Office Market in Houston Melts Down, Watch The Banks!

Wolf Richter wolfstreet.com, www.amazon.com/author/wolfrichter
Commercial real estate is highly leveraged. Debt is everything. The entire math is based on high rental rates and low vacancy rates. Without them, the debts cannot be serviced. But now in Houston, both are shooting in the wrong direction.

OK, Houston’s economy is diversified, they say. The oil bust hurts, and there have been waves of layoffs of highly paid engineers, but it won’t hit the city as bad as the last big oil bust did, they say.

And yet, the amount of office space vacated by companies that are trying to slash their operating expenses and that is now on the market as sublease space has spiked 69% by the end of 2015, to 7.6 million square feet (msf), according to real-estate services firm Savills Studley. And they “continue to sit on the market.”

It’s going to get worse:

New sublease blocks are expected to hit the market in 2016, particularly in the CBD [Central Business District]. Shell is projected to vacate 250,000 sf in One Shell Plaza and EP Energy, likewise, is anticipated to leave 100,000 sf in the Kinder Morgan Building. Shell would likely also shed space at BG Group Place should its pending $70-billion acquisition of BG Group clear governmental hurdles and finalize.
Many large tenants who paid at the very top of the market in the last few years warehoused space in anticipation of continued headcount growth. As a result, many firms had surplus space even prior to the implementation of layoffs in the last year. In 2016, the office market should see more shadow space listings….

Occupancy, after five years in a row of increases, fell by 1.4 msf (“negative absorption”), the biggest decrease in occupancy since 2009. Going forward, M&A and bankruptcies “will contribute to additional negative absorption” and will hit the vacancy rate. It already spiked to 23.2%.

And it’s going to get even worse:

After a tremendous building boom in 2013 and 2014, a total of 17 msf is expected to hit the market over the next few years, with 7.9 msf scheduled for completion in 2016. Only about two-thirds have been pre-leased. Some of these pre-leased properties will enter the shadow inventory as soon as they’re completed. But 5.5 msf has not been leased.
These new buildings will hit the market at the worst possible time, competing with 7.9 msf of sublease space and large amounts of shadow inventory, during a period of negative absorption.
Already the first “see-through buildings” in this cycle are appearing — that infamous phenomenon of vacant and transparent buildings dotting Houston’s business district during the oil bust of the 1980s.
Piedmont Office Realty Trust last year “opened a glassy 11-story building in the heart of the Energy Corridor district without any tenants,” the Wall Street Journal reported. The company’s CEO Don Miller lamented in November during the earnings call that “there’s no real genuine activity in the marketplace.”
And “several notable mistimed projects to be completed this will be under immense pressure,” Savills Studley reported, including:
609 Main. Of its 1,000,000 sf, only 62,000 sf have been leased so far. “Only time will tell whether that space continues to remain vacant after delivery or if the landlord successfully cannibalizes other CBD Class A buildings through new relocation deals.”
And Energy Center Five, scheduled to deliver in April, “remains completely unleased with 524,328 sf available.”
Leasing activity in 2015 plunged 42% to 8.4 msf, the weakest since Financial-Crisis year 2009. While there were some large deals in the fourth quarter, they were “bearish moves”:

Apache Corporation, for example, extended its 524,000-sf lease in Post Oak Central for just one year, pushing back its expiration from December 2018 to December 2019. It executed this extension instead of moving forward on a new development with 6.4 acres of land that it purchased in BLVD Place in 2012.
The quarter’s second largest lease, finalized by Bracewell & Giuliani at Pennzoil Place, was a renewal that saw the law firm downsize by an entire floor to 189,061 sf.

Now the market is in a holding pattern, without real demand, and lots of supply. Savills Studley’s report:

Landlords are feeling the marked reduction in tours, requests for proposals, and ultimately deal volume. Rents appear to be adjusting in spots, but the gap between tenant and landlord expectations has widened.
Many landlords still want to hit or come close to their pro forma financials. In contrast, some area businesses expect rents to adjust on a level that matches the sharp slide in energy pricing.

So overall asking rent edged down 1.6% to $28.99 per square foot, the second quarter in a row of declines. Class A asking rent fell 2.5% to $34.70. But the oncoming flood of sublet supply and new space, while demand is actually declining, will likely lead to “sharper rental rate erosion in future quarters.”
And this is where it gets tricky for banks. Commercial real estate is highly leveraged. Without high rental rates and low vacancy rates, the math won’t work and the debts cannot be serviced. Now both are shooting in the wrong direction.
Last time this happened, it turned into a gigantic mess that helped tear up over 400 Texas banks between 1980 and 1989, including nine of the state’s 10 largest.
So now everyone is hoping for a miraculous turnaround in the price of oil, in addition to healthy growth in the overall US economy, and everything else will follow. They’re hoping for another oil boom, and all that comes with it. But if their wishes come true even modestly, it would very quickly lead to a boom in production and thus an extension of the glut that would destroy the price of oil all over again before it ever gets back to a survivable level. And the shakeout in the real estate bust will simply get worse.
And how are banks that lent to the oil & gas sector dealing with? “All of it is in the gutter.” Read… Banks Much Deeper in the Hole on Oil & Gas Collateral than they Pretend