Buying Value-Add Office Properties In Houston Is A Big Gamble Right Now. Investors Are Doing It Anyway

Houston’s office market has one of the highest vacancy rates in the country, a carryover from the energy sector’s prior downturn in late 2014 and cautious leasing activity by oil and gas tenants in the subsequent years. The latest downturn, coupled with the uncertainty of the coronavirus pandemic, has weakened the market further.

In an environment where further distress is likely, office users and opportunistic investors are swooping in to look for value-add bargains, betting on the future recovery of Houston’s office sector. Industry experts say that gamble is often on buildings that are heavily or entirely vacant, where adequate cash flow returns from tenants could be years away.

“It's a great time for a user to buy a vacant office building,” Transwestern Executive Vice President Michelle Wogan said. “Is it a great time for an investor? Yes, it is, as long as you can hold it for five years or longer.”

Houston’s direct office vacancy rate was 19.8% in Q4 2020, while its total availability rate was 25.8%, according to Transwestern’s Q4 2020 office market report. Both rates increased throughout 2020 in response to pressures from the energy downturn and the pandemic.

Like many U.S. cities, Houston went through a construction boom in the 1980s, thanks to major tax reforms that stimulated massive growth in the commercial real estate sector and a simultaneous oil boom that buoyed Houston’s economy. As a result, the city has millions of square feet in office buildings that are more than 30 years old. That product is now a prime target for value-add acquisitions.

Wogan said she has personally been handling more value-add office transactions than usual recently. The properties either have high vacancy rates or are stabilized but with lower rents that will rise as the market recovers. Most buyers are looking for bargain prices, particularly as it could take five or six years for Houston’s office market to recover. Other investors are buying bank notes on buildings for lower than the value of many properties.

Another trend that is emerging in Houston is more traditional office users looking to buy their own properties. In addition to the prospect of bargain prices, Wogan said there are various tax advantages, the user can tailor the property to its own needs, and most importantly, it can limit who enters the building — a higher priority in a pandemic-driven world.

“We're also not only seeing investors out there looking for opportunities to purchase, but we're also finding tenants that have historically been leasing office properties that are now looking at controlling their own environment and saving millions and millions of dollars over a long period of time,” Wogan said.

The biggest problem with buying a vacant building is the lack of cash flow. With so much uncertainty in Houston’s office market, including the timeline for the energy sector’s recovery and how much space companies will want in the future, investors are taking a hefty risk.

“These are big gambles,” CoStar Director of Market Analytics Justin Boyar said. “By gamble, I mean that it's solidly a tenant’s market right now. Rent growth is low or negative in most places, tenants are being offered large amounts of free rent and concessions, and they sort of have their pick of the litter, so to speak.”

Over 85% of leases closed in Houston since 2018 were signed in buildings either built or renovated since 2011, typically translating to Class-A office space, according to a CoStar analysis.

“In that environment, if a brand-new Class-A building with all the bells and whistles is competitive with an older Class-A building that's just been renovated, then, all things considered, if they're the same price, the tenant's probably going to go into the newer building,” Boyar said.

Not every investor looking for a bargain is interested in buying vacant properties. Nitya Capital CEO Swapnil Agarwal said his firm prefers to buy office buildings that have many smaller tenants and a relatively high level of occupancy.

“We're not buying core kind of assets, which have an institutional quality and the top three tenants make up 50% of the lease,” Agarwal said. “We are actually looking for cash, day one. So we are not looking for vacant buildings, we're looking for anywhere occupancy [is] above 75%.”

Agarwal noted that purchasing vacant buildings and sitting on them for years is a strategy that works for some investors. But for him, it comes with too much risk.

“Buying a vacant building in this market after COVID and trying to increase occupancy seem very risky to me,” Agarwal said.

Nitya Capital has traditionally been a player in the workforce housing space, buying older multifamily properties and adding value. But the economics of Houston’s office market, along with falling cap rates, prompted the firm to start buying office in 2018. Now, Nitya owns about 1.5M SF of office property in Houston, with plans to buy more.

“We are very opportunistic. So we are actively looking at office assets in Dallas and Las Vegas, and in different parts of the country. We are going to expand, but again, Houston is still going to be our home base for the corporate office,” Agarwal said.

The company made headlines in August when it purchased One Westchase Center in West Houston following the transfer of the property to special servicer LNR Partners. A pending maturity date and the effects of the pandemic were cited as the reasons for transitioning the property to the lender.

Boyar said one of the biggest value-add acquisitions to happen in the Houston office market within the past year was the purchase of Two Westlake Park by Younan Properties, a 455K SF office property in the Energy Corridor. Others included Triten Real Estate Partners' acquisition of 1111 Fannin, Capital Commercial's acquisition of 6500 West Loop South, and Realty.com's acquisition of 363 North Belt. All the properties had either a high vacancy rate or a rent roll with high turnover.

Wogan noted that for much of 2020, there was very limited office investment happening because of the energy downturn and the pandemic. The demand hasn’t fully returned, but there is noticeably more activity happening on the investment side.

In particular, smaller investors are getting into the Houston office market, both local and out-of-state, according to Wogan. Many are looking to invest in assets valued at $5M or lower and can pay in cash. In particular, smaller investors from California are being very active in Houston because office property is so much more affordable.

“Their prices are so much higher than Houston. They look at Houston, and they go wow, I can buy an office building for $40 a foot? Why wouldn't I buy an office building for $40 a foot? They're looking for ways to put their money to work,” Wogan said.

Despite the high rate of office vacancy in Houston, the pandemic and energy downturn has not resulted in a flood of distressed properties that was originally anticipated.

Boyar said that’s because many tenants have signed long-term leases and are continuing to pay rent as their employees work from home. That’s providing a measure of stability to landlords, who have loans of their own to pay. 

Houston also hasn’t seen a massive amount of new sublease space come onto the market. The energy downturn that began in 2014 forced many large oil and gas tenants to shed unnecessary space. As a result, other users had already absorbed much of that square footage before the latest energy downturn and pandemic crisis.

“In Houston, whatever distress we did see, we probably have seen most of it during the shale bust,” Boyar said. “Part of me thinks that a lot of best value-add deals have probably already hit the market if they were really in trouble. But we could see a few more this year as this thing drags on.”

Wogan said the court systems have been shut down and foreclosures have been on hold for months. That pent-up demand could translate to more distressed Houston office properties hitting the market.

“There have been buildings that should have foreclosed last year that did not, that will foreclose this year. So that activity of servicers coming back into the market, servicing the loans, foreclosures — that will happen, it will be an uptick in 2021 and 2022,” Wogan said.