Six years of spec could leave five to seven on deck

Transcription

1 Houston office construction forecast Six years of spec could leave five to seven on deck Robert Kramp Director of Research & Analysis Texas-Oklahoma Division More than 30 million sq. ft. of Class A office space has been developed in Houston during the latest construction cycle that began in Construction is mainly concentrated in the five submarkets comprising West Houston and the Central Business District (CBD). The high concentration of energy occupiers throughout these two areas means office leasing is intrinsically tied to the fortunes of the oil & gas sector. That said, investment bank projections for crude oil prices indicate steady recovery over the next 2 years, averaging $58/bbl by Q4 2017, up approximately 15% from October Therefore, assuming projected job growth scenarios, Class A availability should peak in 2017 at approximately 24% in West Houston and 19% in the CBD, and then begin to decline with the most momentum on occupancy gains occurring during Based on prior cyclical job growth and office absorption, Houston s CBD Class A market has historically seen 10 sq. ft. of absorption generated per job added to the overall Houston economy while West Houston Class A has captured 16 sq. ft. per job. As a result, CBRE Research estimates a period of 5-7 years of steady office space absorption patterns prior to the start of another significant Class A construction and development cycle in the West Houston market. OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 1

2 The Houston office market and West Houston to an even greater extent is situated at the convergence of a construction cycle space overhang and an extended period of recovering global commodity prices. Prior years of strong economic growth were propelled by an energy sector boom that generated more than 30 million sq. ft. of new construction, with more than half delivering just as crude oil prices collapsed. New construction deliveries, combined with a record-breaking amount of sublease space given back to the market, has pushed up office availability rates to levels unseen since the mid 1990s. With sublease space expected to reach 12 million sq. ft. by 2017 and with more than 4 million sq. ft. still in the development pipeline CBRE Research analyzed the West Houston office market development cycle in search of an answer to a fundamental question: what does the future look like for West Houston s next office development cycle? THE SETUP FOR AN INVENTORY IMBALANCE Houston s current inventory cycle was fueled, literally, by its signature energy sector which brought on five years of strong job growth, as crude oil prices approached record highs, topping over $100/bbl. As the shale oil boom drove oil and gas companies to expand, Class A office availability shrank quickly from 17.9% at the height of the Great Recession in 2009 to only 3.5% in 2012, providing area occupiers limited options for the prime space needed to retain and attract new employees. Anticipating rapid future growth and with the assumption of high sustained oil prices oil and gas majors began securing additional space beyond their immediate needs. Strong forecasted demand and clear fundamental signals led to the kick off of an aggressive construction cycle. Figure 1: Houston Economic and Construction Cycles 1970s, 80s & Early 90s MSF NEW INVENTORY The New Millenium 16.7 MSF NEW INVENTORY OIL OPULENCE OIL BUST SLOWLY STABILIZING MARKET RECOVERY MERCHANT ENERGY BUBBLE Mini Oil Boom 9.0 MSF NEW INVENTORY Energy Shale Renaissance 31.8 MSF NEW INVENTORY MERCHANT ENERGY BUST ENERGY BOOM PART II GREAT RECESSION SHALE OIL BOOM COMMODITIES CRASH Construction Cycles OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 2

3 Yet, as oil prices began to decline at the end of 2014 due to rapidly growing domestic shale production and global production levels that outstripped global demand, energy companies announced cutbacks in capital expenditures and shed payrolls to improve cash flow. Companies began marketing their excess leased but unoccupied space, propelling Houston s sublease inventory to a record high of 12.2 million sq. ft. equivalent to the total building net rentable area (NRA) of Houston s entire Greenway Plaza urban submarket, where an estimated 66,000 workers office daily. Although construction has slowed, more than four million sq. ft. is still in the Houston market pipeline. As this new supply trails off and demand slows, recently delivered vacant space, coupled with new and expiring subleases, will continue to be a near-term drag on occupancy rates. Meanwhile, overall Houston office space availability has climbed to a 20-year high (Figure 2), uniquely affecting the major office submarkets of West Houston, the CBD and the West Loop/Galleria. With an emphasis on the most acutely affected area of Houston s office leasing market the five submarkets in West Houston the immediate questions become: Where and when will availability peak? How long will it take to absorb the surplus space? And when, as it will inevitably occur, can West Houston expect the start of its next construction cycle? Figure 2: Houston Development Cycle Availability 26% 22% 19.8% 18% 14% 20-year average 15.8% availability 10% Vacancy Availability OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 3

