Vacancy Rates Rising In Houston’s Energy Corridor Amid Low Oil Prices

Houston’s Energy Corridor experienced a major economic shock during the 2014-2016 oil downturn, when the energy industry shed more than 90,000 jobs and vacancy rates in that market went from around 5% to 21%, exacerbated by the delivery of new office inventory.

Not fully recovered from the last downturn, the submarket is now contending with the latest decline in crude oil prices, which could elevate the vacancy rates and dampen absorption in the Energy Corridor for the next two years.

“In our current forecast, so far, we have vacancies going up by the middle of 2021 to around 23%, from where they are at 21%,” CoStar Advisory Services Senior Consultant Juan Arias told Bisnow.

Including sublease listings, availability is already around 25% in the submarket, and likely to grow as absorption potentially turns negative this year.

Prices for West Texas Intermediate crude oil fell from between $50 and $60 per barrel at the beginning of the year to negative pricing in April, before recovering to around $30 per barrel in mid-May. The volatility was initially driven by disagreements over production cuts and a subsequent price war between Saudi Arabia and Russia.

Historically high U.S. oil production levels also collided with the coronavirus pandemic, which has reduced demand from sectors that typically use oil, like transportation fuels and manufacturing.

The financial impact of wildly swinging oil prices has rippled across the energy sector, but among the hardest hit are upstream oil and gas companies involved with exploration and production. A wave of bankruptcies, furloughs and layoffs have begun to appear, illustrating the typical boom-and-bust cycle that has commonly been associated with energy, and with Houston’s own economy.

When the energy industry enters a recession, it is usually reflected in Houston’s office market, as companies aggressively cut costs and reduce headcounts. Houston’s Energy Corridor is particularly affected by hard times in the energy industry. Named for its concentration of office spaces occupied by oil and gas companies, the corridor runs along I-10 West, from Beltway 8 to the Katy area.

The submarket has about 28M SF of office space. CoStar estimates that over 40% of that submarket is occupied by energy tenants.

Arias said that in the Energy Corridor submarket, vacancies are at about 21.2%, but could rise to 23% in that submarket by mid-2021.

“Not much of a vacancy change, relative to the past, but still, 23% is a very high vacancy rate for an office market,” Arias said.

Houston’s overall office vacancy rate was 16.9% at the end of Q1 2020, according to CoStar.

JLL Executive Vice President Louis Rosenthal told Bisnow that over the past two to three years, the company has assisted with more subleasing activity in the Energy Corridor than direct leasing, triggered by the last energy boom and bust — energy companies took large amounts of space in the early part of the last decade, and then found they didn't need nearly as much after the downturn of 2014 — and as companies have sought to become more efficient with their office space.

To survive the current oil price environment, energy companies have been cutting capital expenditures by 40% to 50%, effectively halting any expansion plans and elevating the likelihood of subleasing activity in that submarket, Rosenthal said.

“That will result in dramatically less demand for space over the next probably 12 to 24 months.”

In the last 60 days or so, overall vacancy rates in the Energy Corridor submarket have risen to around 26%, including available subleasing space, according to Rosenthal.

CoStar tracks a separate availability rate, which reflects all space that is available to be leased or subleased, even if it hasn't been vacated yet. Right now, the company estimates the availability rate is around 24.1%.

Subleasing trends tend to lag a few quarters. The Energy Corridor had about 580K SF available for sublease in late 2014, when the downturn began. That rose to a peak of over 2.2M SF of available sublease space by mid-2016. Right now, the submarket has about 890K SF available, according to Arias.

With so much economic uncertainty, there has been little leasing activity in the Energy Corridor submarket since the coronavirus pandemic forced businesses and schools to close their doors in mid-March.

“From an overall leasing perspective, it's been very quiet the last 60 days,” Rosenthal said.

Though the pandemic has been disruptive, low oil prices are what most energy companies are more concerned with. That could translate to fewer new leases and relocations in the short- to medium-term.

“I think most of our clients are just, for the time being, not doing anything. They are sitting tight until they have a clearer picture of what the next 12 to 24 months will look like,” Rosenthal said. “If their lease comes up, they would typically try to kick the can down the road and do a short-term extension.”

Negative absorption is also expected to emerge by the fourth quarter of 2020, as companies look to sublease out more space they don’t need.

CoStar’s baseline scenario shows negative absorption affecting the Energy Corridor submarket at the end of 2020, and could last about a year, CoStar Group Director of Market Analytics Justin Boyar said. In a more severe downside scenario, negative absorption could last as long as two or three years.

Rosenthal is also expecting negative absorption to appear during the fourth quarter of 2020, and extend through to 2023.

“I think you're going to end the year with negative absorption, and I think you'll probably see negative absorption for the next, I would say, at least 24 to 36 months, or two to three years,” Rosenthal said.

One of the few upsides is that no new office inventory is slated to deliver in the Energy Corridor submarket this year. Developers have had little economic incentive to invest in the area, as high vacancy rates have given tenants more bargaining power for lower rents over an extended period of time.

During the last energy downturn, low oil prices and a wave of new office deliveries boosted vacancy rates from 5% in Q2 2014 to 21% by Q3 2016. Of the 8M SF that has come online in the Energy Corridor submarket since 2010, over 6M SF was delivered during 2014 and 2015, Arias said.

“This time around, we don’t have that much inventory on the way, but we do expect vacancies to rise because these companies — partly it’s going to be, some of them will give back space, sublet some space. Others, you’ll see the bigger oil companies buy out the smaller companies and then consolidate all office space as well,” Arias said.

Rosenthal said that unlike the last downturn, it is unlikely that the market will see as much sublease space become available.

“If I had to guess, I would say that you will not see as much sublease space come on the market as we saw in the 2015-2016 downturn, because companies … have already shed a lot of space, and they've been operating under tighter budgets and more scrutiny since then,” Rosenthal said.

There is one other potential silver lining: As companies across industries feel the impact of the pandemic and the oil downturn, they may be looking for bargains, and if rents decline in the Energy Corridor, it could become an affordable relocation option for office tenants in areas like the Galleria and Downtown Houston, Boyar said.

There is a strong correlation between the price of oil and asking rent prices for office space in Houston. When oil prices rise, the leasing price per square foot also tends to rise fairly quickly. Conversely, when oil prices fall, it can take about a year for office rents to reflect the decline. 

The average asking rent per square foot in the Energy Corridor submarket is $30.37, according to CoStar. That is more expensive than most submarkets in Houston, but rent has only seen 5% of cumulative growth since 2010. Class-A office space averages $34.80 per SF.

“If companies want to expand their footprint and they want to still attract talent in a challenging environment, and they want to have a new space, that might support the Energy Corridor,” Boyar said.

Boyar said the flight-to-quality trend in the Energy Corridor has become apparent, with over 80% of office leases over the last few years occurring in Class-A space or buildings that have either been built or renovated since 2011.

In the absence of new construction and demand for quality, owners of some older Class-A buildings will have no choice but to renovate, if they hope to compete for tenants in the submarket.

“There’s still an abundance of new space, quality space, at a value, which could be attractive for some companies,” Boyar said. “That stuff is going to have to renovate to compete, even in the nicest areas.”