Plano that was bought by Pennsylvania-based Equus Capital Partners.

Austin: Know When to Hold

In Austin, deal velocity has been slower. Landlords are largely asking themselves if it’s worth holding their assets to see how much higher the rent and price escalation can go, or if they should sell before the handful of recession indicators become a reality.

“As hot as the Austin market is, there haven’t been a ton of trades because owners are holding and watching rents go up a little bit every month,” says Gio Cordoves, also a senior vice president and asset manager at KBS. “That’s the kind of growth you’re seeing right now, and investors are curious to see how far it can go.”

Office rents in the state capital have accelerated more in a shorter time than in virtually any major market in the country, which is working to keep potential sellers on the sidelines. Per CoStar, average market rents for Austin office properties have risen by nearly 54 percent over the past decade, ascending from $24.22 per square foot in 2009 to $37.29 per square foot in 2018.

Brandywine Realty Trust is developing a 150,000-square-foot office building in Austin’s Garza Ranch development in response to the market’s rampant job and rent growth.

Cordoves, whose firm is active in all of Texas’ major office investment markets, notes that vacancy is tight in Austin — below 10 percent overall and below 6 percent in top submarkets like the CBD and the Domain/North, according to CoStar. But the slow pace at which new development proceeds in Austin is hindering the amount of new supply that’s needed to meet demand, which bodes well for landlords.

“There’s not a ton of deals out there, but the ones out there are wildly competitive,” says Cordoves. “Investors that traditionally didn’t target Austin are now drawn to the city’s tech sector and labor supply and are looking for those newly built, buttoned-up deals. As a result, that space has become very competitive and priced up.”

But while core office product in Austin continues to attract plenty of buyer interest, owners just don’t have the motivation to sell en masse right now. Not only is a basic fear of missing out on further rent increases at play in the psyches of office landlords, but there’s also an uncertainty of where to re-allocate proceeds from sales, given that a comparable trade would come at quite a steep price.

Houston: Investors Target Trophy, Value-Add Assets

The Bayou City’s office market as a whole continues to feel the strain of depressed energy prices, with overall vacancy still deep in the double digits. However, CoStar Group notes that despite sustained volatility in the oil and gas markets, the Houston area still added approximately 82,000 new jobs between August 2018 and 2019 — a sign that the market is becoming more economically diverse.

But much like DFW and Austin, core properties in select submarkets of Houston are performing well as larger tenants continue to target high-quality spaces in a perpetual effort to recruit and retain top talent.

“There’s a major flight to quality across Houston, not just in terms of the age and construction of the building, but also the location,” says Rick Goings, vice president of JLL’s Capital Markets Group. “Well-located Class A and B buildings continue to draw tons of interest, and pricing on these assets hasn’t gone down. We’re seeing sub-6 percent cap rates on the best-located, newly constructed buildings.”

John Dailey, executive vice president and managing director of investments at Madison Marquette, also sees a relatively stable investment market for core assets in Houston, as well as a growing value-add segment that is coming to define the market during the oil downturn and recovery.

“This the biggest flight-to-quality market we’ve seen, any just about every deal we do for a core property is sold at above-replacement costs and often breaks a record,” he says. “But those are for properties that are leased up and can survive from cycle to cycle. In the value-add space, there just aren’t enough properties on the market to quench investors’ appetite.”

Goings adds that in Houston, private equity firms have emerged as leading buyers, and many are targeting value-add deals. Houston continues to offer an exceptional supply of 1980s-construction office buildings that are in need of a facelift, a full renovation or something in between.

“There’s more value-add capital in the market today than we’ve ever seen, and those deals are fiercely competitive,” says Goings. “Any property that is less than 80 or 85 percent leased, needs some capital and can be purchased at a discount to replacement cost is drawing strong competition, especially if it’s a well-located building with good bones.”

The healthy volume of value-add capital is one of the Houston office market’s strongest attributes, sources agree, because it reflects investors’ belief that the overall economy is moving in the right direction and that there’s ample runway left for rental rate growth in the coming years.

Dailey notes that the growth of Houston’s value-add market has created a variety of sub-types of deals within the space. While the city has its share of buildings that are struggling to maintain occupancy and need repositioning, the prices on some of these deals are preventing value-add buyers from hitting the returns they need.

“Value-add buyers need higher yields because we take on greater risk,” says Dailey. “To make our yields, we have to reposition. There’s a limited number of sellers and a lot of capital chasing the deals that are out there, so we’ve seen core buyers buying core-plus assets and core-plus buyers buy value-add properties.”

— By Taylor Williams. This article first appeared in the November 2019 issue of Texas Real Estate Business magazine. 

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