Market Overview: Houston's Retail Sector Shows Strong Fundamentals

In the dynamic terrain of Houston’s retail real estate market, strategic partners and real estate private equity firms are continually seeking to optimize their investment portfolios. The latest CoStar Retail Market Report provides a comprehensive overview of the market trends, economic indicators, and sales data crucial for informed decision-making. This post will dissect these findings and offer guidance for large institutional investors looking to sell their privately held partnership interests in this vibrant commercial real estate landscape.

Leasing Momentum: Reviewing Houston’s Retail Space Dynamics

Defying National Trends in Leasing Activity

Bucking the national trend, which has seen quarterly leasing activity decline each of the past four consecutive quarters through the end of 23Q1, in Houston, this has not been the case. Aided by pent-up demand and new store openings, the market’s quarterly total leasing activity has held steady during this time, averaging 2.1 million SF during each of those quarters, in line with the quarterly average seen between 2015 and 2019.

Suburban Expansion Dominates Leasing

Following suburban rooftop growth, areas outside the 610 Loop accounted for more than 85% of leasing activity over the past 12 months. This trend underscores the shift towards suburbanization, where retail follows residential development, catering to the needs of growing suburban communities.

The Surge of Smaller Tenants

Smaller tenants are the most active. In a given year, at least 85% of new leases are for spaces under 5,000 SF. The quick-service restaurant sector, with brands such as Starbucks, Shipley Donuts, and Salad and Go, is particularly dynamic. Cellular retailers like T-Mobile and Boost Mobile, along with convenience stores such as 7-Eleven, have also been significant contributors to the leasing activity for smaller spaces.

Big Moves by Major Retailers

The largest leases were driven by tenants in fast-growing suburban locations, chasing demographic and economic strengths found in these areas. Notable lease commitments from major retailers such as Target and H-E-B Supermarket in mixed-use developments highlight the strategic moves by large retailers to capitalize on the suburban growth.

Retail Demand Formation and Absorption

The strong level of leasing activity has boded well for retail demand formation. Throughout Houston, 3.2 million SF of retail space was absorbed over the past 12 months, most of which flowed into either the general retail (1.7 million SF) or neighborhood center (790,000 SF) segments. Big-box retailers and grocery stores are among those expanding their footprints in Houston’s fast-growing suburbs.

Vacancy Rates and Speculative Developments

Houston’s vacancy rate is 4.9%, which is slightly above the national average of 4.2%. This has been consistent since 2017 due to ongoing construction levels. However, with a three-year high of new supply expected, Houston’s market will have to manage an increase in speculative projects, which currently represent a larger portion of the construction pipeline compared to other high-growth Sunbelt metros.

Demographics as a Driving Force

Strong demographics are assuredly a tailwind. Houston has seen a significant population increase over the past decade, making it one of the only metropolitan areas in the United States, alongside Dallas-Fort Worth and New York, to have added at least 1.2 million residents. We expect wealthy and high-growth suburbs to the north and west to continue driving the expansion of retail.

Rental Resilience: Tracking Houston’s Retail Rent Trajectories

Current Rent Growth Trends

Positive trends in leasing and absorption have driven average retail asking rents higher, with trailing 12-month growth standing at 3.8%. This growth rate surpasses the national average of 3.5% and outpaces Houston’s five-year average of 2.7%. Notably, even during the economic uncertainties of 2020, Houston’s rent growth remained resilient, avoiding a downturn into negative territory.

Category-Wise Rent Uptick

All retail categories have experienced an increase in market rents. Strip centers have seen a growth of 3.8%, neighborhood rents by 4.0%, and malls by 3.4% over the past year. This uniform rise across different retail spaces indicates a broad-based recovery and growth in the retail sector.

Suburban vs. Urban Rent Dynamics

Suburban areas, particularly those with strong population growth like Far Katy North and Fairfield, have posted some of the most significant rent gains over the past year. Urban centers such as the CBD and Uptown/Galleria have also witnessed considerable rent increases. However, there is a cautious outlook for urban core areas due to the potential long-term impact of hybrid and remote work patterns that could reduce foot traffic and, consequently, retail demand.

Real Rent Growth and Inflation

While nominal rent growth has been robust, the real rate of rent growth has been negative when accounting for inflation, which has yet to be matched by rent increases since the pandemic began. Like other Sunbelt growth markets, Houston has faced some of the highest inflation rates in the country. The Consumer Price Index (CPI) in Houston, historically around 2%, has seen a significant uptick, affecting retailers’ real purchasing power and costs.

Forecasted Rent Growth Deceleration

Looking ahead, retail rent growth is expected to slow, with a base case scenario predicting a growth rate of 2.8%. This forecasted rate is a notable deceleration from the 5.1% growth recorded in 2022, reflecting more than a 200 basis point decrease.

Premium Rents in Select Submarkets

Certain submarkets, particularly around Uptown, command a significant premium over the metro-wide average. In areas like Uptown/Galleria, rents are about 90% higher than the metro-wide average, while in the Inner Loop River Oaks Submarket, they are 60% higher. The pre-pandemic influx of ultra-luxury retailers, attracted by comparatively lower rents than global metros like New York and London, has contributed to this premium. For instance, average retail rents in the Inner Loop River Oaks Submarket are around $35/SF, which is substantially lower than those in New York’s Plaza District.

Building the Future: Unpacking Houston’s Retail Construction Boom

Rebounding Construction Activity

Retail construction in Houston is experiencing a resurgence, marking a significant shift from the previous two years of subdued activity. Between 2021 and 2022, the market delivered around 2.8 million SF annually, which was less than half of the 6.8 million SF annual average delivered between 2016 and 2020. The anticipation of approximately 4.2 million SF of new retail supply marks the highest amount in three years, signaling a robust recovery in construction activity.

