Houston Office Market Show Signs of Stabilizing
Key Takeaways
- Office vacancy rate stabilizes with no change
- Sublease space declines for the second consecutive quarter
- Net absorption positive for both quarters
- Leasing volume increases
Houston Highlights
Houston’s office market posted minimum net absorption of 35,777 square feet in Q2 2023, but this activity continued a positive trend for the year for a mid-year total of 240,815 square feet. The overall average vacancy rate stabilized at 22.1% for the year, dropping from 23.5% year-over-year. Leasing activity jumped 23.4% from a sluggish first quarter, recording 3.5 million square feet. The Katy Freeway submarket reported 38% of the total, although many of the largest new signed leases represent reductions in overall square footage. The under-construction pipeline remains limited at 1.8 million square feet, while three buildings totaling 227,848 square feet in two submarkets delivered during second quarter. Houston’s overall average gross rental rates nudged up to $29.87 from first quarter’s $29.73 but declined from the same period last year. Houston’s Class A average rental rate increased to $35.46 per square foot from $34.76 in Q1 2023.
Commentary
Houston’s office market continues to face challenges as we enter the sixth quarter of the new interest-rate environment. During recent earnings calls, most large investment banks reported they are sharply increasing credit loss reserves primarily due to office loan maturities through 2024. That being said, there is cautious optimism for a broad range of office assets in the Bayou City with some bright spots, some acute pain points and some economic realities being reset.
The Good
There are undeniable positive trends going on in certain submarkets in Houston. Job growth through May of this year is +18,500. Employment hit 3.4 million (an all-time high for Houston), we had positive absorption of 240,815 square feet at mid-year, vacancy for Class A space was flat quarter over quarter, and leasing activity is sharply up to 3.5 million square feet. Houston remains among the leaders in workers returning to the office, currently with Kastle Index’s highest return-to-office percentage at 61.2%. Class A assets near residential and retail centers are performing well as employers work to shorten commute times.
For stable assets with long-term creditworthy leases, there is still an appetite for new conventional debt. From a supply side, the limited speculative development is a plus with only 1.8 million square feet of space underway. Several older assets are acquiescing to their obsolete status and will eventually be taken out of the rental pool. Impairments to current CRE equity investors will present attractive opportunities during the next 24-to-36 months with transaction velocity to increase as loans mature.
The Bad
It is difficult to have attractive opportunities without pain manifesting itself on the other side of the trade. Economics are dynamic, causing distress, particularly in the Class B space. The market did not cycle while we enjoyed the prolonged low, interest-rate environment, while values inflated and created a proforma bubble on many transactions that closed in the last three years. As tenants continue to shrink their footprint and seek out the best assets in the most desired locations, we will see the cannibalism of lower-class assets for the foreseeable future.
Negative leverage is here to stay until cap rates continue their upward trend or we see a sharp decline in the cost of capital. Most prognosticators do not anticipate this happening any time soon. Liquidity concerns are also worth noting. Year-over-year, middle-market CMBS volume is off 75%, taking a primary source of liquidity off the table for office product. Banks are looking for less office exposure and are reeling in their lines to the debt funds. Life insurance companies are selectively picking their spots and declining to romance any sort of risk profile. In short, there is capital for office product, but most buildings do not qualify for the usual lending suspects. Anything maturing in the near term will have some difficult decisions to make.
The Reality
Outstanding commercial real estate debt totals $5 trillion, with $1.5 trillion secured by office product. Lenders are keeping a close eye on this, and it explains their reluctance to pursue assets they would have pursued pre-COVID. Maturities are starting to roll in as well as the problems that are tethered to them.
Remote and hybrid work are the primary drivers of the demand reduction, and they are the new norm. Operational stagflation will result in a “pushing-the-can” process with incumbent lenders versus “kicking the can.” If you are facing a
maturity default with an underperforming asset, lenders will likely assess your asset and consider an extension but expect to write an equity check if you receive one.
Landlords must adapt to the new post-COVID economic environment. Values are falling, demand for space is shrinking, and it is all happening in an era of high interest rates and tightened credit. Expect the market to remain tenant friendly through the end of the year. Sitting out and waiting for a recovery (like in 2008-2009) is not an option. Tough decisions will need to be made, and these multifaceted market conditions will require close attention, cautious optimism, and a strategic approach.
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