Houston Office Market Returns to Positive Net Absorption in Q3
Key Takeaways for the Houston Office Market
- Net absorption turns positive
- Office vacancy rate stable
- Sublease space up but still low
- Leasing volume dips
Houston Office Market Highlight
Although Houston’s office market returned to positive net absorption gains of 64,110 SF during the third quarter, leasing volume dipped along with rents. As firms occupy their new smaller offices, net negatives brought the overall absorption totals down. Fluor occupied its new 308,186 SF in Three Eldridge, with its former 1.2M SF in Sugar Land left vacant and being redeveloped. The overall average vacancy rate remained steady at 26.8%, up from 26.4% year-over-year.
Leasing activity declined to 2.2M SF, a 16.3% drop year-over-year. The Central Business District (CBD) contributed 15.5% of the third quarter’s total activity with notable leases including 65,909 SF at 708 Main and two separate deals totaling 106,913 SF at 845 Texas. Both the Katy Freeway West/Energy Corridor and The Woodlands submarkets each represented 14.4% of the quarter’s leasing activity while the West Loop reported 9.3%; these four submarkets represented 53.6% of the total leasing activity for the third quarter.
The construction pipeline remains limited, with only three buildings totaling 597,410 SF under construction. Vitol fully leased the 146,000-SF building that broke ground during the third quarter in The RO, a new mixed-use development. No new properties were delivered during the third quarter. Class A rental rates at $36.36 PSF decreased slightly from the previous quarter but increased marginally from the same period last year. The overall average gross rental rate declined slightly to $30.42 PSF from the previous quarter’s $30.48
Net absorption rebounded to overall positive gains during the third quarter, despite seeing large net losses in specific submarkets as larger spaces were returned to the market. New supply has been limited but continues to be the choice for those seeking quality space while overall leasing activity experienced a slowdown.
The overall vacancy rate has remained steady the last five quarters and will likely continue that trend or increase slightly as tenants occupy their new downsized offices and leave larger spaces vacant. Sublease space showed a marginal increase quarter-to-quarter but has declined from the same period last year.
Executive Summary
Rising construction costs are creating more of an impact on leasing expenses for tenants looking to design and build attractive and functional office spaces.
A recent Construction Pricing Index based on metrics from the Bureau of Labor Statistics provided monthly and year-over-year trends on construction material pricing. Compiled by Houston-based construction firm O’Donnell/Snider Construction, the index also compared material pricing between today and pre-COVID levels. One key takeaway: although construction material prices have dropped from their peak (which was 60% higher in May 2022), they are still about 43% higher than in January 2020.
Consequently, Tenant Improvement Allowances (TIs or TIAs) – the money landlords provide to tenants for office-space buildout — are becoming a focal point during lease negotiations. Business owners continue to prioritize enhancing the office environment to attract employees back to the workplace.
The common practice for tenants to cover the difference between the landlord-provided TIAs and their desired scope could be changing due to rising costs and economic uncertainties. Some tenants are becoming reluctant in deploying capital towards buildout, eventually looking to landlords to shoulder the difference.
Historically, landlords have offered sizeable TI packages to remain competitive in attracting and retaining tenants, creating an expectation that landlords will provide a significant portion, if not all, buildout expenses. Yet, persistent inflationary pricing has banks and financial institutions tightening their lending criteria amid economic uncertainty, leading to reduced liquidity and fewer options for landlords seeking to fund buildouts. This situation is compounded by elevated interest rates, making borrowing even more expensive.
In summary, the 43% increase in construction materials costs, compared to pre-pandemic levels, is creating a challenging landscape for landlords, who are facing financial constraints while still needing to fund tenant demands to remain competitive and sustain their portfolios.
Despite these ongoing economic challenges, both tenants and landlords need to explore collaborative solutions to bridge the gap. Strategies such as maximizing the overall lease terms or agreeing to more standardized buildout designs can create both mutual benefits and shared costs.
Ultimately, the key lies in prioritizing an open dialogue so both landlords and tenants can successfully navigate the complexities of the current market and find innovative ways to create more attractive and viable office spaces.
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