FEATURE ARTICLE, FEBRUARY 2006

LOOKING BACK, MOVING FORWARD: PART III
Commercial Texas takes a final look at the evolution of Austin's office market during the past 25 years.
Michael Kennedy

In January 2000, the Austin office market had less than 6.5 percent vacancy with 2 million square feet absorbed in 1999 and about 3 million under construction or planned. An additional 1 million was to begin construction as well.

In March 2000, the NASDAQ fell. In September 2000, there was less than 100,000 square feet of sublease space available, by year-end that number topped 500,000 square feet. By June 2001, sublease space totaled about 3.5 million square feet and there was another 4 million under construction. Not only had the music stopped, the lights were out and everyone had gone home — except for the construction workers completing all that office space.

Year-end 2001 Class A rates had risen to a citywide average of $31 per square foot from $22 per square foot just 4 years earlier. Rates began to plummet, and vacancy moved from under 6.5 percent to approximately 12 percent. However, when sublease inventory was added in, the vacancy rate grew by an additional 6 percent to more than 18 percent total. And this with an additional 3 million square feet under construction in less than 18 months!

The technology job contraction plus new construction and the events of September 11 led to a precipitous decline in demand for office space.

The year 2002 saw negative absorption citywide, the first ever for Austin. Job losses and the stagnant economy led to sublease inventory equaling 10 percent of the total market while new inventory was still in the delivery phase, most notably the Frost Bank Tower at Fourth and Congress. Rental rates for Class A dropped by more than 10 percent with the northwest markets facing the worst due to the large number of tech companies in the sector.

Building purchases virtually stopped, and most forecasters were negative. The hangover from the 1990s was brutal.

The Federal Reserve Bank, however, through its manipulation of interest rates, propped up the owners of commercial real estate. These properties had been proformaed on 7 percent (and higher) interest rates. When rates were reduced to as low as 2 percent to 3 percent, the carry cost of vacancy was reduced greatly. Ownership of many buildings were in deeper pocketed groups such as REITs, and the added benefit of a technology tenant base that was either still flush with cash from their IPO, or fully funded from their venture capital, kept many landlords receiving rent checks monthly. This was not a typical bust in that the Federal Reserve and the financial liquidity of the companies, regardless of the viability of their business models, provided a financial cushion that protected owners and the market from a repeat of the 1980s.

The following year, 2003, really was the darkest year. Negative absorption, job losses, and additional sublease and direct lease inventory added to the general malaise. Average Class A rents dropped another 20 percent. Any offer for lease space was a good offer, if it could be found.

Entering 2004, expectations were low but by mid-year activity had picked up. As 2004 closed, it was agreed the market had turned. The artificial stimulus provided by the Federal Reserve and the job growth in Austin put it back in the positive column for absorption.

Additionally, subleases began to be taken back and be converted to direct leases, or just burned off as their terms expired. An uneven recovery began, first in the southwest market as companies returned to the marketplace searching for the best space available. The “Flight to Quality” continued to gain momentum until vacancy in the southwest market went to 10 percent and new construction was being discussed. The other markets stabilized. Immigration of companies returned and internal growth intensified.

All in all, mid-2004 would be the bottom. It was time for another upward climb for Austin commercial real estate.

Investors' interest in Austin, much less the country, began in earnest. Investors seeking returns that were low by historical standards but higher than in other asset classes have driven purchases up to record pricing with cap rates as low as 5 percent. While these prices are not in sync with current rentals, the underlying investor faith in a recovery, and the lack of other equally rewarding investment possibilities, along with Austin's attractiveness, have led to a tremendous buying frenzy.

As 2005 moved into its last quarter, Austin was once again the brightest star of Texas cities with a solid job growth rate, leasing and investor activity, and absorption that is the envy of all.

The open space initiatives are being felt as the limits on development in southwest and northwest are being met. Density and the CBD renaissance are making housing and retail the hot spots in the Capital City. Meanwhile, outlying communities, south to San Marcos, west to Marble Falls and Dripping Springs, east to Bastrop and north to Georgetown, are reaping the growth renewal. In fact two new office projects are under construction in the southwest market with $19 NNN asking rates.

And traffic? Austin's issues are being addressed late, expensively, but rapidly through toll roads.

During the 1980s and even 1990s, Austin did not line up nor fight, lobby or even ask for Department of Transportation money for roads. Those roads would have brought more people. The political strategy backfired and now toll roads are the only way, with a restricted DOT budget, to avoid gridlock. But, the extension of MoPac North, the 130 toll road east of Austin, the SH-45 North and 620 upgrade all will be largely complete in just 30 short months. This roadwork will pull development to the east, a preferred development area, and increase mobility.

Additionally the Capital Metro commuter rail starter line from Leander to the CBD will add capacity, as will plans for the MoPac rail, if realized.

The city's initiatives on Block 21 and the Seaholm Power Plant downtown are extremely exciting as are the numerous residential developments for the CBD.

The future? If 2005 was Austin's year to shine, as Dr. Mark Dotzour of the A&M Real Estate Research Center said at mid-year 2005, it's even brighter as we enter 2006.

Through year-end 2006, expect to see vacancies shrink and rents rise in office; the delivery of 4.5 million square feet in additional retail; and an industrial market continuing to recover.

Continued job growth and business expansion, along with in-migration of employers and capital from the West Coast, will fuel the ongoing recovery, which will be fully realized in 2007.

Austin — the National Champion in more than just football — is the story of 2006!

Michael Kennedy is president of Austin-based Commercial Texas.

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