Job Growth Will Spark Office Market Recovery in Texas

Only a few skilled office building owners have emerged unscathed from the latest recession. For the majority of investors who weren’t so fortunate, early indications point to Texas leading the national recovery this year. After being one of the last states to feel the effects of the recession, Texas is well positioned to emerge first. In fact, the four major Texas metros will post the largest percentage gains in employment in 2010, each projected to grow more than 2 percent.

Venture Capital, Tech to Spur Austin’s Growth

Austin led the nation in economic growth in 2009, a trend expected to continue this year as the venture capital markets begin to thaw, helping to support a turnaround in the local office market. The metro’s largest venture investment since 2007 recently transpired, signaling that pension funds and universities are willing to reinvest in small businesses. Although startups will be the catalyst for job growth, the small blocks of incubator space occupied by these companies will make only a modest dent in absorption. Operators in the Northwest submarket, in particular, will struggle to fill vacant speculative space until major office users initiate expansion plans. Although tenant interest in some of these vacant buildings has escalated in the area due to the concentration of major corporations, most office users with expiring leases are requesting and receiving substantial concessions to remain in their current spaces, keeping tenant churn relatively low. The large, contiguous blocks of space will likely begin to be absorbed later this year by companies relocating from other states to reduce business costs.

The relatively light economic downturn in Austin has led to a wide disconnect between buyers and sellers. Although some owners anticipate a rebound in valuations, market realities are beginning to permeate the investment climate. Forced sales and off-market REO deals will make up a considerable share of transactions.

•   Employment Forecast: Payrolls are anticipated to expand by 2.5 percent in 2010 with the addition of 19,100 positions. Of those, 4,700 jobs are expected in office-using sectors, a 2.6 percent gain.

•   Vacancy Forecast: Demand growth will be outpaced by new construction, resulting in a 140 basis point rise in vacancy to 21.5 percent by year-end 2010. Last year, vacancy climbed 130 basis points.

•   Rent Forecast: Asking rents will retreat 4.1 percent this year to $24.65 per square foot, while effective rents will slide 5.9 percent to $19.75 per square foot, the lowest rate since 2006.

•   Investment Forecast: Most traditional office deals that take place in 2010 will involve older Class B assets with local tenants. Investors are targeting these properties priced below $3 million and at cap rates above 10 percent.

Absorption Ramps Up in Dallas/Fort Worth

The strength of the Dallas/Fort Worth economy will return in 2010, though office operations will remain relatively weak, especially in Class A buildings. While sublease space will be the most significant hurdle for top-tier operators, most of the attractive locations should be absorbed by the end of the third quarter. Some companies with available space have teamed with property owners to offer extended leases with blended market and sublease rates to secure tenants. Additionally, a portion of available sublet space will be pulled from the market as lease expirations approach. Nonetheless, concessions in the form of tenant improvements at Class A buildings are expected to be the catalyst for attracting office users to top-tier space through much of the year. Leasing incentives will reach levels last recorded during the building boom of the early 1980s, when nearly 40 percent of the current stock came online. Weakness in the office sector is driven by a 0.4 percent decrease in demand, however, as inventory growth in the past five years has averaged just over 1 percent annually, and supply expansion will be in the sub-1 percent range in 2010.

Many local buyers are targeting assets on a price-per-square-foot basis to define opportunities. Awash with capital, savvy investors who accumulated wealth by acquiring properties in the last run-up will attempt to expand their portfolios. Although most of these transactions will include properties with high vacancy, buyers are looking for upside, and some have major tenants waiting on the sidelines. Out-of-state investors, meanwhile, are renewing interest in the D/FW Metroplex. Well-positioned, performing assets should attract bids at cap rates slightly above 10 percent.

•   Employment Forecast: Payrolls will expand by 66,000 positions this year, a 2.3 percent gain and the largest absolute increase in the country. Office-using employers are projected to add 16,000 jobs, a 2.1 percent boost.

•   Vacancy Forecast: Vacancy is on pace to reach 24.2 percent by year end, up 100 basis points from 2009 and 270 basis points above the 10-year average.

•   Rent Forecast: The pace of rent declines will moderate this year as the employment market gains traction. Asking rents are forecast to slip 4.5 percent to $18.52 per square foot while effective rents retreat 5.6 percent to $14.38 per square foot.

