Houston Office Market: Unpacking 10 Crucial Insights for Investors

Market Saturation and High Availability

Houston’s office market struggles with an excessive supply, marking one of the highest availabilities on record.

With a staggering 76.7 million square feet available for lease, accounting for 21.4% of the total market, availability is near historic peaks, according to CoStar. The Central Business District most prominently exhibits this trend, having seen the largest increase in space since 2020.

Economic Factors Versus Market Weakness

Despite several attractive economic incentives, Houston’s office market remains under pressure.

The area benefits from no state income tax, and housing costs 18% below the national average, factors which typically bolster market strength—however, more than these advantages are needed to overcome the overarching challenges in the office sector.

Historic Overbuilding and Its Lasting Effects

A legacy of overbuilding has left Houston with one of the highest vacancy rates among major U.S. cities.

The vacancy rate has climbed to a new peak of 18.6%, a significant rise from historical averages. This stems mainly from aggressive construction activities in the 1980s, which had long-term impacts on the market.

Changing Tenant Preferences

A shift in tenant preferences currently characterizes the Houston office market, impacting the demand for office space.

While Houston shows a high return-to-office rate at 60%, the demand for office space is evolving, with tenants now opting for 12% less space than in previous years. Ongoing changes influence this shift in workplace arrangements.

Disparity in Asset Performance

The performance gap between older and newer office properties is widening, with newer properties seeing lower vacancy rates.

Newer, high-quality buildings are generally experiencing vacancies below 10%, demonstrating resilience in a challenging market. In contrast, older buildings, particularly those constructed before 2010, face greater difficulties.

Implications of High Vacancy Rates

Elevated vacancy rates are forcing landlords into a position with little leverage on pricing.

The high vacancy rate has directly impacted landlords’ ability to command higher rents, with real-term rental prices declining. Given the current market dynamics, we expect this trend to continue.

Impact of New Inventory

An influx of new office developments will introduce additional challenges for a saturated market.

Approximately 4.8 million square feet of new office space is anticipated by year-end, with a significant portion still available for lease. This is likely to exacerbate the existing conditions of oversupply in the market.

Market Transactions Reflect Caution

The office property transaction market reflects a cautious approach from buyers, influenced by broader economic concerns.

Recent trends indicate a reduction in properties trading, reaching a three-year low. This is reflective of higher borrowing costs and tighter lending standards.

Focus on Premium Properties

Despite general market challenges, premium properties attract attention and command higher prices.

Properties that are well-leased and positioned at the higher end of the market continue to perform well. For instance, the Medical Center of Tomball recently sold for a significant premium, illustrating ongoing interest in quality assets.

Market Outlook and Adaptation

The Houston office market continues to adapt to evolving trends, with a focus on reducing footprints and prioritizing quality spaces.

This trend is evident in major lease transactions and relocations, such as Bechtel and Modec International, which opt for buildings that offer modern amenities and a better overall work environment. These moves reflect broader changes in how companies approach their office space needs in Houston.

Stagnant Rent Growth in Houston

Houston’s rent growth remains tepid compared to national averages, with only a slight year-over-year increase.

Houston’s asking rents rose by just 0.9%, lagging behind the minimal national average growth of 0.7%. Substantial sublease options continue to exert downward pressure on rent increases. Since 2015, the annual growth rate has not reached 2%, indicating a prolonged period of stagnant growth.

Uniform Concession Strategies Across Markets

Free-rent offerings in the CBD and suburbs show no significant variance, indicating a uniform approach to attracting tenants.

Office brokers across Houston typically offer three months of free rent on a three-year lease. For longer commitments, such as a five-year lease, tenants might receive six to eight months free and even more—12 to 18 months—for a ten-year lease. These generous concessions reflect maintaining occupancy rates despite a weak leasing environment.

Premium Rent in High-Grade Buildings

High-quality buildings command the highest rents in Houston, particularly in the CBD and The Woodlands.

Houston’s average gross office rent is $29.00 per square foot. The CBD, with rents over $36/SF, and The Woodlands, at about $33/SF, lead in high asking prices. These areas, rich in 4 & 5 Star office buildings, account for a significant portion of Houston’s premium office space.

Impact of Rising Sublease Availability

The increasing availability of sublease space contributes to the downward pressure on Houston’s office rents.

From early 2020, the sublease availability rate in Houston increased from 1.4% to 2.0%. Large blocks of sublease space, especially in downtown and the Energy Corridor, are offered at deep discounts, ranging from 25% to 60% below direct rents for similar high-quality properties. For instance, sublease rents at Comerica Office Tower and Twelve Greenway Plaza are significantly discounted compared to direct rents in their submarkets.

