FEATURE ARTICLE, JUNE 2006

TEXAS OFFICE LEASING REPORT
Brokers discuss the current state of the office leasing market in the Lone Star State.
Interviews by Lindsey Walker

While the office market in many Texas cities has experienced some downward movement during the past few years,  activity is once again on the rise. Cities such as San Antonio are starting to see vacancies filled, and — with an increasingly active job market in many regions throughout the state — the office sector looks to have more positive growth ahead. Texas Real Estate Business recently spoke with Bernard Deaton of PM Realty Group in Dallas; Don Cox of Don Cox Company in Austin, Texas; Anthony Tarantino of Tarantino Properties in Houston; and Lisa Villarreal of USAA Real Estate Company in San Antonio to discuss the current state of office leasing in Texas.

TREB: How is office activity on the investment side in your area? What assets are garnering the most attention? What institutions are most actively seeking to acquire properties?

Villarreal: Investment activity continues to be steady for office product in San Antonio. While some of the institutional investors and REITs have exited the market, private investor groups that are new to San Antonio are entering the market at a time when rental rates are on the rise, vacancies are declining, and a few new speculative office developments are about to come out of the ground at the hands of local developers. Several user-driven transactions have occurred for office product. In many instances, the user has purchased the building, but in other situations, like the National Security Agency transaction, an investor group acquired the property with the tenant in hand. Much of the market continues to being driven by 1031 exchange buyers.

Tarantino: A lot of the clients that I represent haven’t been driven toward office buildings because the office market has been a tough go for the last 3 to 5 years, with the low occupancies and high vacancies. It’s just a tough sale to make. However, that doesn’t mean that Houston’s not active in office building sales. There were a lot of sales in 2004 and 2005. In 2005, for example, there were 61 office sale transactions in the Houston area. The average sale price is more than $100 per foot. That would be a blend of Class A, B and C product.

Of the office industry, medical buildings recently have been a very popular and developing market. Medical has been a great new growth, with a lot of renovations of old centers as well as new construction. They’re saying that medical office is a new recession-proof property category because there are always going to be doctors. As far as other assets garnering attention, there’s been a lot of attention in the West Houston/Katy area where the Energy Corridor is.

REITS have always been active in Houston on the bigger product. They have almost half of the acquisitions in the suburban markets. 

Deaton: Office investment in the Dallas/Fort Worth metropolitan area is extremely active. There are quite a few portfolios that are hitting the markets today, as well as individual buildings. Investors that bought property 3 to 4 years ago are seeing the market rise and rates increase, and see this as a time to “cash in” and reinvest. Across the country, there is a great deal of investment dollars chasing real estate, and Dallas is still considered a good investment.

Due to the positive market and a lot of product back out in the market, there is a high demand for office space.

Dallas has it all — both core buyers and value-add buyers. Dallas is seeing more value-add buyers who can buy at decent price, make improvements and create a more valuable asset to turn. In turn, the product that is coming back on the market is both value-add and Class A for the core buyer.

Cox: There is competition among at least four groups for Austin office buildings — one sale setting a possible Texas record.

TREB: What are the current trends in office leasing in your market?

Deaton: There are rising rental rates and fewer rental concessions in certain areas of Dallas/Fort Worth. Positive job growth in Dallas is having a positive impact — inventory is slowly but surely going away. Overall, the climate is good and the leasing market is improving.

Villarreal: Activity in 2005 was strong in San Antonio. Absorption was a positive 359,617 square feet, according to REOC Partners. Trends in office development include secondstory office space above retail. There are at least four new projects under development in North Central and Northwest San Antonio that include this concept. Local developers have also been successful in small office condo sales. Additionally, three new proposed office projects, each more than 100,000 square feet, are planned to break ground in 2006.

Cox: Space in Austin is being leased and rates are escalating faster than anyone predicted.

Tarantino: We are certainly trending in a positive direction, and there is starting to be positive absorption in the office leasing market. The downtown market is starting to show some positive growth in leasing. They had a lot of vacancy — at more than 20 percent — and they’re projecting this year to improve to as much as 85 percent occupancy. That’s related to the expansion of the Energy Corridor, with companies like Exxon, Conoco, Phillips 66 and Citgo, going to the downtown core and to the Westchase/Westheimer area as well.