•   Investment Forecast: Medical office properties are trading at cap rates approximately 200 basis points lower than traditional office assets. Although first-year yields are in the low-8 percent range, investor attention for these assets will remain healthy, particularly in the North Central Expressway/North East Dallas submarket.

Drop in Values Fuels Competition for Houston Assets

The rapid expansion of oil companies two years ago that generated demand into secondary office markets and spawned some of the largest rent gains in the country will adversely affect the Houston office market in 2010. Cash-heavy oil companies are acquiring smaller competitors, resulting in overlapping departments and job cuts. As these companies downsize space requirements, many are moving to prime office areas such as the CBD and Energy Corridor, putting sublease space on the market. Additional pressure on operations has come from a return of build-to-suit activity. PinnacleAIS and Lufkin Automation recently announced plans to build new headquarters in Pasadena and Missouri City, respectively. Exxon Mobile, however, is anticipated to make the most significant transition out of competitive stock by planning a campus in Spring, which will leave 2 million square feet of space available in Greenspoint, or nearly 20 percent of the area’s existing inventory.

As the effects of the credit crunch linger into 2010, trends that emerged last year will dominate the Houston investment landscape. The average sales price dipped from $10.3 million per transaction to just over $5 million in 2009, as financing was difficult to obtain and buyers mitigated risk. Deferred maintenance will play a larger role in pricing as some assets will require significant capital infusion before occupancy can be stabilized. These deals will attract a wave of cash-heavy buyers seeking upside potential, keeping bidding competitive and preventing a huge downturn in valuations.

•   Employment Forecast: Job growth will resume in Houston this year as employers add 54,000 positions, a 2.1 percent gain. Office-using employment will expand by 2 percent with the creation of 10,800 jobs.

•   Vacancy Forecast: Marketwide vacancy will climb 90 basis points to 16 percent this year. Over the past 10 years, vacancy has averaged 14.7 percent.

•   Rent Forecast: As vacancy pushes above the long-term average, concessions will expand as owners attempt to attract tenants. Asking rents will retreat to $23.26 per square foot while effective rents slip to $19.15 per square foot, annual declines of 3.4 percent and 5.4 percent, respectively.

•   Investment Forecast: The education and health services segment will expand by nearly 10,000 positions this year, driving demand for medical office space. With vacancy in the segment 200 basis points below the market average, investor interest will remain elevated for local medical office assets.

Low Business Costs Attract Tenants to San Antonio

The San Antonio office market will continue to mature this year; however, Class A deliveries outpaced demand during the relatively shallow downturn. As companies move to the area to take advantage of low business costs and the growing population, some of the supply overhang should be absorbed by the end of 2010. Old cornerstones of the local office market are expanding, but new top-tier space users have surfaced. Medtronic is adding positions at its recently completed Rim office space; Nationwide has announced plans to bring high-paying jobs to the market, and Whataburger relocated its headquarters to the metro in 2009. As payrolls grow at the fastest pace in the nation this year, San Antonio is anticipated to be one of the first metros to emerge from the downturn.

While the buyer/seller disconnect remains wide, some local owners have begun to come to terms with market realities and re-examine valuations. As first-year yields across the country and state climb, sellers have started to adjust offerings to compete with buyers who have a number of options. As a result, cap rates among listed properties will likely touch 10 percent this year but should retreat if capital becomes more readily available. Due to a lack of distressed listings, most buyers will target stabilized properties with at least 90 percent occupancy rates and strong tenant rosters. Some Class A office buildings that have failed to secure tenants may be offered at steep discounts toward the end of year.

Employment Forecast: Payrolls will expand by 2.6 percent this year with the addition of 22,000 jobs. Office-using employment will gain 2.6 percent, or by nearly 5,000 positions, erasing most of the losses recorded in 2009.

Vacancy Forecast: Employment gains will lead to positive net absorption this year, though vacancy will rise 140 basis points to 19.9 percent as supply growth outpaces demand.

Rent Forecast: In 2010, asking rents will retreat 1.5 percent to $19.21 per square foot, and effective rents will slip 2 percent to $15.34 per square foot.

Investment Forecast: The population of the downtown core continues to expand as gentrification efforts show dividends. Over the next few years, population-serving employers will begin to absorb space in the area, enabling owners to push rents higher.

Tim Speck, first vice president and regional manager of the Dallas office of Marcus & Millichap Real Estate Investment Services, wrote this article in conjunction with J. Michael Watson, regional manager of the Austin and San Antonio offices, and Brent Smith, regional manager of the Houston office.