COVER STORY, APRIL 2009

OFFICE AND INDUSTRIAL UPDATE
By Lindsey Walker Marcec

The office and industrial markets in the Houston, Dallas/Fort Worth and Central Texas metropolises are all trying to hold steady in the face of the growing pressure trickling down from the national economic crisis. Professionals from each of these regions share their insight into the forces that are shaping the office and industrial sectors and what we can expect to see as the second quarter gets under way.

After a solid year of growth, Houston’s industrial market is now seeing the impact of the national economic crisis. Activity is slow, and the deals that are being executed are being done with much shorter terms, according to Bob Berry, executive vice president of Jones Lang LaSalle in Houston.

“The industrial sector is challenged,” Berry says.

According to the Grubb & Ellis Fourth Quarter 2008 report for Houston’s industrial sector, the vacancy rate for all property types finished at 6.5 percent at the end of last year — an overall increase of 30 basis points from the previous quarter. New space deliveries continue to outpace demand, and vacancy is increasing monthly.

Many projects have been put on hold or dropped altogether; however, there are some major developments still under construction. Pathfinder Energy broke ground in December on a 260,000-square-foot facility, and Halliburton began construction of its 70,000-square-foot building in January.

No new industrial tenants have moved into the Houston market recently. On average, spaces are renting for 10 percent to 15 percent less than the 6- to 8-month average, Berry says.

“Industrial rent is softening up compared to last year,” he says. “The industrial market is a clear-cut tenant’s market.”

In both of the office and industrial sectors in Houston, restructuring leases and reducing occupancy costs are a priority. No major tenants have moved into the market from either category. Instead, most clients are waiting for the economy to turn around before making any major decisions, and those who are doing business desire a short term in their new leases and require consulting and planning expertise, says Dan Bellow, president of Jones Lang LaSalle in Houston.

“The office sector is seeing a similar slowdown to that of the industrial side, but the market is still active in renewals, subleases and small new deals,” Bellow says.

After 3 years of being a landlord’s market, the office sector has now swung toward neutral territory. Concessions such as free rent, abated parking and increased TIs are being seen in most markets, though top-of-the-market landlords have no shortage of demand and have maintained their asking rates. Class A spaces average $31 per square foot, direct gross.

But Bellow notes, “Realistically, deals in Class A buildings in the central business district, West Loop and Katy Freeway submarkets are being done in the $32 to $36 range.”

Even with the slightly higher “realistic” rents in the CBD, West Loop and Katy Freeway submarkets, Houston remains the low-cost alternative to its competing major markets. Of the top 30 major office markets in North America, Houston is within a couple million square feet of tying for 4th largest, according to Bellow.

“As one of the largest markets, Houston’s office space is still significantly less expensive than New York, San Francisco, Los Angeles, Boston, Washington, D.C., Miami, San Diego, Seattle, Chicago and many others,” he says.

Currently, 5.5 million square feet of office space is under construction in Houston, with approximately 35 percent of that space being pre-leased.

“Only mixed-use projects with small office components have been placed on hold,” Bellow says. “All other major office projects that began construction before the credit crisis are on track for delivery.”

“As for any proposed projects that failed to receive adequate financing before the credit freeze, they never got off the ground and remain in planning stages,” Bellow adds.

He says that 50 percent pre-leasing levels are the new minimum for future office projects, and spec is no longer the norm.

One of the reasons spec is no longer the norm is because direct vacancy has increased approximately 110 basis points from the end of 2007. Though, it isn’t just spec space that is sitting vacant; Bellow asserts that the increase is primarily due to the delivery of 4 million square feet of new inventory that was 50 percent pre-leased at delivery.

“Additionally, the decrease in demand for direct space placed a ceiling on building occupancies with higher-than-average amounts of available space, and sublease space has been on the rise for 12 months,” Bellow says. “However, despite recent upticks in space, the current overall vacancy rate of 14.2 percent is still historically low compared to the last 10-year peak of 20 percent in 2003.”

From a financial perspective, Houston’s office and industrial markets are still better positioned than in most cities around the nation, even with the recent decline in activity.

“In the Houston market, these sectors are fairing better than most parts of the country,” says James Murnane, president of North Houston Bank. “But, we are not immune to the global crisis. While occupancies and rental rates are holding generally well, there are very few new transactions being done, as the markets are fairly frozen still.”

Matt Franke, vice president of Q10 Kinghorn, Driver, Hough & Co. in Houston, agrees.

“Financing for new construction has virtually disappeared; however we have been able to source debt for existing stabilized assets,” Franke says. “It is interesting to see some of our borrowers place new debt on previously un-leveraged assets as they seek to raise capital and pursue acquisition investments from their weaker peers.”

