Houston: A Tale of Two Office Markets

by CoyDavidson on November 13, 2010

The Flight to Quality

Houston has proven to be one of the more resilient office markets in the United States and the pain inflicted by the “Great Recession” has been much less severe than many major market around the country. That being said, Houston has not been immune to the impact of the most recent recessionary economic cycle.

At the end of the third quarter, year-over-year Class A Rental asking rental rates dropped 2.0 percent in the CBD to $35.16 psf, while while suburban Class A space decreased a minimal 0.2 percent to $27.30 per square foot. Year-to-date, Houston city-wide, has recorded negative 311,225 square feet of net absorption, after recording 1.1 million square feet of negative absorption in 2009.

Despite slow leasing activity overall, there is a positive attitude from landlords of top tier assets based on completed transactions and an increased deal flow, that an improving economy, albeit slowly is pushing many tenants past the stage of indecision and into action. One of the more encouraging signs that we are seeing with our clients is the move to quality assets and ownership. The concept of “flight to quality” whereby tenants with lease expirations in a challenging economic climate are able to leverage deflating asking rents and liberal leasing incentives into more premium office space under a cost structure equivalent to what they were previously paying.

The evidence of the flight to quality is two-fold, as we are seeing tenants move from Class B projects to Class A, as well as tenants who were previously in older Class A project move to the newer Class A projects coming on-line, or that have been completed in the last couple of years.

Bifurcated Market

This trend of flight to quality creates somewhat of a bifurcated market forcing landlords of the lower quality space to slash their asking rents significantly and offering substantial periods free rent in a scramble for tenants. With, positive net absorption yet to appear, it is simply a case of musical chairs in an attempt to increase occupancy levels.

High Quality Landlords have an Distinct Advantage in this Economic Climate

The flight to quality also applies to the quality of the building ownership.  What I term as a high-quality Landlord relates to a healthy financial position for the building owner, as well as superior property management. The benefit of having a quality landlord is important, as they have the adequate capital to weather the current economic cycle, maintain the building properly, as well as fund the tenant improvement obligations of  lease transactions.

Credit is King

In Houston, the downward pressure on Class A rental rates while noticeable has not been severe. We are seeing more liberal concession packages and a more creative deal making perspective from most landlords, especially for credit-worthy tenants. This is seen in longer term leases with healthy tenant finish allowances, abated parking charges and a tenant motivated to lease space that provides a high quality work environment for their employees.

“Flight to Quality” Extends to the Investment Market

The general perception that the higher quality assets are performing better extends to sales activity as well. Nationally, we are seeing investment capital flow into Class A, urban core office in gateway cities, as this is perceived as the next market segment to improve substantially. Cities most often mentioned included New York, Washington DC, Boston, San Francisco, Los Angeles, and (to a lesser extent) Dallas and Houston. The recent report that Brookfield Office Properties is under contract to purchase the 1.2 million square foot Heritage Plaza in downtown Houston, at a price of $285 per square foot is evidence of this in our own backyard. In Houston, the CBD, Galleria, Greenway Plaza and the Energy Corridor are generally considered “core submarkets”.

I believe the Houston market will continue to soften somewhat until more robust job growth returns, but the window of opportunity to “trade up” to higher quality office assets at a perceived value will be the first to close, particularly for larger tenants. How soon, is the ultimate question.

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