Targeting Affluence and Demographic Growth

Strategic focus directs construction activity to areas with affluent households and robust demographic growth. This trend has been consistent over the past decade, with particular emphasis on fast-growing, exurban submarkets such as Montgomery County, Far Katy North, and Far South, which are seeing a significant amount of new development. Despite the general suburban trend, there is notable construction within the 610 Loop, including in the Inner Loop River Oaks and Inner Loop East End submarkets, which are experiencing densification.

Major Projects Underway

Among the most significant projects currently under construction is Weitzman’s Manvel Town Center’s phase 1, anchored by H-E-B. This project aims to rank among the metro area’s largest open-area retail-focused developments, spanning over 1 million square feet of retail, entertainment, hospitality, medical, and office space. Manvel’s population has exploded, growing by nearly 200% over the past decade, making it a prime target for developers.

Diverse Construction Projects

The Houston area is also seeing a variety of other large construction projects, including gyms and grocery-anchored power centers. Notable developments include The Market at Willis, which introduced the first H-E-B to Willis, and a 140,000-SF Life Time Fitness in Shenandoah, slated for completion in 23Q4.

Retail and Multifamily Synergy in Urban Core

A recurring theme in new retail supply, especially in urban core areas, is the integration with multifamily developments. This trend is evident in projects that combine retail spaces within apartment buildings or as part of larger mixed-use centers. The Allen, a $450 million mixed-use development in the Inner Loop River Oaks submarket, exemplifies this trend with its luxury hotel, retail, and office components, anchored by the Residences at The Allen Tower.

Speculative Retail and Mixed-Use Developments

The Allen’s 62,000 SF speculative retail portion, which was fully leased before completion, delivered. This demonstrates the strong market demand for retail spaces that are part of mixed-use developments, offering a blend of residential, commercial, and leisure facilities in a single location.

Market Movements: Dissecting Houston’s Retail Sales Trends

Robust Investment Activity Amid Financial Headwinds

Houston’s retail investment market remains remarkably active despite elevated borrowing costs and a widening bid-ask spread. Although transaction volumes have seen a decline over the past three consecutive quarters through 23Q2, the market’s resilience is evident. Even after accounting for undisclosed sale prices, saw retail property sales exceed $1.7 billion, marking it as the second-largest total on record.

Stable Average Pricing Amidst Rising Interest Rates

The average pricing for retail properties in Houston is consistent with the national benchmark, averaging $250/SF. Despite the impact of rising interest rates on pricing, strong net operating income (NOI) growth and a focus on quality deals have sustained high pricing levels in the retail sector.

Shifts in Acquisition Trends

A pullback in acquisition activity from REITs and institutional investors, feeling the pinch from the rising cost of capital, has influenced the sales environment. In contrast, private out-of-state buyers have remained a driving force, accounting for a significant portion of the sales volume, with a keen interest in suburban properties that align with rooftop growth.

High Demand for Secure Investment Types

Triple net credit deals and grocery-anchored shopping centers continue to attract significant buyer interest due to their perceived economic resilience. These properties, often featuring credit tenants on long-term leases, have been trading at cap rates between 3% and 4%, although there has been an upward trend in cap rates in response to the rising interest rate environment.

Cap Rate Adjustments in a Changing Market

The shift in the interest rate environment has led to an adjustment in cap rates, with newly-built properties seeing rates above 5% and older properties nearing 8%. An example from 23Q2 illustrates this trend, where a private Houston-based buyer acquired a property at an 8.2% cap rate, highlighting the market’s response to economic conditions.

Redevelopment Opportunities Amidst Demographic Growth

Investors are actively seeking redevelopment opportunities, leveraging Houston’s strong demographic tailwinds. Notable transactions include the acquisition of a former JCPenney building by a Los Angeles-based firm, indicating a strategic move towards repurposing retail spaces with potential for higher-value uses.

Low Distress Levels and Refinancing Risk

Looking forward, Houston’s retail market shows few signs of distress, with a delinquency rate on CMBS loans well below the national index. The limited number of loans maturing in the near term further reduces refinancing risk, underscoring the market’s strong operating performance and demographic advantages.

Economic Indicators

Favorable economic conditions buoy Houston’s retail market. Job growth and a controlled unemployment rate create a conducive environment for retail operations. For institutional investors, these indicators are promising; they not only reflect the market’s current strength but also its potential for sustained growth.

Strategic Implications for Institutional Investors

For institutional investors, the current market conditions in Houston present a dual-edged sword. On one hand, the strong sales and pricing trends offer a chance to exit investments at a peak. On the other, the stable leasing and economic indicators suggest holding and potentially increasing investments in the retail sector.

Selling Privately Held Partnership Interests

When considering the sale of privately held partnership interests, institutional investors must approach the market with a strategic partner that understands the nuances of commercial real estate transactions. Planners must meticulously time such sales to coincide with market conditions that favor high sale prices and low cap rates, as the report indicates.

Engaging with a Capital Group

Collaborating with a capital group that has a deep understanding of the Houston retail market can be instrumental. A group with the necessary expertise and resources can navigate the market’s complexities to ensure the execution of partnership interest sales maximizes value for all stakeholders involved.

Closing Remarks

The report paints a picture of a robust and growing market. For large institutional investors, the data points toward a strategic window for the sale of privately held partnership interests. By partnering with seasoned real estate private equity professionals and leveraging the insights from comprehensive market reports, investors can make informed decisions that align with their long-term financial objectives.

In conclusion, the Houston retail market continues to offer a compelling proposition for institutional investors. Whether the strategy involves divesting at a market high or capitalizing on the stable economic growth, the key is to act thoughtfully, armed with the latest market intelligence and the right strategic partners.