Houston industrial market - an investment outlook
Commentary by Jason Tangen | Vice President | Houston
Good news first...
It seems that overall activity, although still slow comparative to normal, started to significantly pick up towards the end of the 2nd quarter across the board from tenants to investors. We believe this trend will continue as companies realize that waiting on the sideline for an immediate resolution to this will not happen in the near-term. Companies seem less paralyzed to make a decision as they did two months ago.
There is a massive amount of equity liquidity in the market right now, specifically looking to acquire BOTH value-add and stabilized industrial properties to add to their respective portfolios. The major REITS hit the pause button for the time being with only a handful continuing active acquisitions through the COVID pandemic. However, within the last 15 days or so, we are starting to see them slowly move back into the marketplace as their respective investment committees are releasing the acquisition professionals to look at new deals. The most active investors over the last 90 days have been smaller private equity funds and family offices.
The industrial asset class has been the one specific asset class to weather the storm best throughout the COVID nightmare and this has not gone unnoticed by private equity. There are several large private equity investors and JV vehicles that have formed from those groups that previously had no exposure to the space. We are seeing PE firms trying to round out and mitigate risk of portfolios that were previously focused solely on other asset classes such as office and multi-family or retail – Industrial is seen now as the safest/conservative play.
Because of this, CAP rates have remained stable – we have not seen any substantial increase in CAP rates from where they were eight months ago, except for those buildings occupied by tenants specifically in the energy services industry.
Similarly, we have not seen what I would call a “real” market movement in lease prices – I say “real” because the market fundamentals are still there. The only action has been from a handful of landlords that were sitting on vacancy prior to COVID, marking prices down in hopes of getting a deal done, but the majority of these spaces are still sitting vacant due to the lack of touring going on.
The bad news...
Debt liquidity is hardly as easy to come by – the debt markets and lenders are acting as an emotional teenager swinging dramatically to either turn the spigot on or off depending on the news on any given day. Lenders from life companies to regional lenders have been tough to pin down in a given week regarding their appetite to loan on new deals. One week credit committees will approve term sheets and new loans for a given deal, but the next week they could be shut off again for a deal with the same economics and credit as they dive into their current loan portfolio and re-evaluate outstanding risk based on what the news is reporting the economic outlook is that week. That said, when new commitments are issued loan terms, they are still very competitive. For example, loan terms for a stabilized single-tenant, light manufacturing property with a middlemarket credit tenant on a 5 to 7 -year lease look like the following: interest rate 3.875% to 4.5%, 70 to 75% LTC, 25-year amortization, the less aggressive being for non-recourse and more aggressive for partial recourse. On the construction loan for new development front – many larger national and regional lenders have hit pause on loans in which the developer or sponsor does not have a current relationship or a loan with the bank. Ground-up spec development loans are still achievable, but with lower leverage and more recourse – typically 50 to 55% LTC and a good amount of new commitments in this space type is getting done within the regional bank space.
Availability within the market to find a strong stabilized or value-add property to acquire in current market conditions is very limited. There is substantial pent-up demand from investors with dry powder; however, there is a significant constraint in supply. Typically, this would compress CAP rates as more bidders are chasing the same available properties, but this has not been the case thus far, showing we are more than likely at the top of the curve for industrial values this cycle.
The industrial asset class is poised to come out on top when we get through the slump of the COVID pandemic, especially within the distribution sector. The amount of final mile and 3PL requirements are expected to continually grow as we get back to a new normal as a mass amount of the population specifically within the baby boomer and gen x generations who were not as apt or eager to adapt the on-line order and delivery model, were forced into doing so through stay-at-home orders, are now adapted and embracing the model.
In Houston specifically, there may be a pullback in investment in manufacturing properties in the future, as more vacancy filters through the market due to energy services related companies that currently occupy large swaths of this space going dark or downsizing, however, this has not yet happened on any sizeable scale to date.
Vacancy & Availability
On an annual basis, Houston’s average industrial vacancy rate increased 40 basis points from 7.7% in Q1 2020 to 8.1% in Q2 2020 and by 190 basis points annually from 6.2% in Q2 2019. The increase in vacancy is due to the addition of 4.9M SF of new inventory which was 45% leased, adding 2.7M SF of vacant space to the market. At the end of the second quarter, Houston had 47.6M SF of vacant industrial space for direct lease and an additional 2.0M SF of vacant sublease space. Among the major industrial corridors, the Inner Loop Corridor, Liberty County and the South Corridor have the lowest vacancy rates of 5.3%. The submarket with the largest percentage of vacant space is the North Corridor, which has a 10.0% vacancy rate.
Absorption & Demand
Houston’s industrial market posted 2.3M SF of positive net absorption in the second quarter, a decrease of 34.3% over the quarter. Some of the tenants that relocated or expanded in Q2 2020 include Five Below moving into 860,000 SF in the North Corridor, Eugene B. Smith & Co., Inc. moving into 345,200 SF in the South Corridor and Dunavant Distribution Group moving into 251,680 SF in the Southeast Corridor.
The majority of second quarter positive net absorption occurred in the North Corridor, recording 1.2M SF. All of the major industrial corridors recorded positive net absorption in the second quarter, with the exception of the Inner Loop Corridor.
4.9M SF of new inventory delivered during the second quarter. The North Corridor had the most significant amount of new inventory, with 1.7M SF, followed by the Southeast Corridor with 1.6M SF of new product.
According to our data service provider (CoStar Property), Houston’s citywide average quoted industrial rental rate for all product types increased from $7.52 per SF NNN to $7.83 per SF NNN over the quarter. According to Colliers’ internal data, actual lease transactions are in the $4.56 – $5.16 per SF NNN range for newer bulk industrial spaces. In contrast, flex rates range from $7.20 to $10.80 per SF NNN depending on the existing improvements or the allowance provided for tenant improvements and the age and location of the property.
Based on data from our data service provider, the average quoted NNN rental rates by property type are as follows: $7.32 per SF for Warehouse Distribution space, $10.29 per SF for Flex/Service space, Tech/R&D space averaging $13.70 per SF and $6.05 per SF for Big Box.
According to our data service provider (CoStar Property), Houston’s industrial leasing activity decreased over the quarter from 6.5M SF in Q1 2020 to 6.0M SF in Q2 2020. Most of the second quarter transactions consisted of leases for 50,000 SF or less; however, there were several larger deals that occurred.
Currently, 14.8M SF of industrial space is under construction in Houston with 48% of this space pre-leased. The largest project under construction is a 2,165,000-SF distribution warehouse for Ross Stores Inc., located in Brookshire, TX. The majority of projects under construction are located in the Southwest, Northwest and Southeast Corridor submarkets.