4 THE WILD, WILD WEST HOUSTON MARKET Woodlands This forecast refers to the aggregated West Houston market, comprising the Energy Corridor, Katy Freeway, Westchase, West Belt, and Far West submarkets (Figure 3). West (2015) Houston was chosen as a focus due to its large concentration of related industry tenants, and other structural features such as a distinct, responsive (2015) construction cycle and geographic contiguity. North (2015) Figure 3: West Houston Office Market Original Boundary New Boundary (Growth) The physical area of the West Houston competitive market has expanded dramatically in recent years. FM 1960/Highway 249 West Belt FM-1960 FM-1960 GEORGE BUSH INTERCONTINENTAL North Belt North Loop Far West Energy Corridor Westchase Katy Freeway W West Loop/ Galleria Allen Pkwy Greenway Plaza CBD Ea Southwest Freeway South Main/ Medical Center WILLIAM P HOBBY For perspective, nearly 60% of occupiers in the Energy Corridor submarket are tied intrinsically to the oil & gas sector, and historical demand cycles reflect this composition. West Houston has traditionally operated in distinctive office development cycles that are largely correlated with the pricing movement for crude and Greater natural Pearland gas. When energy commodities are on the rise, local exploration and drilling operators expand, which then triggers organic demand for new office space a historically demonstrative trend in the five submarkets comprising West Houston. Miles KM CBRE, Inc. This information has been obtained from sources believed reliable. We have not verified it and make no guarantee, warranty or representation about it. Any projections, opinions, assumptions or estimates used are for example only and do not represent the current or future performance of the property. You and your advisors should conduct a careful, independent investigation of the property to determine to your satisfaction the suitability of the property for your needs. CBRE and the CBRE logo are service marks of CBRE, Inc. and/or its affiliated or related companies in the United States and other countries. All other marks displayed on this document are the property of their respective owners. All Rights Reserved. Sources: CBRE Mapping Services (877) ; Nielsen, StreetPro. MapFiles\Work\National Project\MarketView Submarkets\Workspaces.wor 10/6/2014 OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 4

5 As a result, West Houston is now bearing the brunt of the oil price downturn, representing nearly 50% of total citywide sublease availability. In addition, three buildings in West Houston are fully available for sublease, including the newly delivered, but never occupied, 597,628 sq. ft. Energy Center 4 in the Energy Corridor. For the first time in any submarket, Class A sublease space in the Energy Corridor has surpassed the amount of directly vacant office space. The dramatic boom-driven demand swings that have led to a considerable West Houston space overhang is subject to two related variables: the recovery of energy prices and the return of Houston s job growth, both of which are territory regularly trod by the Houston economy and its highly volatile energy industry. DOWNTOWN HOUSTON S (MORE) MATURE DEVELOPMENT CYCLE When compared to West Houston, the dense urban submarkets of Houston s CBD and West Loop/Galleria have relatively limited recent demand for new office construction product and have historically been more conservative in building starts, characteristics of a more mature office market. This is partly due to the tighter availability and higher cost of land compared to Houston s outlying western submarkets, and therefore properties must command higher rents required to sustain new in-town development. Energy occupiers presently located in the CBD continue their recent and cyclical trend toward downsizing, leading to further direct space availabilities caused by both merger & acquisition and bankruptcy filings. Despite the struggling of energy tenants, flight to quality has also been observed as a significant recent trend. For instance, the 1,056,658 sq. ft. 609 Main, a trophy class development currently underway by Hines in the CBD, is now 40% pre-leased by non-energy occupiers (although a number of occupiers serve the oil and gas sector). Meanwhile, CBD Class A availability is expected to crest 18% once 609 Main delivers near the end The nature of the energy bust has led to discounted blocks of high-quality, extended-term sublease space in the CBD that is now regularly competing head-on with direct space, resulting in substantial downward pressure on effective, negotiated Class A rents. THE URBAN SUBURBAN: HOUSTON S WEST LOOP/GALLERIA Given that the West Loop/Galleria submarket is likewise relatively mature in its inventory cycle, the area has not been subject to the same demand swing as West Houston. In fact, several large tenants recently vacated West Loop/Galleria, heading to West Houston in order to consolidate and centralize their office operations. Moreover, this submarket is well diversified and tends to see strong, stable tenant demand from smaller occupiers such as independent law and accounting firms, consultants, temporary staffing companies and public relations and advertising professionals. OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 5

