Houston’s industrial market continues to expand amid economic and political uncertainty
Commentary by Ryan Byrd | Principal and Patrick Duffy | President
Third-quarter economic activity recovered in the U.S. after a precipitous drop in Q2 as COVID lockdowns in most of the country were eased. The energy sector, a major contributor to the industrial industry in Houston, continued to struggle as rig counts dropped to a historically low level of approximately 270 active rigs in the U.S., down 570 from the same time last year and down by over 1,600 from the peak in 2014. Oil and gas prices have been trading in a range that will not spur new drilling of any significant amount in the near term. Oil field services firms, a significant component of our local industrial economy, have been hit very hard.
The Houston industrial market plodded through the 3rd quarter with a lower than average absorption number of 1.3 million square feet, but despite continued COVID slowdowns, leasing activity remained steady. At almost 6 million square feet of leases executed, Houston remained on par with the previous two quarters. General market uncertainty caused many tenants (who had the option) to delay real estate decisions and created a dampening of activity. We believe that underlying demand is more robust than the absorption numbers suggest. The lockdowns have accelerated the growth of e-commerce globally, a significant driver of industrial (distribution) demand. Amazon remains the most significant player locally at almost half of the quarter’s absorption. Local tenants in the 40- 60,000 square foot range remained the most active tenant group, especially in the Northwest and Southwest submarkets. Downward pressure on rents increased over the quarter, with the North submarket pressed to give the most concessions.
At the beginning of the year, we were concerned that supply was outpacing demand; however, Covid and low oil prices led to the delay of several proposed projects. The trend toward a “flight to quality” continued to benefit several new deliveries encouraging a handful of developers who had paused to restart speculative building. There are approximately 16 million square feet of institutional-grade projects under construction, and almost 8 million SF delivered in Q3. We continue to see developers build larger buildings as Houston moves to more of a big-box market. Of the 24 million combined square feet under construction and deliveries, almost half is found in fifteen buildings that are 400,000 square feet or larger.
Along with E-Commerce growth, freezer/cooler requirements have increased dramatically in the third quarter. More people working from home and the economic slowdown have created an increase in home food consumption. Further, this trend is occurring nationwide, which will spur enhanced activity within Port Houston.
The superior performance during COVID and long-term trends for industrial CRE have significantly increased investor demand both in rotation from other CRE asset types and as new funds enter the market in search of yield. Limited availability and increased demand have caused middle-market asset CAP rates to compress. We expect this trend to continue well into 2021 as interest rates remain low and the economy continues to recover from the shutdowns.
In the past few weeks, Houston’s industrial market has seen an uptick in leasing activity and new tenant requirements as employees have started getting back to the workplace, and students have gone back to school. As Houston begins to see a pickup in activity, the industrial market unfortunately still appears caught between what we hope to be the tail end of Covid and the 2020 elections’ uncertainty. The elections will impact the oil and gas industry as the two parties have significantly different approaches to the fossil fuel sector. Hopefully, with the elections behind us and a potential vaccine roll-out in Q4, we will see the exceptional uncertainty in the market calm, allowing companies to make more informed long-term real estate decisions.
Vacancy & Availability
On an annual basis, Houston’s average industrial vacancy rate increased 40 basis points from 8.1% in Q2 2020 to 8.5% in Q3 2020 and by 190 basis points annually from 6.6% in Q3 2019. The increase in vacancy is due to the addition of 191 new buildings added to inventory since the beginning of 2020. Only 45% of the 29.3M SF of new inventory has been leased since delivered.
At the end of the third quarter, Houston had 51.6M SF of vacant industrial space for direct lease and an additional 1.7M 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 5.7%, 0.8% and 5.1%, respectively. 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 1.2M SF of positive net absorption in the Q3 2020, a decrease of 68.4% over the quarter. Some of the tenants that contributed to absorption by relocating or expanding in Q3 2020 include Amazon moving into 443,500 SF in the Northwest Corridor and also into 200,400 SF in the South Corridor, American Furniture Warehouse moving into it’s 498,700 SF warehouse in the Northwest Corridor and Goodman Air Conditioning and Heating moving into 312,640 SF in the Northwest Corridor.
The majority of Q3 2020 positive net absorption occurred in the North Corridor, recording 1.5M SF. All of the major industrial corridors recorded positive net absorption in Q3, with the exception of the Inner Loop, Southeast and Southwest Corridors.
According to our data service provider (CoStar Property), Houston’s industrial leasing activity increased over the quarter from 5.4M SF in Q2 2020 to 5.9M SF in Q3 2020. The majority of third quarter transactions consisted of leases for 50,000 SF or less; however, there were several larger deals that occurred. The table below highlights some of the larger transactions that closed in Q3 2020.
15.2M SF of industrial space is under construction in Houston, with 38% 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, North and Southeast Corridor submarkets. Below is a partial list of the largest buildings currently under construction.