Anya Marmuscak, JLL
It’s safe to say that the recent drastic drop in oil prices is a hot topic everywhere, and it certainly dominates the discussion in Houston real estate.
As we read market predictions of how long it will take for the price of oil to rebound and the impact it will have on the economy, we must try to predict on a micro level what the consequence will be to tenants and landlords.
With the price of oil below $50 per barrel and still declining, it is understandable why the uncertainty of the market is causing many tenants to put their space requirements on hold or reconsider their occupancy plans altogether.
Despite the Greater Houston Partnership’s projection for 63,000 new jobs to be added in Houston in 2015 and the countless construction cranes that can be seen all over the city, the daily announcements of layoffs, reduced capital expenditure plans and mergers leave considerable room for doubt and uncertainty about the market.
Although the Houston economy is more diverse today than it was 30 years ago, a strong correlation between the price of oil and office rental rates remains. The Houston employment and real estate market will, however, benefit from its experience during the oil price collapse in the 1980s and the more recent collapse in 2008.
Developers and banks are now more sensitive to overbuilding, and many companies, especially energy companies, learned that hasty layoffs resulted in a struggle to rehire the best talent once the price of oil recovered. However, if the decline continues or prices remain below $50 per barrel for more than 12 months, we should expect demand for space to weaken and many tenants to postpone their real estate decisions or put space on the market for sublease. In response, some landlords will be forced to take action to keep their buildings leased and remain profitable.
Rental Rates to Soften
But, how long of a lag will there be to see a change in landlords’ positions? Which landlords will respond first? How aggressive will those responses and concessions be? Based on the decline in activity we have seen during the past 90 days, we anticipate rental rates in the overall Houston market have already begun to plateau and will continue to soften, after experiencing several years of compounded growth.
Rental rates in active submarkets including West Houston and the Galleria have seen strong cumulative growth during the past two years, and landlords are accustomed to that growth. Many landlords will be resistant to concede and will try to withstand the pressure to lower rents.
The landlords that do make concessions will look to various factors including the submarket location, the cost basis and capitalization of the building, the vacancy rate of the building, the tenant composition and the lease expirations.
For example, in a submarket such as the Galleria/West Loop where the direct vacancy rate is a low 7.2 percent and there is a little more than a million square feet under construction (600,000 square feet is preleased to BHP), there is less likelihood of discounts from landlords.
In contrast, the Katy Freeway/Energy Corridor submarket, which has experienced record levels of absorption during the past two years with more than one million square feet absorbed in both 2012 and 2013, is primarily driven by tenants in energy-related businesses and may be impacted differently.
While this submarket has a very low direct vacancy rate of 6 percent, it has almost 6 million square feet under construction, which represents a 33 percent increase in inventory. During the fourth quarter of 2014, the submarket saw the lowest net absorption it had seen in any of the past 14 quarters. Perhaps the 2014 demand had already been satisfied, or this pause represents the beginning of a shift in the market.
Trimming Space.
We expect that the current market uncertainty will cause tenants to react in various ways as well.
Some tenants see the oil price decline and expect landlords to immediately reduce rental rates, similar to the drop in price at the gas pump. These tenants may decide to enter the market seeking aggressive landlords and the first responders.
However, if the market truly begins to shift in the tenants’ favor, we will see a number of savvy tenants reviewing their current leases and pursuing opportunities to renegotiate early or relocate to more desirable space at a lower cost.
Other tenants, unsure of how their businesses will be impacted or what their future space needs will be, may decide to withdraw from the market, wait to enter the market or only make short-term extensions.
It is important to note that the price of oil will not be the sole factor that could change the dynamics of the Houston real estate market and what will happen in 2015. We often see more tenants abandoning private offices and embracing open plan and collaborative work environments.
Even law firms have cut their space requirements considerably by reducing the size of private offices and by increasing their support staff ratios. Companies’ greater dependence on digital files, telecommuting and IT networking capabilities, which have improved the efficiency of their businesses, have also allowed them to trim space.
The combined effect of tenants integrating these modern workplace strategies and the impact of the current economy on their businesses could create a bigger swing than initially anticipated by the market. As real estate professionals, our experience during previous oil price swings and our market research enables us to better advise our clients and help them develop plans and strategies to react to changes in the market.
While we can’t control how the market reacts, we can anticipate the changes and help our clients exploit opportunities.
Now is not the time to sit back and wait, and as Roger Staubach says, “There are no traffic jams along the extra mile.”