‘Massive Compression Play’ Begins Unrolling In Houston Office Market

“Rightsize” was the word of the day as Houston commercial real estate professionals came together to discuss how the long-awaited office shakeout is finally beginning to play out in a city already beset with one of the highest vacancy rates in the nation.

Though Houston boasts a far higher return-to-office rate than most other cities, tenants are paring their spaces by as much as half as leases come up for renewal, flocking to tonier and more expensive buildings as part of the oft-cited flight to quality and relocating farther west. 

The industry has been bracing for this moment since the onset of the pandemic. But it is finally happening, and where Houston lands is still an unanswered question, according to panelists at Bisnow’s Office Market Insights event held earlier this month at the Houston Marriott West Loop by the Galleria.

“The rightsizing — I mean, we've been talking about it forever, but people are actually doing it,” Savills Corporate Managing Director Lesa Nickelson French said, pointing to law firm Vinson & Elkins scaling down from 400K SF to 200K SF as one example.

“The portfolio clients that I work with, they're all looking at their offices and saying, ‘OK, partners, we know you like your corner office, but we're not doing it anymore. We're going to standardize the offices,’” she said. “And they're just actually doing it, which has been very surprising to me, and a lot of it is being done so that they can go to better buildings. … That has been a big move.”

Trammell Crow Co. Managing Director Aaron Thielhorn said big moves like Vinson & Elkins’ have skewed data, making it appear Houston’s office market is faring far worse than is the case.

Houston’s office vacancy rate sits at 19% — the highest among any major market, per new CoStar figures reported by The Real Deal — and about 9M SF of the metro’s 350M SF of office space is available for sublease. 

McDermott International’s decision to sublease 293K SF at Energy Center V to pipeline company Enbridge 18 months after leasing the entire building illustrates how such numbers racked up in the first place, Thielhorn said. While Energy Center V remains 100% leased despite the new tenant mix, Enbridge vacated more than 600K SF at the Galleria in the process as it, too, sought to shrink its footprint.

“Compound that times, you know, the whole entire market, and it's just a massive, massive compression play,” he said. “You can't really look at the statistics of the overall market and get a good indication of the health of the market because in that instance, I mean 630K SF of negative absorption, statistically speaking, that's a big black eye on the Galleria market. But it's showing that flight-to-quality phenomenon that we're all talking about.”

Midway Cos. Executive Vice President of Development Larry Sloan said there are office properties that have zero value and no attempt at repositioning via tenant improvements will get them to the point of covering debt service. Developers are also scaling back on speculative projects, though all is not lost.

“There's the vacancy headlines that all the core institutional investors pick up and love to point to when you have conversations on the capital market side, but there's really a lot happening behind the scenes,” he said of the development environment. “You just have to be conscious about delivery, what the team wants and be disciplined in how you execute it.”

Thielhorn said historic core investors in Houston’s office market such as pension funds and life insurance companies are on the sidelines amid lingering doubt about office’s future and economic shifts that have made buying an office building at a 5% cap rate in an era of 6% interest rates unattractive. Foreign capital is also sitting it out, he said, opening up the field to private and opportunistic buyers, who are doubling down on Class-A properties.

Transaction volume has “dropped tremendously” as a result, he said, but that could soon change as lenders get itchy to unload troublesome properties.

“I think we'll see in the next year that there's a number of deals out there that are really valued below the level of the current debt,” Thielhorn said. “Lenders, I think, are going to start pushing some transactions. … I think we're gonna see some larger transactions that are going to hit the market at an inopportune time from a pricing perspective, really driven primarily by the lender of that asset.”

The pandemic and subsequent turmoil in the office market have spurred western migration. Bechtel, Apache Corp. and Enbridge are all examples of firms that have taken space closer to their employee bases, and Moody Rambin Managing Director Bob Cromwell II said he expects the trend to continue with Downtown tenants moving to the Galleria as Galleria tenants decamp for points west.

“People are saying, 'I'm tired of my commute, I want to [work] closer to home,' and as the city continues to expand and grow … they don't want to commute down to the Galleria, they don't want to be inside the Loop,” Hartman Management senior leasing agent Ami Figg said. “People want accessibility and they want to be close to their families so they don't have to spend a lot of time commuting.”

Tenants are also seeking out what Thielhorn called horizontal development in walkable urban environments like EaDo and Sawyer Yards. Such developments are also easier than big office towers to develop, as deals tend to be smaller and easier to capitalize.

Both trends have come at the expense of Downtown Houston, as demand shifts away from huge, million-plus-square-foot office towers with expensive and distant parking structures. 

“We so overfilled the city in the ‘80s,” Cromwell said. “And we did not build anything from 1986 basically till almost 2000. In this older stock, we have these ‘80s-vintage classic buildings, they're just not getting any looks at all, and I'm concerned about Downtown because we have a lot of them down there.”

Panelists agreed Houston needs to begin capturing its share of corporate relocations to give the city a jump-start. Dallas and Austin have dominated the list of newcomers, many from California. Of the 17 corporate relos announced so far this year, just four went to Houston, according to the YTexas relo tracker.

Nickelson-French said the city could strengthen its incentives, especially given a labor pool that ranks among the top three among Sun Belt cities and should theoretically be a major draw. But the city known for oil and gas production also needs to do more to position itself in a world in which ESG is growing in importance.

“I think the world's learning right now that you can't decouple from fossil fuels as quickly as it thought it could, but it's very real from a capital perspective, very real,” Sloan said. “This ESG initiative is real, and how we frame the narrative in Houston — because we're not just an energy city — is really important to attracting these tenants, and I think that's still providing some real headwinds.”

Texas has been a leader of the nascent anti-ESG movement, passing a law forbidding its six public pension funds from investing in financial products that “boycott energy companies.” 

One prospect floating in the ether could give the city the major boost it needs, Thielhorn said: the rampant speculation California-based Chevron could move its headquarters to Houston. The company has sold its 92-acre headquarters campus in San Ramon, California, and announced plans in late September to move 200 workers to Downtown Houston, where it already has 6,000 employees. Chevron has denied reports it is considering a move.

“That would be a huge impact for Downtown,” Thielhorn said, pointing to the deals that made Houston an energy capital in the first place — deals that have slowed in recent years. “It'd be great to see the energy business kind of get some momentum, and even if it's an alternative or green tech-type energy [company], that would be a big driver.”

Thielhorn pointed to Greentown Labs and the climate tech companies that have spun out of that incubator, as well as companies like SCF Partners and EnCap Investments helping foster energy innovation.

“I'm optimistic that that will continue and those type of companies will actually flourish here, because that is the type of technology-oriented tenant that would be great to grow in this market,” he said.