Franke notes that his firm has been fortunate to arrange financing for both office and industrial buildings in Texas recently, and the loans have primarily been place with Q10’s correspondent life company lenders.

“[Life company lenders] have remained active despite the illiquidity in the overall debt market,” Franke says. “More than 80 percent of our life company lenders are still in the market for new commercial real estate loans.”

In the Dallas/Fort Worth Metroplex, the office and industrial markets are showing signs of softening, as more sublease space is being consistently placed on the market.

“Landlords sense this softening,” says Paul Whitman, president of the Dallas/Fort Worth office of Jones Lang LaSalle. “They are also concerned with capital constraints, which may put additional pressure on them to aggressively retain existing tenants rather than spend additional upfront concessions to land new tenants to their properties.”

According to Whitman, the industrial market rents have only decreased by 1 percent, and new sublease space to the market has remained flat.

“For the most part, industrial rents have been stable for the last 5 years, ranging from $3.00 to $3.50 per square foot net,” he says. “Compared to the seven largest industrial markets, Dallas is the second least expensive.”

As for the Dallas office market, overall Class A space was renting for $21.59 per square foot at the end of 2008. In Fort Worth, rents ranged from $23.00 to $27.50.

“Dallas office rates are some of the lowest in the nation, ranking at the seventh least expensive out of the 30 cities tracked by Jones Lang LaSalle,” Whitman says.

“In Dallas/Fort Worth, it’s a tenant’s market,” he adds. “There is abundant availability of space in nearly every size range from 10,000 to 1 million square feet. Competition for good credit tenants is fierce.”

While Chesapeake Energy, AT&T and Comerica both took a significant amount of office space recently, vacancy rates for office buildings have remained relatively flat at 20.5 percent overall. Whitman notes that there likely will be an increase by the end of 2009.

On the industrial side, a number of major leases and sales have occurred throughout the Metroplex. In Dallas, Advanced H2O has taken 350,000 square feet; Farleys has signed for 1 million; and Aldi and Alcatel have signed leases for 500,000 square feet each. In Fort Worth, Deloitte has signed on for 750,000 square feet; Blue Cross Blue Shield is leasing 160,000; and Cinram is taking 788,160 square feet.

Even with all of these companies filling industrial space, 9 million square feet was scheduled to come on line in the first quarter, which will likely cause the vacancy rate to increase from its already high percentage of 10.3 (from 8.8 percent at the beginning of 2008).

“The 9 million square feet of space under construction will put additional downward pressure on rental rates, making relocation for those companies able or needing to do so very attractive,” Whitman says.

Though some projects were on the books to start in 2009, they most likely will be delayed. No new developments are planned to start this year.

Whitman predicts that, with limited financing available, owners with loans coming due could lose properties if they don’t have what their lenders want.

“The lenders in the market have become increasingly selective and are putting more emphasis on the sponsorship and quality of assets,” says David Steele, an originator with LMI Capital in The Woodlands, Texas. “Lenders are scrutinizing more in the areas of the borrower’s liquidity, net worth, experience and asset stability.”

This is good news for those companies that meet these qualifications, as they will be the first to penetrate the market once cap rates rise due to more foreclosures in office and industrial, Steele says.

“Additionally, construction in both asset types has mostly subsided, which will allow markets to recover more quickly and evade over-supply,” he adds.

Austin and San Antonio’s office markets have positive outlooks for a recovery; however, both will see fundamentals weaken this year first, according to Marcus & Millichap’s new National Office Report.

“During the fourth quarter, Class A office rents were $30.28 per square foot in Austin and $21.91 in San Antonio,” says Brent Smith, sales manager for Marcus & Millichap in Austin. “Austin’s office vacancy finished 2008 at 18.7 percent, up 430 basis points from the end of 2007. San Antonio office vacancy stood at 15.6 percent at the end of last year, up 160 basis points from year-end 2007.”

Recent office leases in Austin include 92,000 square feet to the IRS, and the Texas Department of Human Services moved into 66,000 square feet in December in San Antonio. The 207,000-square-foot East Avenue project is the largest office development under way in Austin, according to Smith, and Tesoro’s 1.8 million-square-foot headquarters project leads the way in San Antonio.

The following is an excerpt from Marcus & Millichap’s latest office report on Austin:

“Although the Austin office market is well-positioned for an eventual economic recovery, supply-side pressure is expected to weigh on fundamentals throughout 2009. In particular, the addition of speculative space in major office-using districts within the Northwest and Southwest submarkets will push marketwide vacancy above 20 percent, resulting in a significant increase in concessions. Developments are coming online in the tech-rich areas during a time when global demand for computers and software is waning, and space demand is falling as a result. Weakness in these submarkets is anticipated to be mild compared to the recession earlier this decade, however, payroll expansion and lease signings by tech companies were more restrained during the recent run-up than in previous years. Additionally, Austin’s healthy government sector should help to sustain office demand through the downturn.”