TREB: How is the market performing so far in 2006?

Villarreal: Market performance for the San Antonio office market in 2006 remains steady so far. The demand for office space is continuing, and new office developments are coming on line at a controlled pace. An informal poll suggests that in the submarkets with decreasing vacancies, the landlords are ticking up rental rates. Also noteworthy, concessions have been significantly reduced from the previous 18-month period.

Tarantino: As I mentioned, we’re starting to see positive absorption, mainly in the Class A and B product. The Class C is actually showing negative absorption. We’re seeing this because with the softer rental rates, tenants are choosing to upgrade their image a little bit, so they’re moving from the Class C to the B, and from the Class B to the A. They can afford the price, and they’re taking advantage of that opportunity now.

Deaton: Leasing activity in 2005 was slower than anticipated, but we are seeing a positive growth in 2006 (began at the end of 2005). This should be a banner year for tenant absorption.

Cox: In Austin, it’s like the song — “hot, hot, hot.”

TREB: What is driving current activity?

Deaton: The economy is improving, job growth is continuing to be positive, and retail sales are good which drives distribution. When the retail and industrial markets are doing well, the office market follows suite.

Cox: Austin firms are expanding, and firms from outside Austin are either relocating here or are opening offices here.

Villarreal: Current activity is being driven by a healthy local economy, which is feeding off relatively strong regional and national economies. Businesses already located in San Antonio continue to expand and several companies are moving into the San Antonio area for the first time, trying to build a presence and take advantage of the strong demographics and economic activity.

Tarantino: A lot of the oil and energy-related companies, and also a lot of the tech companies, are starting to come back to Houston.

TREB: Who has the upper hand in lease negotiations: landlords or tenants?

Tarantino: It’s still on the tenants’ side in Houston. Even though the office leasing market is improving and we’re gaining some positive absorption, there are still more than 33 million square feet of vacant space in the greater Houston area. So, it’s still a tenant-driven market. Rental rates are starting to creep up a little bit, but very slowly, and deals still have to be very aggressive on the landlord’s side in order to get the tenant.

Cox: Landlords.

Villarreal: The pendulum appears to be swinging back to the favor of landlords. Who has the leverage depends on the submarket and product type. Most Class A office buildings in North Central and Northwest San Antonio are well positioned. Landlords however, should not dismiss prospective tenants with excellent credit ratings.

Deaton: Landlords do not have an upper hand in Dallas/Fort Worth yet, but it’s moving closer to equilibrium. We are seeing fewer concessions in 2006 compared to 2005, but there are still large amounts of vacancies in parts of the city, so we’re not there yet.

TREB: Are you seeing more interest in urban or suburban office space in your area?

Deaton: In Dallas, the urban markets – uptown markets in close proximity to the central business district (CBD) – have the lowest vacancy in the city. In the CBD, Class A buildings are leasing very well. Vacancy is declining with the resurgence of urban residential and the conversion of office buildings to residential. We have also seen an improvement in the market as law firms and the banking industry are doing well and expanding. Northern suburbs are also strong. Suburban growth depends on growth patterns, and the northern suburbs are doing well. 

Villarreal: At year-end 2005, the CBD submarket had an 18.5 percent vacancy factor compared to the Non-CBD vacancy rate of 15.3 percent, according to REOC Partners.  Not surprisingly, demand for suburban office space is greater than urban office space. There will always be certain industries that require a CBD presence.  One positive sign for San Antonio’s urban submarket is the acquisition of AT&T by SBC Communications, since they are headquartered in downtown San Antonio.

Cox: Both are seeing vibrant activity in Austin.

Tarantino: There’s increased activity in downtown with a lot of positive absorption. At 86 percent occupied, the suburban office market is still showing better occupancy than the CBD, which is 81 percent occupied. Overall, we’re still getting better growth in the suburbs, but the downtown seems to be on the comeback.

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