6 Indeed, large tenant demand remains more or less muted in Houston s urban-suburban West Loop/Galleria, located less than 10 miles west of the CBD. Most tenant movement here will be a flight to quality within the area to renovated buildings or newly delivered projects such as the 380,000 sq. ft. Amegy Bank Building. Although there has been a recent uptick in sublease space, the West Loop/Galleria has not been disproportionately impacted to the degree of West Houston or even the CBD. HOW THE WEST HOUSTON OFFICE CONSTRUCTION CYCLE (MIS)BEHAVES West Houston s office cycle is a signature boom and bust market, both in terms of its development and general rate of business for the energy industry that comprises its primary tenant base and fuels the majority of its office leasing demand. With respect to the business cycle, economic rents, market rates, and asking rents each behave differently through the successive phases, and in response to progressing market conditions. Beginning early in the cycle, as office availability descends and approaches our 10% natural availability rate threshold or the natural settling point between the kick-off of a new development cycle both market and asking rents respond by tightening as space becomes increasingly scarce (Figure 4). Meanwhile, market rents show a more delayed response time (to the tightening market) than do respective asking rents. Figure 4: Natural Availability and the Construction Cycle Availability (%) 25 West Houston Starts (MSF) Historical data indicates that the natural availability rate the rate at which the market is in equilibrium is between 10% and 11% for West Houston West Houston Starts (MSF) Availability (%) 0 OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 6

7 As the cycle enters its peak and new development projects subsequently break ground, market rents briefly overtake asking rents as competition for space places upward pressure on prices (Figure 5). This period lasts only briefly because new deliveries begin to come online, adding new competitive inventory and relieving upward rent pressure driven by inventory scarcities. As the bulk of this construction delivers and businesses enter the late cycle, space overhangs develop, laying sharp downward pressure on market rents and pushing them below the more stable asking rents. (CBRE Research notes that the stickiness of asking rates in the late cycle environment can be explained by landlords reluctance to voluntarily lower their asking rents during a temporary period of lowered demand, as well as potential implications for a property s pro forma.) Figure 5: Availability, Market Rent, and Asking Rent FSG (per sq. ft.) $45 Availability (%) 30 $40 $35 20 $30 $25 10 $20 $ Q Availability Asking Rental Rate Market Rental Rate (Effective) 0 Through the length of the development and business cycle, economic rents remain relatively stable, rising steadily over time at a rate of around 4.7% year-over-year. The compound annual growth rate of economic rent significantly exceeds the last decade s inflation rate and the fairly stable cost of land, but only mildly exceeds the 4.4% growth rate of construction costs. Growth in economic rent is most closely tied to increases in construction costs over time development cost growth can be generally forecasted from construction costs, assuming stable costs of capital and land. OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 7