In San Antonio, owners are facing challenges presented by not just the recession, but also by the ongoing construction activity, the Marcus & Millichap report on San Antonio’s office market says.

“Historically, few projects in the metro have broken ground without significant pre-leasing commitments, and the area’s office segment is geared toward support operations for major firms located elsewhere,” the report says. “The recent statewide employment boom has encouraged speculative construction, however, creating a surplus of Class A space, especially in the North Central and Northwest submarkets. As such, owners will raise concessions rapidly to fill new product, leaving Class B buildings largely vacant.”

At the end of last year, the manufacturing and distribution operations in San Antonio were being hit the hardest as retailers were forced to cut their costs by cutting their inventory levels. This led to a reduction in sales and a decline in profitability felt throughout the United States.

“Struggling with similar issues confronted on the national level, San Antonio’s industrial leasing market remained flat during the fourth quarter, posting a mere 5,527 square feet of negative absorption,” according to Grubb & Ellis’ Industrial Market Trends San Antonio Fourth Quarter 2008 report.

According to the report, total absorption for 2008 reached just above half a million square feet, well below the 1.7 million square feet absorbed in 2007. Citywide vacancy rose by 40 basis points, making it 70 basis points higher than just 1 year ago.

Negative absorption plagued Austin’s industrial market as well with the city posting a 375,000-square-foot loss — the largest quarterly loss since the first quarter of 2003.

“By nearly every measure, the second half of 2008 pointed to a market in decline,” says Grubb & Ellis’ Industrial Market Trends Austin Fourth Quarter 2008 report.

At the end of 2008, citywide vacancy reached its highest level since the first quarter of 2006, rising 140 basis points from the third quarter, according to the Grubb & Ellis report. In spite of this, the citywide weighted average for asking rates remained flat.

Bob Moore Construction Takes On Secon Rooms To Go Distribution Center Rooms To Go distribution center Arlington, Texas-based Bob Moore Construction is building the new, 1 million-square-foot Rooms To Go distribution center in Houston. The expansive project, which sits on the south side of Interstate 10 between the cities of Katy and Brookshire, is the firm’s second project for Rooms To Go in Texas. In 2004, the company completed an 851,000-square-foot Rooms To Go distribution facility on State Highway 360 in Arlington, Texas. “Our previous experience with the professionals at Rooms To Go was very positive, and we look forward to working with them on the Houston project,” says Ed McGuire, vice president of construction for Bob Moore. Bob Moore Construction broke ground on the project in February. The main structure will span 988,000 square feet; a 12,000-square-foot, stand-alone trailer maintenance building will be built on the site as well. Considering the state of the construction industry, delivering such a large facility on-time and on-budget was a concern for Bob Moore Construction when the company embarked upon the project. “One thing we are doing to address these concerns is use the latest technologies, including project management software and web-based project collaborative tools, to minimize the time required for responses to critical issues,” says senior project manager Curt Hellen. “The ability to occupy a facility and begin generating revenue is a top concern for the developer.” Construction is projected to take 11 months. Rooms To Go is acting as its own developer; Atlanta-based MacGregor Associates Architects, Inc. is the architect. — Lindsey Walker Marcec

Cadence McShane Completes Major Project in 180 Days, Despite Hurricane Ike InterPort Business Park Despite the loss of workdays and damage incurred by Hurricane Ike, Cadence McShane Construction successfully completed the second phase of the 88-acre InterPort Business Park in Pasadena, Texas, last December after just 180 days. “This aggressive schedule was already challenging enough for a building totaling 734,448 square feet,” says Jason Morgan, director of operations for Cadence McShane. Hurricane Ike destroyed 39 wall panels of InterPort Distribution Center II, which had to be recast and retilted. In order to maintain the original completion schedule, Cadence McShane immediately evaluated the site and repairs were made quickly so that no additional workdays would be at risk. “This project would not have achieved its success without the teamwork that was displayed by all parties involved,” Morgan says. “We had an owner, First Industrial Realty Trust, Inc., and a team of subcontractors that understood what we were up against. Each member associated with the project’s construction facilitated their responsibilities in a manner that allowed us to complete this project within the original schedule.” The 44-acre site, which features generous car and trailer parking spaces, is situated within the Port of Houston and provides access to the Union Pacific rail line. The building includes 114 dock doors, drive-in doors and a 30-foot clear height. Powers Brown Architecture provided architectural services. — Lindsey Walker Marcec

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