Houston’s office market continued to contract during the fourth quarter
Commentary by Patrick Duffy, MCR | President | Houston
As you will see from our submarket analysis included in the PDF report, Houston is a vast market and the submarket matters. The Houston MSA is physically larger than nine states. From a population perspective, we are larger than over thirty states. This summary includes all of Houston as if it is a single, homogenous market – it is not. Even within submarkets, some office buildings have significant competitive advantages over others. Colliers believes that these quarterly reports, with the submarket data tables included, can give the reader a reasonable understanding of the market’s health and trends but will never replace a specific requirement analysis for granular understanding by a specific occupier/user. We hope you find this information helpful and welcome the opportunity to dive deeper with our clients.
The Houston Office Market continued to contract during the fourth quarter as the COVID-driven, government-mandated lockdowns continued. The fourth quarter ended with approximately 875,000 square feet of negative absorption following three consecutive negative quarters in 2020. For the year, occupancy went down approximately 3.9 million SF. We track absorption as the change in physically occupied space between the current quarter and the previous quarter. Negative absorption literally means that less office space was occupied vs. discussing an increase in vacant space, including new space delivery. Occupied office space dropped to 79% (21% vacant) of the total 238M square feet of space we track.
As we observed in Q3, despite the increase in vacancy, asking lease rates stayed steady. However, the concession packages became more aggressive in the last quarter, especially free rent and tenant improvement allowances. The landlord’s theory seems to be “accelerate occupancy, but hold the line on the long-term rental income,” which has historically been a sound strategy during perceived short-term economic downturns. Landlords continued to show flexibility for short-term renewals requested by their tenants, who did not have the confidence to extend for a typical 3 to 7-year term. Clarity on the work from home (WFH) approach mandated by many local governments and adopted by most large corporate users, and the long-term strategies aligned with WFH is still hard to come by. Most companies have reported that work is getting done. They can function more smoothly after a few months of practice with video conferencing and online collaboration tools.
Last quarter we reported that “Most corporate leadership consensus seems to have shifted from “it’s working surprisingly well” to “we do not see our normal productivity, collaboration and innovation that we had when we were all working in the same space.” Every seasoned office advisor knows that office space is not just a place to work – if that is all it is, then remote work would quickly replace it. Office environments are designed to attract talent, enhance collaboration and productivity, act as a cultural leverage point, and create environments where our employees’ intellectual capital is best deployed. If this is true, while remote work might get the in-box emptied, it does not provide for the rest of the package required to truly leverage our workforce’s talents. We see no change to that position at year-end.
The COVID vaccines started their roll-out in December. They should be widely distributed by the end of Q1 and potentially distributed/administered at a sufficient level by the end of Q2 to finally bring a level of “herd immunity” required for the lockdowns to be removed as a mandated counter-COVID approach. If this forecast holds, we expect office users to return to the office in large numbers in the 2nd half of 2021. Long term solutions for the need and configuration of space are being vetted as we write this. There are many theories ranging from massive structural changes to returning to a more pre-COVID approach. We tend to lean toward the latter outcome. Shortly after the 9/11 attacks, the talking heads were discussing the end of New York City as a major business hub and companies abandoning high rise office space. Obviously, that did not happen. In the middle of a storm, it is hard to predict long-term impacts. This storm is ending this year, hopefully in the first half.
Speculative office construction should be minimal in the next two years and all substantial new office construction will likely be tied to pre-leasing success. We have decades of available office space on the ground today, given historical absorption numbers. The migration of businesses from California and other less business friendly states, and a probable stabilization in the energy sector, will likely accelerate our recovery, but we have a very long way to go before we return to a balanced occupancy in the Houston MSA.
Historical Available Sublease Space
Of the 1,680 existing office buildings in our survey, 92 buildings have 100,000 SF or more contiguous space available for lease or sublease. There are 26 options with 200,000 SF available for lease or sublease. Citywide, 6.6 million SF of sublease space is listed as available and 2.6 million SF of the space is vacant.
Absorption & Demand
Houston’s office market posted negative net absorption of 836,140 SF in the fourth quarter, pushing the year-end 2020 total net absorption to negative 3.9M SF. There were just a handful of submarkets with positive absorption in Q4 including Katy Grand Parkway, Northwest, Southwest, The Woodlands and West Belt. 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 Q1 2021.
Houston’s average asking rental rate increased over the quarter from $30.33 per SF to $31.02 per SF. Houston’s average suburban rental rate rose from $27.47 per SF from $27.98 per SF and the average CBD asking rate increased from $40.00 per SF to $41.20 per SF. As stated in the commentary, rental rates have remained relatively flat; however, landlords have been more generous with concessions.
Houston’s office leasing activity decreased 4.5% over the quarter from 2.2M SF to 2.1M SF. 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 Q4 2020 are listed in the table below.
Houston’s office investment sales volume increased over the quarter from $247 million in Q3 2020 to $330 million in Q4 2020. The average sales price per square foot dropped from $251 to $177 per SF annually and Houston’s average office cap rate increased from 7.0% to 7.4%, according to our data provider, Real Capital Analytics.
Office Development Pipeline
4.2 million SF of office space is under construction, and approximately 63% is pre-leased. 2.4 million SF is spec development, of which 57% is pre-leased. Below is a summary of the office buildings under construction with a GBA of 150,000 SF or greater.