Market Conditions Continue Gradual Shift in the Office Tenant’s Favor
Houston’s office market once again posted anemic market indicators at midyear, including negative net absorption, rising vacancy and decreasing rental rates for all property classes. Although there were no dramatic decreases in any one indicator, the consistent decline – and in some instances, consecutive quarterly decreases (as with rental rates) – since late 2008, continued to weigh heavily on the market. Citywide, negative net absorption of 316,519 SF in the second quarter canceled out the first quarter gains, bringing the year-to-date total to negative 116,498 SF. In keeping with double digit vacancy, CBD Class B properties reported the largest rental rate decrease of 16.0% in the second quarter to $22.95/SF from $27.32/SF one year ago. In contrast, CBD Class A properties have shown remarkable resiliency with occupancy levels above the mark through the second quarter, although landlords still lowered rental rates by 7.5% to $35.86/SF in the second quarter.
Looking forward, several key events this year are contributing to a cautious outlook for the local office market over the next 6 to 12 months. The announced merger between Houston-based Continental Airlines and Chicago-based United Airlines expected to close by year end is likely to result in local corporate positions being transferred to Chicago headquarters. In the suburbs, the end of NASA’s space shuttle program and debate among the Obama administration and Congressional leaders over the direction of the space program are also a concern. Some layoffs are expected by major employers in the NASA-Clear Lake area, all though maybe not on the same scale as once feared. On a larger scale, the moratorium on offshore drilling in response to the BP rig explosion and ongoing oil spill in the Gulf of Mexico is also likely to have some negative affect on local energy firms who represent a significant component of the local office market tenant base. The moratorium has affected 18 firms active with deepwater rigs in the Gulf and 16 of those firms have a significant presence in Houston. The consensus opinion is that when drilling resumes, the industry will operate under stricter regulations, new economics and closer federal government oversight. While the long-term effects of each of these events remain to be seen, a primary concern is that they represent the potential loss of office employment for the Houston area.
Despite these challenges, Houston continues to be recognized as one of the strongest metros in the U.S. for business activity, with the employment sector reporting marked improvement from this time last year. In the twelve-months ending in May 2010, Houston’s job losses totaled 22,000, significantly below the 100,000 jobs lost in 2009, with the local MSA projected to end 2010 with positive job growth.
Occupancy & Availability
Houston’s office occupancy continued falling at midyear with the citywide average for all property classes at 83.5% in the second quarter, compared to 84.9% in the same quarter last year. With the exception of suburban Class B properties, occupancy levels citywide have decreased at a slow measured pace over the past year.
In the CBD, Class A office occupancy fell to 91.0% from 91.6% one year ago. The downtwn top-tier properties’ ability to maintain single-digit vacancy stood in sharp contrast to the CBD Class B occupancy at 77.2% (or 22.8% vacancy), down from 78.0% twelve months earlier.
Double digit vacancy continued for all suburban property classes at midyear. Suburban Class A occupancy fell to 80.4% (or 19.6% vacancy) at the end of the second quarter from 84.5% one year ago, marking the largest occupancy decrease citywide. Suburban Class B occupancy fell a more modest 0.1% to 83.7% from 83.8% during the same period.
Citywide, a total of 60 office properties had 100,000 SF or more available for lease in both direct and sublease space – with almost half of these (27) listing 200,000+ SF of available space – at the end of the second quarter. Sublease space on the market totaled 4 6M SF including 2 1M SF of vacant space and an additional 2.5M SF of subleases available for occupancy over the next 12 months. The largest sublease space being marketed is located downtown in the RRI Energy Plaza building (1000 Main, CBD) where 432,862 SF is available for occupancy in October 2010 (through October 2018). Outside the CBD, Williams Tower (2800 Post Oak Boulevard, Galleria) posted 127,464 SF for sublease, including 71,000 SF of contiguous space.
Absorption and Demand
Houston recorded negative net absorption of 316 519 SF in the second quarter 2010, compared to 471,229 SF negative net absorption in the same quarter last year. Positive net absorption for the first quarter was revised down to 200,021 SF bringing the year-to-date total negative net absorption to 116,498 SF. CBD Class A product continued to be the hardest hit sector with year-to-date negative net absorption of 241,856 SF, followed by suburban Class A with negative net absorption at 137,788 SF through the second quarter. In contrast, suburban Class B and Class C have managed to maintain modest positive net absorption year-to-date with 212,978 SF and 83,993 SF, respectively. Prevailing economic uncertainty is likely to continue negatively impacting overall absorption levels through the end of 2010.