Challenges in Raising Rents

The current market conditions suggest that increasing rents will be a significant challenge for landlords in the near future.

With a substantial volume of sublease space available and general market softness, there is little room for upward movement in rents. Landlords may continue to need help with low growth rates and may need to rely more heavily on offering concessions to attract and retain tenants.

Reduction in Construction Activity

Houston’s construction pipeline for office spaces has decreased significantly in recent years.

Only 4.4 million square feet of office space were under construction, making up just 1.2% of the city’s total inventory. This figure is much lower than the 10-year average of 7.4 million square feet. Current projects primarily concentrate on key submarkets like the South Main/Medical Center, the CBD, Katy Freeway East, and The Woodlands, with about 70% of the space already preleased.

Focus on Life Sciences Development

The shift towards life sciences is evident in the types of projects currently under construction.

The largest share of new construction is in the South Main/Medical Center Submarket, where significant developments like the 700,000-square-foot Dynamic One at TMC Helix Park are underway. This project will primarily serve the Baylor College of Medicine.

Continued Development in the South Main/Medical Center

The South Main/Medical Center Submarket continues to see robust development activity with multiple projects.

Among these projects is the 520,000-square-foot Horizon Tower, a state-of-the-art facility by Texas A&M and Medistar, expected to be completed in the first quarter of 2024. The area also recently welcomed the 265,000-square-foot spec building at Levit Green, which focuses on providing advanced lab spaces for life sciences firms.

Emerging Projects in the CBD

Recent developments in the CBD highlight Houston’s evolving office market landscape.

Skanska’s 1550 On The Green represents a significant new trophy spec office development, with law firm Norton Rose Fulbright as a major tenant. Additionally, the Texas Tower by Hines, delivered in 2022, is another notable project, anchored by Vinson & Elkins and serving as Hines’ new global headquarters.

Concentration of Office Inventory

A strategic segment of the city holds a significant portion of Houston’s office inventory.

This area spans about 40 square miles, stretching from Downtown West to the Energy Corridor, with significant highways bounding it. Despite making up less than 0.5% of the metropolitan area’s land, it houses nearly half of all office inventory, underscoring its importance to Houston’s commercial landscape. This concentration includes several key submarkets, each contributing to the area’s dynamic office market.
Cooling Investment Sales Activity

The deal flow in Houston’s office market has slowed to levels last seen at the start of 2020.

Since mid-2022, the volume of transactions has decreased, mirroring the slowdown at the beginning of 2020. With anticipated rate hikes this year, we expect borrowing costs to rise, requiring investors to increase their equity contributions. This trend will likely dampen investment sales activity in the near term.

Pricing Trends and Market Comparison

Houston’s office market sees average pricing below the national level.

The average pricing for office properties in Houston is $200 per square foot, significantly lower than the national average of $300 per square foot. The cap rates in Houston are nearly 100 basis points higher than those in other major Sun Belt markets like D-FW and Atlanta, reflecting a less favorable investment climate.

Changes in Buyer Demographics

There has been a noticeable shift in the types of investors active in Houston’s office market.

Since 2020, private investors have increased their market share, comprising 45% of sales volume, up from 30% in previous years. Conversely, institutional investors and private equity groups, who were more dominant before, now make up a smaller portion of the market. This change indicates a shift toward less institutional investment in the market.

Focus on High-Quality Assets

Investors are primarily targeting top-tier office properties in Houston.

Of the $479 million confirmed office sales in the past year, $304 million was for 4 and 5-star assets, representing 65% of the total investment volume. This trend underscores a continued focus on quality over quantity in the investment landscape.

Market Adjustments and Distressed Sales

The market is seeing an increase in distressed sales and significant discounts on multi-tenant office towers.

Recently, a notable transaction involved the sale of the San Felipe Plaza, a 5-star property, at a substantial discount. Additionally, with a high rate of delinquent CMBS loans and many loans maturing soon, the market is bracing for an uptick in distressed sales activities. This situation presents both challenges and opportunities for savvy investors.

Properties Trading at Land Value

Some office properties in Houston now trade merely at land value, reflecting the market’s difficulties.

For instance, Service Corporation International acquired two buildings of Dairy Ashford Plaza at land value, paying only $42 per square foot. This trend may continue as the market adjusts to the current economic climate and the heightened refinancing risks.

Final Thoughts

In conclusion, Houston’s office market navigates an adjustment period with moderated deal flows and a focus on high-quality assets. Investors are seeing opportunities in distressed sales and properties trading at land values. Strategic insights will be crucial for capitalizing on these conditions as the market evolves. For tailored investment strategies and guidance, contact Lumicre for your investment needs.