Houston, We Have a Problem—City Tops November Morningstar Watchlist

Just as Houston's office market is starting to show signs that the worst is over, Morningstar Credit Ratings added seven loans totaling $263.5M backed by Houston properties to its watch list. Over the past 12 months, the balance of Houston loans on the watch list has grown by more than 50% to $748.1M.

Much of the increase can be attributed to 2007 loans—their watch list exposure more than tripled—and 2013 loans, which leapt 188.2% over the past 12 months. Six of the seven loans added to our watch list have Morningstar loan-to-value ratios greater than 90%, including five with LTVs above 100%.

Five of the loans recently added are backed by office collateral. Office vacancy increased to 14.6% in the third quarter of 2016, up nearly 400 basis points from 10.8% in 2014, according to CoStar. Sublease space pushes the total availability to roughly 20%.

That includes ConocoPhillips’ 242k SF sublease, or 57.7% of the gross leasable area, at Three Westlake Park (pictured). The 420k SF building secured an $80M CMBS loan in 2014, and it's just 59% occupied since BP Amoco Corp vacated at its November lease expiration. However, Morningstar doesn't view the loan as a near-term default risk because the property can still cover its debt service, as ConocoPhillips will continue to pay rent for three years even without a subtenant.

CoStar expects office rents to finish 2016 with their slowest growth rate in five years and to start dropping over the next two years. Supply growth could exacerbate an already weak situation, as more than 3M SF of office space will hit the market over the next two years. However, there may be hope. Sublease activity recently picked up, with the inventory of sublease space decreasing by 5% so far in the fourth quarter to 11.8M SF. In addition, if it follows through, OPEC’s recent agreement to cut oil production to spur an increase in oil prices should benefit energy-dependent cities like Houston.

Morningstar is keeping an eye on four loans in particular; 

• 717 Texas Ave, $160M loan accounting for 13.4% of the CMBS loan MSC 2007-IQ15

"While the loan is not a near-term default risk, we added it to our watch list because of the sizable amount of available space for sublease or direct lease at the nearly 700k SF office building in Downtown Houston."

• 10333 Richmond, $34.7M loan accounting for 3.1% of JPMBB 2014-C22

About one-third of the property’s space is available, up from the reported 22% vacancy in June.

The debt service coverage ratio may fall to below break-even from 1.14x in June. The property’s value has slipped since issuance, dropping to $27.6M (using a discounted cash flow analysis), which yields a concerning LTV of 125.7%.

• 801 Travis, $28.6M loan accounting for 2.7% of JPMBB 2013-C17

Morningstar added this loan to the watch list because the collateral, a 220k SF office property in the CBD, has about 38% availability. Although the property was last sold in April 2015 for $46.3M, discounted cash flow analysis suggests a $27.6M value, meaning a 103.8% LTV.

• 9801 Westheimer Road, $14.6M loan accounting for 1.5% of WFRBS 2012-C9

The loss of the largest tenant (NOV) and high 2017 lease rollover at this office building in the Westchase submarket will limit the borrower’s ability to secure take-out financing by the loan’s November 2017 maturity date without additional equity. 

Is there any good news? Morningstar VP Steve Jellinek tells us the gap between sublease asking rents and direct asking rents is the widest it's been in 17 years, which could spur leasing activity. But it would be a long climb back, since there's still nearly 12M SF of sublease space available, up from roughly 3.5M SF in 2014.