Office rental rates for all property classes continued to decrease on a year-over-year basis through the end of the second quarter, with CBD Class A and Class B buildings bearing the brunt of the economic slowdown. While tenants shopped for the best lease terms citywide, landlords increased lease concessions, including free rent and generous tenant improvement packages.
On a year-over-year basis, CBD Class A average quoted rental rates fell 7.5% to $35.86/SF (from $38.78), while suburban Class A rental rates decreased 0.9% to $27.35/SF (from $27.59). CBD Class B average quoted rental rates posted the largest decrease of 16.0% to $22.95 per SF (from $27.32), while suburban Class B rates fell 2.9% to $17.95 per SF (from $18.48) on a full-service basis. With supply outpacing demand for office space, the office market is expected to continue its gradual shift in the tenant’s favor that began in the first quarter of 2009, through the end of the year.
Investment sales activity in the second quarter marked an improvement over the first quarter, with better quality buildings trading at levels not seen since the credit crisis began in late 2008 and transaction activity came to an abrupt halt. Year-to-date through the second quarter, office transactions totaled 29 with a total dollar volume of $376M, averaging $92/SF with a 8.2% capitalization rate.
Among the most significant transactions closed in the second quarter were:
- Wells REIT II acquired the 332,000 SF Energy Center I from Trammell Crow Company for $94M ($283/SF). Located in the Energy Corridor, the building was completed in 2008 and at time of sale was 100% leased to Foster Wheeler USA.
- Beacon Investment Properties acquired the 162,909-SF One Park Ten Plaza from Parkway Properties for $15.7M or $96/SF. In a separate transaction Beacon acquired the 139,834 SF Atrium at Park Ten from KBS Realty for $14.9M or $106/SF. Both properties are located in the Energy Corridor.
- Victory Realty Solutions acquired the 101,880-SF office building located at 5850 San Felipe from American Spectrum for $10.5M or $103/SF. The property was 92.3% leased at time of sale.
Houston’s office leasing activity reached 2.5 million SF in the second quarter, compared to 3.3 million SF in the same quarter last year. Although still below levels before the recession, an increasing number of office tenants are renewing lease commitments with better concession packages or relocating to buildings and/or submarkets offering more attractive terms.
Significant non-renewal office leases signed in the second quarter included: U.S. General Services Administration’s 132,896-SF lease at Wells Fargo Plaza (CBD); Aon’s 46,796-SF lease at Marathon Oil Tower (Galleria), relocating from Four Oaks Place (Galleria); Sutherland Asbill & Brennan’s 41,410-SF lease at First City Tower (CBD); Praxair’s 32,984-SF lease at The Reserve at Sierra Pines (The Woodlands); Houston Area Community Services’ 32,960-SF lease at Brooktree Office Building (Northwest); Petrohawk Energy’s 24,727-SF lease at Wells Fargo Plaza (CBD) and Ensco Offshore Company’s 20,717-SF lease at Two Park Ten Place (Energy Corridor).
Among the largest office lease renewals signed in the second quarter was SUEZ Energy’s 130,846-SF renewal of 130,846-SF at Post Oak Central Three (Galleria).
Office Development Pipeline
Houston’s development activity remained slow at midyear, with only 2.2M SF under construction year-to-date. Two new CBD office projects – Hines’ 972,474-SF Main Place (slated for delivery by February 2011) and Trammell Crow Company’s Hess Tower (formerly Discovery Tower, continue to be the sole high-profile buildings under construction at the end of the second quarter. Notably, both downtown projects began construction before the economic downturn of late 2008. Even under less than ideal market conditions for office development, however, a few developers have ventured to introduce new product in high-growth suburban markets, including two projects in the E. Fort Bend County-Sugar Land submarket: Midway Companies’ 152,619-SF Eco Center at Lake Pointe (scheduled for completion by January 2011) and Newland Communities’ 40,000-SF The Exchange at Telfair (expected by year end 2010). Other key suburban projects include Greenwood Corporation’s 156,000-SF Chasewood Crossing II in the FM 1960-Highway 249 submarket (scheduled for completion in April 2011), as well as Black Forest Ventures’ 70,000-SF Black Forest Park, located in The Woodlands submarket.