Downtown Houston Shed Its Sublease Space Just In Time

The 2014-2016 energy downturn flooded Downtown Houston with millions of square feet of sublease space. But thanks to ongoing absorption over the past couple of years, and strong subleasing activity in the second half of 2019, the vast majority was absorbed by the end of the year, right before the latest drop in crude oil prices began.

“We had just gotten to the point, I would say, at the end of 2019, to a point of almost equilibrium, which is a great thing,” JLL Senior Vice President Jessica Ochoa told Bisnow.

The Downtown Houston submarket’s total inventory is about 52M SF, according to data from CoStar. Of that, about 18.5% of direct leasing space is vacant, amounting to 9.5M SF. In comparison, sublease office space in Downtown Houston is scarce, at 1.8% vacancy, or around 935K SF.

“Probably close to 3M SF has been leased up over the last few years,” Cushman & Wakefield Executive Vice Chairman Tim Relyea said. Of that, Relyea estimates that about 2M SF was subleased by Cushman & Wakefield.

In October, Relyea predicted that all of Houston’s sublease “hangover” would be gone. The volume has certainly dropped, though it does not sit entirely at zero. Instead, it has reached a healthy balance.

The significant reduction of sublease space by the end of 2019 has been a relief for the Downtown Houston office submarket, which otherwise could be facing a more difficult vacancy situation in the wake of the coronavirus pandemic and another energy downturn.

“Downtown Houston is still probably the strongest market in the city because it didn't have the congregation of major engineering companies or the big major energy service companies,” Relyea said.

The tenant mix in each Downtown Houston office building varies, but the area doesn’t have as many large exploration and production energy companies, which have been particularly hard-hit by falling oil prices. As a result, the submarket will probably not see a major volume of sublease space appear in the coming months, but no company is immune from the effects of the global pandemic.

“Have we now started to see some smaller, independent companies cut back on some space? Yes,” Relyea said. “Are we going to see more? Yes.”

Relyea estimates about 250K SF of sublease space has returned to the submarket since the beginning of the year. Though slow at the beginning of 2020, the pace accelerated in March, when the effects of the pandemic and oil price crisis began to intensify.

CBRE Senior Vice President Jason Presley said most large energy companies are more focused on the immediate survival of their own businesses than worrying about the size of their office space right now.

“We may inevitably see increased sublease space, when these tenants are able to focus on their long-term needs, but we're not there,” Presley said.

In the early days of the coronavirus, overall leasing activity in Downtown Houston mostly ceased as employees shifted to remote work. Though some existing deals remain on hold, others have resumed.

“Total leasing activity ground to a halt completely in March but starting about a month ago, we've seen a pretty solid pickup in activity, and we're cautiously optimistic,” Presley said.

Presley said he hasn’t seen any evidence of an uptick in sublease activity, but that direct leasing has picked up, especially for smaller tenants looking for move-in ready spaces with relatively immediate commencements and shorter lease terms.

“I think these tenants have waited as long as they could to understand how COVID would affect things, and now it's time to get back into the market,” Presley said.

Most of those tenants are seeking direct-lease offices in the 1K SF to 10K SF range, and tend to be entrepreneurial, smaller, owner-led companies that aren’t working on office leases a year or two ahead of time. 

Ochoa’s JLL team handles the direct leasing of four Class-A office buildings in Downtown Houston, amounting to about 4M SF. That includes the Allen Center, a three-building, 3.2M SF complex undergoing renovations.

“We've got deals as small as 2K SF, and then there are some deals we're actively working on that are upward of 200K SF,” Ochoa said.

Ochoa is also still seeing a lot of activity from the oil and gas sector, she said. That trend was common before and hasn’t changed since the onset of the pandemic and lower oil prices.

It is difficult to have a clear sense of the overall direct vacancy rate in Downtown Houston right now because many workers have still not returned to the office, Ochoa said.

“For the properties that I lease, we just did not have many tenants expiring in the first half of the year,” Ochoa said. “We might've had one or two that were maybe under the 5K SF mark and had already planned to vacate. I wouldn't say that was as a result of COVID or as a result of the price of oil.”

Tenants have been asking for shorter leases. When it comes to renewals, tenants typically commit to a five-year term. Now, expirations are more likely to range from one to three years, Presley and Ochoa said.

“Tenants always want to give themselves as much flexibility as possible, and so not locking in to a longer term is one way to do that,” Ochoa said.

Second-quarter vacancy and leasing data from the large real estate firms in Houston will become available in the next few weeks. Most people are expecting those numbers to look very different from the first quarter of 2020, when only the first two weeks of the impacts of the pandemic and energy downturn were factored in.

Whatever the numbers, optimism around the future of the Downtown Houston office submarket remains strong among many brokers.

“Tenants that are used to operating in an urban environment like the [central business district] tend to stay in the CBD because there really is no other submarket where they can get the same type of walkable amenities and central location that they can there,” Presley said. “We tend not to see meaningful movements out of the CBD, and I think this time right now is no different.”

After 42 years in the business, Relyea has seen many cycles and said he still believes the submarket will rebound. The opening of the Hardy Toll Road connector into Downtown Houston at the end of 2024 and the continued growth of the Texas Medical Center and life sciences sector will also help, he said.

“Another boom will happen, and there will be companies we don't even know the name of right now,” Relyea said.

Ochoa said she expects Downtown Houston to remain one of the strongest office submarkets in Houston, although vacancy rates there, and across the city, may rise 2% or 3% above the norm from 10 years ago. This is because much of the Downtown Houston office stock was built in the 1970s and 1980s and is losing its competitive edge.

“Not every ownership is going to be in a position to put in the capital investment needed to keep them in competition with some of the other buildings that have put in substantial investments in theirs,” Ochoa said. “We expect that it's just going to be a new norm of about 2% to 3% higher than what it was 10 years ago because you have a supply of buildings that are just stagnant.”