Houston's office market is melting down

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Office leasing activity in Houston in the first quarter plunged 25% from the already beaten-down levels a year ago, to 1.56 million square feet (msf), worse even than during the Financial Crisis, according to commercial real estate services firm Savills Studley.

That’s down 59% from the 3.8 msf of signed deals in the fourth quarter 2014, back when the oil bust was still considered a blip and hadn’t yet impacted the office market.

The availability rate rose by 4 percentage points from a year ago to 24.5%, or 47.4 msf for Greater Houston. A horrendous office glut! The availability for Class A buildings jumped by 5.3 percentage points to 26.5%, the “highest mark in more than a decade as sublease space continues to hit the market.”

There were large variations: In Houston downtown, where “only” half of the office space is occupied by energy and engineering firms, the availability of Class A buildings soared 5.7 percentage points during the quarter to 21.5%; but in the Katy Freeway sub-market, where about 90% of the office space is occupied by energy firms, availability hit 33.6%. In the Greenspoint sub-market, it hit a stunning 48%!

These are the effects of the collapse of the energy sector timed impeccably with a majestic construction boom.

Now companies are trying to unload empty office space. During the oil boom, “warehousing” empty office space for future growth was all the rage, even as a building boom promised massive additions of new space.

But once the bust hit, companies started laying off people, and offices emptied out, and “warehoused” empty space became an albatross. Since they can’t get out of their leases but are under pressure to cut expenses, companies are dumping this space on the sublease market, where it pressures the 8 msf of new construction that remains unleased.

Just over the course of the first quarter, sublease space soared 19%, to 9.16 msf, “boosted by new sublease blocks from Shell, Marathon, BHP Billiton, and Apache.” It’s up 124% from Q3 2014:

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And there’s more gloom coming down the pike, according to Savills Studley:

In the meantime, it is not a matter of “if” but “when” more sublease space hits the market. Significant amounts of leased, but unused, “shadow” space should continue to open up as tenants move or shed space through mergers and acquisitions, downsizing, or bankruptcy.

The good news is that non-energy companies are picking up some space downtown:

Kirkland & Ellis signed on to be the anchor tenant at 609 Main, the Hines development that will deliver at year-end 2016. The firm, which will relocate from 600 Travis, finalized a lease for 62,000 sf. According to the Houston Business Journal, United Airlines will reportedly take 235,000 sf in the same new development rather than renew at 1600 Smith and 600 Jefferson.

But they’re simply vacating one space and moving to another. On a net basis for the Houston office market, it is a non-event.

And yet, net asking rents didn’t budge “as landlords tried to anchor their starting position in any potential lease negotiation.” But brokers are reporting an increasing gap between asking rents and signed starting rents, with some lease deals showing starting rents of $5 to $8 per square foot below asking rents — huge discounts as rents in Greater Houston average $29.75. And that’s “in addition to increased improvement allowances and rent abatement.”

So when is this pain going to be over? Not anytime soon, according to Savills Studley:

Although the price of oil may have finally found a floor – oil prices hovered between $35 and $40 per barrel for much of the quarter – there is no recovery in sight for the energy industry. The North American rig count sank to 450 by the end of the first quarter; according to Baker Hughes, this was the lowest count since tracking began in 1949 and marked an ominous drop of 56.2% from a count of 1,028 just one year prior.

Maintaining an oil price floor is pivotal in order to avoid an acceleration of weakening in the office market. However, the floor will likely be tested as equity markets remain turbulent and investors implement varying long- and short-term strategies that can spur fluctuation.

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Whatever happens to oil production in the US isn’t the only factor. Other major producing countries, such as Iran, are increasing output and are adding to the glut. Then there’s “the economic slowdown in China and other emerging markets” that are curtailing demand:

So long as the world continues to contribute to a growing supply glut, the price of oil cannot rebound, and Houston’s energy employment will not return to previous levels.

Unemployment has already risen in Houston from 4.6% in Q4 2015 to 4.8% in Q1, “as employment gains in non-energy sectors failed to keep pace relative to energy losses.” Alas, it takes lots of new employees and contractors to fill all this vacant office space. And that’s just not happening anytime soon.

So who is going to get hit?

Construction companies and their workers as the construction boom collapses, and secondary industries supporting them. Real estate is highly leveraged, so a meltdown in the office market hits banks and bondholders. It hits REITs that hold these office buildings. It hits commercial mortgage-backed securities. The consequences of real-estate busts spread far and wide, but they take their time.

But a broadening commercial real estate bust is the last thing the US economy needs. Read… US Manufacturing Sinks Deeper into Mire, Sep. 2009 evoked

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