Mention Houston real estate to an out-of-towner and chances are they’ll ask about empty office buildings in the world’s energy capital. But while the Space City’s office market continues to struggle and there is significant sublease space available, things are not as dire as others would have you believe. To find out some of the bright spots in Houston’s office market, Realty News Report talked with Kevin Roberts, President, Southwest Executive Leadership at Transwestern. Kevin has overall responsibility for Transwestern’s Southwest operations, which includes Houston, Austin, San Antonio, New Orleans, Denver and Salt Lake City. At Transwestern, Kevin oversees the firm’s brokerage services and property management projects across the Southwest. He also serves on Transwestern’s Board of Directors and Executive Committee.
Realty News Report: Houston’s office vacancy is at its highest point since the 1990s and the supply of sublease space remains high by historical standards. At midyear 2017, how would you describe the state of Houston’s office market?
Kevin Roberts: Transwestern’s view is that we are nearing the bottom of the market and logically certain submarkets are in a better position for recovery than others. The full impact of the sublease space is yet to be seen, but is a significant market factor. Consider the west Houston market where almost 54 percent of available sublease space has a term of 3 years or less and is essentially direct space requiring the landlord to fund tenant improvements, commissions and absorb the impact of free rent. This will likely put additional downward pressure on rental rates and force landlords to sweeten concession packages. Some submarkets with large blocks of sublease space and significant term are seeing sublessors making deals and absorbing the deal costs rather than the landlords, or structuring buyouts which allows the landlord to do a direct deal and provide the tenant the use of the buyout money.
Realty News Report: Are the new office buildings performing well?
Kevin Roberts: We are seeing a flight to quality in submarkets where new Class AA assets are being delivered or are under construction. For example, new construction in the CBD (buildings delivered after 2010) has averaged 92,000 square feet of absorption per quarter since the delivery of 811 Main and Hess Tower in 2011, while buildings completed prior to this have averaged negative quarterly absorption of 53,000 square feet over the same time frame. We are still in a tenants market and will be for some time as the market adjusts to the realities of abundant space at very attractive terms, the impact of lower energy prices on decision making, achieved occupancy efficiencies and job growth in areas that do not produce significant office demand. The last wave of office investment was led by well funded institutional investors with a long-term view of the market. They have the ability to weather cycles and in fact underwrite them as they acquire assets. The strength of these owners has allowed for additional capital investment in these properties during this downturn and an elevated tenant experience while trying to hold face rates.
Realty News Report: The Energy Corridor submarket of West Houston certainly has more than its fair share of vacant space and sublease blocks. What do you foresee for the Energy Corridor?
Kevin Roberts: The Energy Corridor will see increased competition for the limited number of available tenants as landlords regain control of sublease space as terms decline to a point where a sublease is not viable. This increased competition will put additional downward pressure on direct rents and result in increasing concession packages.
Realty News Report: What’s your assessment of the downtown office market?
Kevin Roberts: The CBD is one of the more dynamic submarkets in Houston. The ascendancy of downtown east of Main Street has changed the CBD dynamic from a tunnel-oriented, 10-hour experience to street oriented live, work, play dynamic that is drawing people downtown. The best buildings are capturing a disproportionate share of absorption. To compete with the newer assets, iconic buildings and complexes are undergoing significant renovations designed to activate their spaces and create a differentiated environment. Allen Center’s $45+ million renovation is changing the tenant experience by adding a programmed street level experience with game changing dining offerings. Some of the Class A towers that were built in the 1970s and 1980s need significant redevelopments to remain competitive. Some building owners may determine that it makes more sense to let their buildings slide to Class B status.
Realty News Report: Is it wise to let a property descend to Class B?
Kevin Roberts: Transwestern’s view is that the best way to preserve long-term asset value is to compete at or near the top tier level. There will always be a place for the value alternative in the downtown market. Buildings that are well located and have a base building that accommodates these value oriented users will be able to draft behind the higher quality buildings. Buildings with inherent challenges such as inefficient floor plates, poor column spacing, limited or no parking or poor location will always face challenges. The sale of Houston Center and the eventual owners commitment to renovate and re-introduce that campus could be another significant enhancement to the east downtown dynamic.
Realty News Report: Are we seeing a new generation of Class A buildings arise? Are we rewriting the definition of Class A space?
Kevin Roberts: Yes, with the infusion of over 33 million square feet of office space since 2010, classes of property are currently being rewritten. Former trophy properties are being forced to improve their overall competitive position by upgrading services, efficiencies and amenities. There is also the force of five generations in the workplace and the changing appetite for where work takes place that is pushing activation trends noted above and is also pushing the co-working trends. How the market embraces this on a long term is still to be seen.
Realty News Report: Houston has negative absorption, high vacancy and a large supply of sublease space. What will it take to get the office market out of this hole?
Kevin Roberts: Houston’s economic performance during the restructuring of the energy industry has been remarkable when you consider the revenue lost in our major industry. The fact that the city has added population, added jobs, is setting single family home sales records and has seen additional consolidation of the energy industry to Houston as well as added economic diversification is a testament to Houston’s premier position as a desirable location to live, work and play. Having said that, the job growth we have seen has not been in the areas that traditionally absorb the most office space. Houston needs the hiring in the energy industry to continue as that sector adjusts to a new normal on pricing. Energy service companies and other upstream players are adding jobs, but those jobs are typically seen at the wellhead initially and then to Houston. It will happen again and when it does it can happen quickly.
Realty News Report: Investors have a renewed interest in buying major office properties in Houston. Why is this occurring?
Kevin Roberts: We have seen significant interest among investors in Houston office assets across the risk spectrum. The performance of Houston’s economy, the ability to acquire assets at favorable values to replacement and the overheated nature of other major markets have all contributed to the increased interest. We have seen new players covering Houston at levels we have never seen. There is opportunity here and there is a belief that we have seen the bottom.