FEATURE ARTICLE, AUGUST 2007

A WINNING FORMULA
Jones Lang LaSalle discusses how the office sector in Houston has the right ingredients for a bright future.
Louis Rosenthal

What constitutes a winning city? Houston possesses many of the essential ingredients: a booming economy, low cost of living, accessible housing and leaders who encourage growth and advancement toward a sustainable future. Put all of these ingredients together and the stage is set for a new era in Houston commercial real estate growth and pricing.

There are no signs of weakness in the Houston office market. The significant net absorption rates, rental rate increases and building sales volume that made 2006 such a strong year for building owners has carried through the first half of 2007. At mid-year 2005, Houston’s Class A overall vacancy rate was approximately 20.4 percent. During the past 24 months a significant upswing has occurred, leading to the current quarter’s 11.74 percent vacancy rate. Average rental rates in the CBD have increased 27 percent in the last 12 months, while the suburban market followed suit with an impressive 12.4 percent rate increase. Looking toward the future, Houston’s market profile indicates more signs that point to an even stronger second half of 2007, and perhaps a 2- or 3-year period of tight market conditions and prosperity for landlords.

A few key factors have set the stage for Houston office space pricing to be much higher than it has been for a very long time. Houston’s overall prosperity is largely dependent on the success of the energy business. As the world’s “energy capital,” the city benefits when its largest tenants, namely energy and energy service companies, thrive. The office market is no exception. Energy company profits are at all time highs, while capital spending is elevated and projected to climb in the coming quarters. As of the end of June, the price of a barrel of oil was $70, but Houston typically thrives on anything higher than $40 per barrel. The demand for energy in China, India and the Middle East continues to increase and Houston is poised to benefit from this increased demand.

Houston is home to some of the world’s largest companies. There are now 24 Fortune 500 Companies headquartered in Houston, which is second only to New York City. The city’s impressive economic growth is further illustrated in a recent survey that showed Houston leading all cities in absolute job growth in 2006, demonstrating that Houston is expected to add 340,900 new jobs over the next 5 years. Among major United States metro areas, Houston is ranked number one in per capita income, adjusted for cost of living expenses.

The last 24 months have painted a promising picture for Houston’s office market. Houston’s overall office vacancy rate is down 700 basis points to 14 percent, in the last 24 months, with Class A vacancy rates at 11.74 percent and anticipated to be in the single digits by the end of 2007. Currently, there are only two Class A blocks of 125,000 square feet or more available in the central business district (CBD), and only four in the suburbs. Only 3.7 million square feet is under construction and none of the new construction will offer more than 400,000 square feet of contiguous space. New building construction prices are at all time highs and are anticipated to increase by approximately 1 percent per month for the foreseeable future. While there are as many as six new CBD-located buildings being planned, there is only one new building under construction, offering just 200,000 square feet of loft-style space. None of the planned buildings will deliver space until 2010.

Houston’s CBD has long been home to the world’s largest energy companies and the city’s largest legal and financial institutions. After Enron’s demise (Enron was the CBD’s largest tenant) in 2001, the market looked like it was going to be soft for many years to come. At mid-year 2005, the CBD Class A vacancy rate was 23.4 percent, but along came Chevron to fill the Enron void. Chevron solidified Houston’s position as the energy capital of the world. It acquired 1500 Louisiana, the new Enron headquarters building, then leased large blocks of space in 1600 Smith and 1400 Smith, the original Enron headquarters. In total, the company consolidated and expanded in excess of 3 million square-feet, representing 8.6 percent of the total CBD multi-tenant building stock. Chevron made a statement that rippled though the market, providing a jump start to the initial phase of the latest round of major expansions. The CBD has experienced rental rate increase of 27 percent in the last 12 months, with the most desirable building rates increasing by 50 percent to 60 percent if space is available. The city’s commitment to a 24-hour, live/work/play CBD, combined with $70 per barrel oil and its significant investment in infrastructure, sets the stage for one of the most vibrant CBD’s in the country and a new round of construction that will change the skyline.

The Pavilion, a multi-use retail and office project spanning three city blocks, is currently under construction. One Park Place, a 38-story residential building, is under construction, as well as a $100 million public park that will be completed in late 2008. New hotels are being planned, and as many as six new office projects between 600,000 and 900,000 square-feet each, are in various stages of planning and pre-leasing. When the new buildings are completed, companies will have new, efficient, LEED-certified buildings from which to recruit their most valuable resource — human capital.

Houston’s suburbs also are experiencing very positive trends. The suburban market averages 13.5 percent  vacancy. Class A average rates have increased almost 22 percent to $24.26 per square foot. Within 12 months, most of the suburban submarkets will have single-digit Class A vacancy rates. Net absorption of space across the suburbs is near 10 year highs. Among the most active submarkets are the West Loop/Galleria, Westchase and Northbelt areas. While five small suburban construction projects were completed in the last 3 months, suburban construction remains at a minimum and large blocks of Class A contiguous space are scarce. There are 21 new projects currently under construction delivering approximately 3.5 million square feet, but most are in the far-reaching suburbs. There is no new construction in the West Loop/Galleria, Greenway Plaza and Midtown areas, where demand for space is strong.

If you take the convergence of the strength of the energy business as a result of increasing world demand, the low cost of living and supply of housing, the commitment of the city’s leaders to improve transit and quality of life for its residents, and a more transparent and efficient real estate market that promotes controlled growth, you have the formula for a new era in office space pricing and investment returns.

Louis Rosenthal is a vice president with Jones Lang LaSalle in Houston.


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