COVER STORY, NOVEMBER 2011

PEAKS AND VALLEYS
The office markets in Dallas/Fort Worth, Houston and San Antonio are experiencing growth — and challenges.
John Nelson

Texas’ office activity, just like other property sectors, seems to be outperforming most other states. As a byproduct of the overall economy in Texas, office leasing activity has gained traction thanks in part to healthy job gains and booms in the oil and gas industries.

Just like in other states, though, the office market is the last asset class to find its footing in the aftermath of the recession. Occupancy is a hurdle that most markets struggle to clear, especially San Antonio. In spite of the obstacles, companies are making deals and looking to occupy space in different Texas markets. Texas Real Estate Business magazine recently spoke with office specialists in Dallas/Fort Worth, Houston and San Antonio to gauge how each market is faring and what they expect short-term in their markets.

Dallas/Fort Worth

The Dallas/Fort Worth (DFW) office market has benefitted from strong job gains in 2011, with an approximate 3.9 percent growth in office employment compared to a 0.5 percent increase last year.  This upward trend has led to an increase in demand for office space, as evidenced by 736,425 square feet of positive absorption in the third quarter and 1.49 million square feet absorbed year-to-date, according to Grubb & Ellis’ office market report. There remains a high vacancy rate, though, which is peaking at 23.2 percent. This has tethered asking rents for office users, ranging between $22 per square foot for Class A space and approximately $16.71 per square foot for Class B/C space.

A big story for the DFW office market recently has been the complete reconstruction of the LBJ Freeway, a major roadway making up the south side of DFW. The construction is slated to last at least 5 years, according to the Texas Department of Transportation. The long-term project has led some office users to migrate north to the Legacy submarket, which is the number one performing submarket in DFW, according to John Brownlee, senior vice president and partner of KDC Real Estate Development & Investments.

“Legacy has a great amenities base both in terms of retail and restaurants and housing and public schools,” says Brownlee. “From an office employer perspective, it’s the best place to attract employees.”

The positive absorption in the DFW office market shows that office leasing has been on the uptick, and with relatively few new office spaces being constructed, the DFW market is slated to have better occupancy levels for the foreseeable future. This should lead to stronger rents and less TI packages and concessions from landlords.

The DFW market is attractive and has been a target for expansion from national and international companies for a variety of reasons. For one, the offices in high demand are still affordable for most companies when compared to other pillar cities like New York City ($55.81 per square foot), Boston ($35.52 per square foot) and Los Angeles ($31.88 per square foot). Another alluring asset for DFW office users is its proximity to the Dallas/Fort Worth International Airport. This is key because Texas is centrally located in the U.S. Employees can fly to the East or West Coast in the morning and be back home in time for dinner.

The past is not too far back in the minds of most. Andrew Levy, senior managing director of Holliday Fenoglio Fowler’s Dallas office, is noticing a healthy fear of over-expanding among office users.

“Tenants are being careful and not expanding beyond their means,” says Levy. “They’re not taking space in expectation of future growth, but they’re taking the space they need right now.”

This cautious optimism among companies is expected to continue for the next several quarters. Although DFW is somewhat insulated from the struggling national economy, companies are anxious about Europe’s debt woes and the pivotal election year in 2012. Even so, Levy doesn’t see leasing activity slowing anytime soon.

“I don’t see things slowing down here,” says Levy. “Obviously there’s a lot of angst globally, but relative to the other major markets in the country all of the Texas markets appear to be conditioned to outperform their peer group in the short and long term.”

Houston

Houston is recognized as the energy capital of the U.S. with a strong roster of gas and oil companies expanding and relocating in Houston. The strength of the gas and oil industries cannot be overstated in terms of its benefit to the market as a whole. The trickle-down effect to the office assets has been clear with energy companies occupying office spaces with their bolstering labor force. Marcus & Millichap is projecting Houston to add nearly 100,000 positions across the board in 2011 alone. Houston is among the best employment markets in the U.S. and its office market has benefitted from the success.

Three Eldridge Place is a Class A office tower in Houston’s Energy Corridor. BP recently leased 243,998 square feet of office space in the building. Houston and other markets in Texas have experienced increased leasing activity due to the growth in the oil and gas industries.

Asking rents for tenants range from around $29 per square foot for Class A space to $18.85 per square foot for Class B space. This is only a slight increase of 0.7 percent during the past 12 months, which is up from the 2.68 percent decrease the preceeding 12 months.