8 UP AND DOWN BUT NOT OUT ENERGY IS HERE TO STAY IN HOUSTON Even in the midst of a prolonged commodity downturn, Houston s signature energy sector office occupiers are here to stay; these companies, and the metro itself, have long endured volatile cycles of the energy industry, which have led to long-term strategies that will help weather the slump in crude and natural gas commodity prices. Rapidly rising sublease availabilities, though a symptom of the recent oil downturn, simply indicate a demand correction to a more sustainable level. In the near-term, the foremost challenge in the West Houston office market is overcoming a combination of transitory, but precipitous, low levels of energy tenant demand. Complicating these weaker office space demand levels is a significant supply overhang, produced by oil price assumptions and heavy construction activity in the previous development cycle. Forecasts for the more mature CBD and West Loop/Galleria submarkets indicate a steady rate trending toward equilibrium in the next 3-5 years, while West Houston may take as many as 5-7 years. Clearly, using a baseball analogy during post-season playoffs: six years of speculative office construction could leave Houston with 5-7 more years on deck to absorb it. Source: CBRE, OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 8

9 OUR FORECAST An outlook for the aggregated West Houston submarkets is contingent on two component forecasts: a space availability projection and the expected rate of job growth. CBRE Research used projected job growth numbers from the Institute for Regional Forecasting (IRF) at the University of Houston s Bauer School of Business, which were blended with long-term forecast averages provided by Moody s Analytics to provide a longer-term forecast for availability. Using three IRF job growth scenarios (high growth, low growth and most likely rate of growth), the CBRE Research model then forecasts a range of possible office absorption scenarios and their corresponding effect on space availability. The most likely scenario provided by the IRF projects net job losses for both 2016 and 2017, with 2017 losing 30,000 jobs. The following years of 2018 and 2019 are forecasted to be recovery years, where approximately 62,900 and 97,100 jobs are expected to be added to Houston payrolls, respectively. Implicit in the likely job growth scenario is the assumption that oil pricing will recover by a steady 30% by the end of 2017, resulting in an average price of $60-$65/bbl. (Longer term job growth projections through 2023 via Moody s average 51,000 jobs per year, and do not necessarily take into account oil price expectations.) West Houston should see Class A availability rates peak in 2017 at 24.5%, then begin a steady retracement to equilibrium levels. Combined with the projected absorption scenarios, the CBRE Research model estimates that under the most likely job growth scenario, West Houston should see Class A availability peak in 2017 at 24.5%, before beginning a steady decline with an equilibrium level reached as early as assuming no new area development (Figure 6). Figure 6: West Houston Availability and Absorption Forecast Absorption Availability Rate Low Growth Likely Growth High Growth Low Growth Likely Growth High Growth OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 9

10 OUR RESEARCH METHOD EQUILIBRIUM, MARKET RATES & ECONOMIC RENT IN WEST HOUSTON Fundamentals in commercial real estate such as market rates and development cycles are traditionally driven by variables that originate with overall employment levels and economic activity. Market rates, which are generally a spot indicator of office space demand, are the effective rates taken by landlords. To construct a more useful forecast model, it is necessary to incorporate assumptions for both short-term and long-term trends. Under normal market conditions, an economic rental bracket (ERB) the dollar range for rents required to sustain new development can be approximated by aggregating the rental rates from signed prelease commitments over a period of time. When plotted against prevailing market rents or asking rents, it is then possible to more accurately forecast and visualize long-term development cycles and market trends. The economic rental rates that form the range of the bracket are driven by a number of variables, including land and construction costs, as well as other macroeconomic factors like interest rates and additional costs of capital. Market rental rates or, effective rental rates by contrast, adhere to much stricter supply and demand forces and can be modeled more accurately and with less complications. That said, over the past decade beginning in 2005, Houston s economic rental rate has increased on average by 4.7% per year, exceeding the increases in both construction costs (4.4% per year) and inflation (1.9% per year). Growth in the economic rental rate was calculated as a gross rental rate with assumed operating expenses (OPEX) increases implicit in overall forecasted growth historically, average West Houston OPEX rates have increased by 3% year-over-year. With a 3% growth assumption, average annual OPEX in the West Houston submarkets could increase to around $17.50 per sq. ft. by The concept of the ERB as it relates to development cycles in West Houston is informative. CBRE Research determined that, as a relatively young market, development cycles in West Houston tend to exaggerate the cycle of the overall Houston market, reflecting the boom and bust nature of its primarily energy occupying sector. Historical data indicates West Houston s natural availability the rate at which the market is in equilibrium is between 10% and 11%, and serves as an important indicator for demand trends in the office occupying sector. Additionally, this availability level represents a strong signal for new development, as the crossing of the 10% threshold has marked the kickoff of the last two major construction cycles from , and again from OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 10

