A Wave Of Industrial Properties Are About To Deliver, With Nobody Ready To Fill Them

Houston’s industrial market is frequently touted as one of the most robust property types in the city. The market has long benefited from the movement of goods through Port Houston, a rapidly growing population, positioning on major national highway I-10 and Texas’ robust pro-business policies.

But even the industrial market won’t escape some short-term pain in the wake of the coronavirus pandemic and a precipitous decline in the upstream oil and gas sector. 

Houston is in the middle of a significant development wave that was already scheduled to deliver in 2020. As a result, the city is facing a short-term glut of industrial inventory that could take as long as two years to absorb.

"There's not a submarket that will not be untouched by too much inventory,” Duke Realty Vice President of Leasing and Development David Hudson told Bisnow.

Stream Realty Partners tracks institutional-grade inventory in Houston, which totals about 307M SF. At the end of the first quarter of 2020, the vacancy rate was 7.3%. This was a 90 basis point increase from Q4 2019, and was mostly caused by the addition of about 4M SF of new supply that delivered during the first quarter.

Stream Realty Partners Vice President Jeremy Lumbreras said the company expects just over 10M SF of new industrial inventory to deliver during the second quarter. Another 8M SF is slated to deliver over the following three quarters.

“We expect absorption to really suffer over the next two quarters given the stay-at-home mandates. Any new lease of size signed in the next couple months likely will not commence until later this year, closer to Q4,” Lumbreras said.

“Most of the 10M SF expected to deliver this quarter is likely going to deliver vacant. If this occurs, it could push vacancy north of 10%.”

The new supply will be distributed all around Houston, but certain submarkets will find themselves with a bigger excess of industrial property. Those submarkets include the I-45 North corridor near George Bush Intercontinental Airport, the Highway 290 North corridor in northwest Houston, southeast Houston near Port Houston and southwest Houston.

The majority of the industrial buildings in the construction pipeline were likely approved last year, well before the pandemic began to impact the global economy. Hudson said most of that inventory was built on spec, with the expectation that distribution, e-commerce, manufacturing, construction and energy-related firms would continue to expand and need that additional space.

“I see all the product being delivered by fourth quarter 2020, and then Houston's going to be solid for a while, in terms of spec starts,” Hudson said.

Lee & Associates principal Justin Tunnell said the latest wave of industrial development has been driven by developers hoping to land big users like Amazon, Lowes and Wayfair as they expand their distribution and e-commerce operations.

“There's just so few users that are expected to absorb all of this space,” Tunnell said. “Everybody's chasing the same deals, so that means somebody's going to be left with the bag.”

The coronavirus pandemic has disrupted commercial real estate transactions around the country. With so much economic uncertainty, many companies have placed business deals on hold in the short-term. For that reason, vacancy rates in Houston could remain high for anywhere between 12 and 24 months.

Hudson noted that industrial absorption in Houston has averaged about 9M SF each year for the past 10 years. He doesn’t expect it to be that high in 2020, and it could also be a struggle in 2021. 

Over the past three years, it has taken Houston’s industrial market between 12 and 15 months to absorb more than 90% of new delivered product, Tunnell said.

Assuming that the U.S. economy bounces back in the summer and companies begin spending again, it is likely many deals already out in the market will still get done, but perhaps a little cheaper than landlords want, he added.

Hudson also said he thinks rental prices will come down, as landlords will be determined to keep their tenants. Short-term renewals are also likely to make an appearance, as companies hold off signing longer contracts to see how the economy performs.

“There's a lot of product, and I don't think you're going to see rent growth in Houston over the next several months and maybe through mid-2021,” Hudson said.

Industrial will be a tenant’s market in the short-term, given the amount of supply about to hit the ground, Lumbreras said. Though submarket and deal specific, it’s likely that rental rates will be compressed slightly. 

Stream Realty Partners has also seen an uptick in tenant incentives, like free rent, rent concessions and tenant improvement dollars.

“Many existing owners with vacant buildings are getting aggressive to find tenants,” Lumbreras said.

As Texas state officials begin to open up certain businesses, the company has already started to see more tour requests and inquiries.

“These deals, if they happen, will take some time to materialize, but we expect larger absorption numbers Q4 2020 and into the first part of next year,” Lumbreras said. 

“The good news is most of the deals we were working on pre-COVID did not die completely, they were simply postponed — which should lead to pent-up leasing demand.”

Part of the problem for industrial real estate is that consumption of goods could be affected for some time. In the Houston market, industrial absorption is significantly correlated to consumption.

“If you lose well-paying jobs, there's [an impact on] consumption, therefore it hurts industrial absorption,” Hudson said. “It's not tied directly to oil price, but the oil price is tied to jobs, it's tied to consumption, and that's where we get hurt.”

The U.S. energy sector has suffered several major pricing shocks this year, driven by the combination of a price war between Saudi Arabia and Russia, as well as low demand for crude oil and refined products from industrial and regular consumers. Upstream oil and gas companies have been particularly hard-hit, with mass furloughs, layoffs and bankruptcies gaining momentum since March.

Economists had already predicted that 2020 would be a lackluster year for the energy sector. Tunnell said that even last year, he had begun performing valuations of industrial properties belonging to oil and gas companies in Houston, to assist them in divesting those properties.

“I was already looking at helping get rid of unused assets, divesting unused assets and/or underutilized assets, just to get them off the books,” Tunnell said.

Many of those spaces are older, manufacturing assets with metal construction and yard space for storage. Manufacturing activity in those spaces has typically been linked to oilfield services or subsea drilling. 

As the energy sector's situation has intensified this year, Tunnell is seeing newer, nicer facilities also hitting the Houston market, as well as other real estate markets around the country. The longer oil prices remain unsustainably low, the more likely that energy companies will seek to divest excess real estate.

“The valuation process has ramped up a lot,” Tunnell said.

While the industrial market in Houston faces short-term oversupply, there is little doubt from observers that it will regain its momentum in the long term.

Lumbreras said consumer foods, healthcare and plastic resins are the most likely candidates to drive future demand for industrial space, in order to keep up with Houston’s growing population.

“While most of Harris County is forced to work from home, there has been a new reliance on e-commerce and logistics companies to fulfill everyday household needs,” Lumbreras said. “This should only help reinforce the need for these logistics companies and providers to establish local networks to meet this demand. The change may not be overnight, but it’s coming.”

Hudson said that prior to the pandemic, e-commerce was already growing roughly 10% a year in Houston. Some have speculated that current events could super-charge the industry.

“I do know that e-commerce is going to continue to grow, most definitely for the city’s overall retail sales,” Hudson said.

Tunnell noted that prior to Hurricane Harvey, Houston faced a similar oversupply issue. Following the hurricane, the demand for building materials helped fill a significant amount of that vacant space, and has remained strong as Houston’s population continues to expand.

“I think it will mostly be e-commerce and building materials, as long as Houston continues to grow,” Tunnell said.