The office market has experienced 929,528 square feet of positive absorption, making this the sixth consecutive quarter that the office market has experienced positive demand, according to Grubb & Ellis. Class A space experienced more than 1 million square feet of positive absorption, but the overall occupancy fell below the 1 million square feet mark because of the negative absorption in Class B and C space. Occupancy is increasing with an approximate 15.5 percent vacancy.

Dan Boyles, principal of NAI Houston, notes that Houston companies did not vacate as much office space as they have in past downturns, keeping occupancy at respectable levels.

The 520,000-square-foot Sage Plaza is a Class A office building in Houston’s Galleria area. Recently, PSC LLC, an environmental and industrial services provider, leased 71,913 square feet of office space at the property.

“This time around we haven’t seen large blocks of space come on line,” says Boyles. “It was almost like the oil and gas companies and engineering firms were confident enough to not put their vacant space on the market. When things came back around, we saw occupancy levels almost back to pre-recession levels.”

Leasing activity in Houston has obviously benefitted from the oil and gas industries, but the area is also experiencing growth in its medical and technology sectors. Several companies have relocated, renewed or expanded their leases in the Houston area.

Vacancy in the market is projected to decrease even more in the near future due to the amount of large deals that have been done recently. A good amount of these deals that have been inked will come to fruition next year.

In the near future, Boyles is a
little uneasy about the speculation of uncertainty for the global demand of oil, but he sees more of the same in the office market.

“Overall the office market is going to stay stable,” says Boyles. “We probably won’t have the amount of activity that we had at the beginning of the year, but it will stay stable and leasing will stay stable.”

San Antonio

The office market in San Antonio has been struggling with occupancy levels. In the third quarter, the city recorded 46,746 square feet of negative absorption and a vacancy rate of approximately 18 percent. San Antonio has experienced approximately 200,000 square feet of negative absorption year to date. In addition, Class B office space has experienced five consecutive months of negative growth. To make matters worse, companies such as AT&T have announced plans to vacate its current office spaces, leaving behind large blocks of space on the market. This vacant space is going to hinder any gains the office market may make in the near future.

San Antonio is without a doubt a tenant’s market because of the amount of space available for prospective tenants. That trend is not likely to change anytime soon because the vacated space is expected to be absorbed at a slow pace. To attract tenants, Mike Sawtelle, first vice president of CBRE’s San Antonio office, says that landlords are doing whatever they can.

“Landlords are being competitive to attract tenants,” say Sawtelle. “Proposed incentives include free rent and generous tenant improvement allowances.”

Far North Central and CBD are the only submarkets that experienced positive absorption this quarter at approximately 20,000 square feet and 8,751 square feet, respectively. This growth is tempered by the fact that AT&T is vacating approximately 433,000 square feet of space at 530 McCullough Ave. in the first quarter of 2012 to move its operations to Dallas. Also, NuStar Energy, Kinetic Concepts, Inc. (KCI) and Nationwide Insurance are vacating approximately 350,000 square feet of office space in 2012.

On the bright side, San Antonio’s economy is in recovery mode from the recession. San Antonio is seeing a trickle-down effect similar to Houston from the nearby Eagle Ford Shale, one of the more significant shale plays in the world. Companies like EOG Resources and Marathon have leased significant office space in San Antonio because of its proximity to the shale play. San Antonio’s desirable labor force of bilingual speakers has also led to companies such as Consert Inc., Greenstar, Cold Car USA, Summit Power and SunEdison opening locations in the area.

Another bright spot is that Class A properties did experience 17,604 square feet of positive absorption this quarter. The gaping loss in Class B space over powered the Class A gains, but with virtually no new construction slated to open in 2012, San Antonio could make strides to lower vacancy rates and apply upward pressure on rental rates.

San Antonio is struggling in the third quarter and will face an uphill battle with the large blocks of space that will come to the market in 2012. However, Sawtelle believes that the growth of the oil and gas industry in Texas could help San Antonio turn their misfortunes around.

“Haliburton, Weatherford and Schlumberger have acquired large tracks of land to build facilities for operations in the Eagle Ford Shale,” says Sawtelle. “Several law firms from Houston have opened up offices here to be closer to their clients. I am confident we will continue to attract relocation prospects from other parts of the country.”

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