11 Assuming the economic rental bracket and this very clear 10% availability trigger, it is possible to forecast in the near-term West Houston s future availability and the resulting window for new development. The ability to estimate the economic rental bracket, combined with projections of future availability rates contingent on expected job growth scenarios allows for the formulation of a broad forecast for West Houston s fundamentals and an estimation for the prospective start of the next development cycle. Therefore, given that job growth statistics are reported by metropolitan statistical areas (MSAs), it is necessary to calculate the proportion of job growth generated absorption that should be applied specifically to West Houston. This was calculated in two ways using both an absolute method on a one-to-one yearly relationship, as well as on the basis of a three-year moving average in order to preserve a portion of the momentum in the job market. When these two methods were averaged together, it was calculated that in a 20-year average, West Houston has accounted for approximately 35% of total Houston Class A absorption. Using this proportional relationship, CBRE Research applied overall Houston MSA job growth from expected job growth scenarios to West Houston independently. This calculation when paired with corresponding historical job growth indicates that for every job added to the overall Houston economy; about 16 sq. ft. of Class A office demand was generated in West Houston, specifically. Given the time frame of historical cycles, the economic rental bracket (ERB), and the assumption of a 10% availability trigger, we expect the next development cycle to commence sometime during late-2022 to early-2023, with prelease deals signed at economic rental rates ranging between $50 and $54 ($32.50 and $36.50 net) per sq. ft. (Figure 7). Figure 7: West Houston Economic Rental Bracket vs. Market Rates FSG (per sq. ft.) $50 $45 $40 $35 $30 $25 $20 $15 $10 Energy Boom Pt. II Shale Oil Boom Prelease Deal ERB Range Market Rent Range (Effective) OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 11

12 LIMITATIONS OF OUR OFFICE CONSTRUCTION FORECAST CBRE Research has identified three main limits of our forecast: oil price volatility, negative absorption by certain office tenants, and unknown shadow space. Chief among these limiting factors is the inability to meaningfully forecast oil prices, and to a similar extent, West Houston s office job growth that is principally dependent upon oil-based economic activity. Given current forecast estimates for oil supply and demand levels from both industry analysts and the U.S. Energy Information Administration, this analysis assumes a recovering oil price to the $60-$65 level over the next three years. Independent of global oil markets, the opacity of forecasting job growth is increased by the prospect of a mild U.S. recession in , as projected by CBRE s Economic Advisors. Given this potential national slowdown, employment growth would be just one of the many factors impacting commercial real estate fundamentals. Additionally, while the absorption effects of positive job gains have long been estimated, it is more difficult to quantify office space given back due to job cuts. Negative absorption is highly variable, and can only be accounted for on a space-to-space basis dependent on the individual leasing strategy and financials of the occupier. Lastly, shadow space leased, unoccupied space not yet being marketed for sublease could represent a significant contingent of potential sublease space that is fundamentally unknowable. OCTOBER 2016 CBRE Research 2016 CBRE, Inc. 12

13 To learn more about CBRE Research, or to access additional research reports, please visit the Global Research Gateway at FOR MORE INFORMATION, PLEASE CONTACT: Robert C. Kramp Director of Research & Analysis Texas-Oklahoma Division Follow Robert on Cammie Moise Senior Research Analyst Brad Smith Research Analyst Analee Bivins Micheletti Research Analyst Disclaimer: Information contained herein, including projections, has been obtained from sources believed to be reliable. While we do not doubt its accuracy, we have not verified it and make no guarantee, warranty or representation about it. It is your responsibility to confirm independently its accuracy and completeness. This information is presented exclusively for use by CBRE clients and professionals and all rights to the material are reserved and cannot be reproduced without prior written permission of CBRE.