Is A Monster Slumbering In Houston’s Sublease Space?

Houston’s sublease space has stood above 9M SF for nearly four years. Once a latent concern with rents still rolling in, much of Houston’s sublease space will soon tick over to direct vacancy, ending payments. With an office market that is already trudging along, how will Houston’s glut of sublease space going direct affect ownership of Houston’s iconic assets?

The NAI Partners Sublease Index, measured by the amount of sublease space as a percentage of total available space, increased to 15.5% last month. The increase was due to TechnipFMC placing 375K SF of sublease space — the total of its lease — on the market at Energy Tower II. This brings the total amount of available sublease space back up over 9M SF after dipping just below the mark in Q4. Despite this bump in the road, Houston’s overall sublease market has mostly experienced a steady decline since the third quarter of 2016, when available sublease space reached a peak of 12M SF.

Stream Realty Managing Partner and director of the firm’s office team Paul Coonrod said on a 1-10 pain chart, Houston’s sublease space is somewhere between a six and a seven. NAI Partners partner Dan Boyles Jr. reckons Houston’s sublease pain is roughly a six.

“For a town that historically averaged 3.5M SF of sublease space, the idea of sublease space going up three times that has been very daunting,” NAI Partners Managing Director of Landlord Services Jim Tainter said. “It’s an indicator, it influences people’s perception of the actuality of the market.”

Approximately 5.5M SF of sublease is set to expire in the next 12-24 months. Houston’s CBD takes the top spot, with 1.3M SF converting to direct vacancy soon. The Energy Corridor is close behind at 1M SF. Behind the sublease glut are huge chunks of space. Combined, sublease space at 1201 Fannin and 1100 Louisiana account for 600K SF of Downtown Houston’s total, both of which go to direct in the next 24 months.  

“The truth of the matter is that space with less than 24 months left is not really marketable,” Boyles said.

Sublease deals already have a lot of hair on them, making them difficult to close. All that trouble is typically not worth it if you have to move again in less than two years, brokers said. 

“I call it sublease purgatory,” NAI Partners Senior Associate Nick Terry said. “It still hurts to pay rent, but there’s not enough term for it to be seriously marketable.”

Terry is working a couple of sublease deals. He is offering less than half the direct rate, and still is not getting much action. Most of the marketable sublease deals with enough term got signed earlier in the oil downturn, he said. Now, as the market bottoms out, landlords are looking to take back the space to market it more aggressively.

“If you’re a landlord in this town and haven’t looked at your sublease space, you’re behind the ball,” Tainter said.

In the next 24 months, Houston’s sublease space could fall below 4M SF, close to Houston’s historical average, on sublease expirations alone.

“It’s great if the total sublease space goes below a certain number but if none of it gets absorbed, then it doesn’t matter,” Boyles said.

Boyles does not see major ownership issues arising, though. A couple of buildings in Westchase or the Energy Corridor might run into trouble if demand does not pick up, but buildings with large spaces backed by institutional ownership, like those Downtown, are not threatened thanks to well-capitalized ownership.

Spaces going direct is not exactly a bad thing either. Once the landlord takes back the lease, it can be more aggressive in filling the space. Sublease space going direct also helps to alleviate downward pressure on rents, stopping sublease rates from undercutting market rates as the sublessor looks to subsidize the rent.

“Most owners and developers have realized market conditions have drastically changed, they’re starting to sign leases with new market conditions,” Coonrod said. “Because of the flight to quality, you’re starting to see deals get done.”

The sublease deals that are closing have been small. Over the past year, a 19K SF sublease was signed in CityCentre Four. Another 11K SF of sublease space was taken off the market in Courtlandt Square in Midtown. Rockcliff Energy took 9,400 SF off the market on the 15th floor of 1301 McKinney. 

Officer brokers in Houston are hopeful. Despite TechnipFMC’s recent addition, Houston has stymied the inflow of sublease space. Even if the numbers do not show it yet, activity is picking up, our sources said. As the price of oil climbs, so too does Houston’s recovery. Greater Houston added nearly 63,000 jobs in 2017, according to newly released data revisions by the Texas Workforce Commission. Rising oil and gas activity coupled with Houston’s continued ascension in healthcare could be the demand boost Houston’s office market needs to digest millions of square of direct vacancy, according to Boyles. 

Peering into the future, brokers expect the pain of Houston’s sublease to be less 24 months from now.

“We’re not out of the woods yet, but we can see the light. We really need the demand side to kick in,” Boyles said.