June Issue: Energy–Fuel Gauge

Amid plunging oil prices, investors grapple with the fallout.
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During the past few years, the United States has leapfrogged into the top spot among the world’s oil and gas producers. The driving force has been the expansion of hydraulic fracturing technology, which has generated new resources from previously unreachable geologic formations. And in areas with strong ties to the energy sector, ranging from Houston and Denver to Williams County, N.D., this trend has had an enormous impact on real estate market dynamics.

Much of today’s discussion about energy centers on the recent swing in oil prices. In the past year, the average price of crude oil has plummeted from more than $100 per barrel to about $50 per barrel. “This has been a supply-driven phenomenon,” said Ken McCarthy, global chief economist for Cushman & Wakefield Inc. Plummeting prices make it difficult for shale oil production to make economic sense. From a macroeconomic perspective, many experts contend, falling oil prices have a positive effect. Lower prices at the gas pump leave more cash in consumers’ pockets, potentially boosting discretionary spending and giving the economy a bump.

For markets that have benefited most from the energy boom, however, the recent roller-coaster ride creates fresh uncertainty. As the nation’s unofficial energy capital and fourth-largest metropolis, Houston merits particular attention. Though its economy has diversified in recent decades, the fortunes of its real estate sector remain closely linked to energy.

After adding 96,700 jobs in 2014, its second-best performance since 2010, Greater Houston’s job-creation pipeline is expected to slow considerably 2015. The Greater Houston Partnership, an 11-county business coalition, estimates that the market will add some 62,900 jobs this year, primarily in construction, education, healthcare and retail. Conspicuously absent from that list is the energy sector, which the Greater Houston Partnership projects will shed some 9,200 positions. BP, Baker Hughes, