Houston’s office market weakens over the quarter and most likely will not see improvement in the short-term
Commentary by Patrick Duffy, MCR | President | Houston
The Houston office market weathered the first phase of the COVID-19 pandemic, as we anticipated, with limited immediate impact on “the numbers.” The lock-downs and social distancing forced companies to embrace a work from home strategy and begin the process of rethinking their office utilization going forward. The majority of surveys we have seen indicate that the vast majority of office workers and their managers were pleasantly surprised by the productivity they were able to maintain in a remote environment. Returning to the office has been a slow process as the stay-at-home orders were incrementally lifted. Many companies have decided to keep all of their workers out of the office for the balance of the summer and some have told employees to plan on working from home indefinitely. Most companies have adopted a voluntary return to the office policy combined with strong protocols for reducing the risk of infection at the office.
As we begin the 3rd quarter, we have seen an increase in activity from potential office users in pursuing new leases. It appears that after an initial shock and some “wait and see” delays, most companies are starting to realize that we will be operating in a COVID-19 reality for some time and that they can no longer just sit back and wait for the virus to resolve.
The overall vacancy rate increased to 20.5% from 20.1% at the end of Q2. This increase in the vacancy rate was caused by net negative absorption of 513,316 square feet and the delivery of 454,523 square feet of new product. We also observed an increase in sublease availability of approximately 1,000,000 square feet in the second quarter. The bulk of this space was placed on the market by companies concentrated in the energy and petrochemical industries, both hit hard by the drop in demand for refined products caused by the global lock-down.
Asking rents were relatively flat from the previous quarter and the second quarter last year. Downtown saw the most significant decline year over year and suburban asking rents increased very slightly. Our team reports that Landlords continue to fight to hold face rates, but are being much more generous with free rent and tenant improvement allowances for larger, good credit tenants, effectively reducing the occupancy expense over the term.
Newer buildings continue to perform better than the older inventory as the “flight to quality” continues in Houston. With subdued demand and over 4 million square feet of office under construction, we expect the overall vacancy rate to increase over the next twelve months. Companies will be re-balancing their office strategy with more work from home AND more social distancing in the office, which will move us toward a less dense office occupancy. Less density, more distance requires more space – that need will be off-set by more employees working from home. We will not clearly understand the net impact of these two forces on net office space requirements for some time, but we do expect the office market to remain weak for the foreseeable future.
Historical Available Sublease Space
Of the 1,661 existing office buildings in our survey, 87 buildings have 100,000 SF or more contiguous space available for lease or sublease. There are 27 options with 200,000 SF available for lease or sublease. Citywide, 6.6 million SF of sublease space is listed as available and 2.3 million SF of the space is vacant.
Absorption & Demand
Houston’s office market posted negative net absorption of 513,316 SF in the second quarter, pushing the mid-year 2020 total net absorption to negative 794,972 SF. CBD Class B space recorded the only gain in Q2, posting 17,121 SF of positive net absorption, while suburban Class B space reported the largest loss, posting 246,412 SF of negative net absorption. Since tenants typically do not move into lease space immediately after signing a lease, absorption lags and can occur at anytime after. We believe absorption numbers will trail even longer than usual in the short-term due to the “stay-at-home” orders amid COVID-19, so absorption will more than likely remain negative moving into Q3 2020.
Houston’s average asking rental rate increased over the quarter from $29.59 per SF to $29.77 per SF. The average CBD asking rate dropped from $39.38 per SF to $39.10 per SF and Houston’s average suburban rental rate rose to $27.34 per SF from $27.02 per SF. Overall, rental rates only increased by 0.6% on a quarterly basis and by 0.1% on an annual basis. Suburban Class B rates posted the largest annual percentage increase of 4.6%, while CBD Class A rates posted the largest annual percentage decrease of 3.9%.
Houston’s office leasing activity fell 35% over the quarter from 4.5M SF to 2.9M SF primarily due to the Covid-19 “stay-at-home” orders in the greater Houston area. Leasing activity includes new/direct, sublet, renewals, expansions in existing buildings and pre-leasing in proposed buildings. Some of the more notable transactions that did occur in Q2 2020 are listed in the table below.
Houston’s office investment sales volume decreased significantly over the quarter from $462 million in Q1 2020 to $74 million in Q2 2020. The average sales price per square foot trended up from $268 to $281 per SF annually and Houston’s average office cap rate moved from 6.8% to 6.7%.
Office Development Pipeline
4.3 million SF of office space is under construction and approximately 63% is pre-leased. 2.4 million SF is spec development of which 29% is pre-leased. Below is a summary of the office buildings under construction with a GBA of 150,000 SF or greater.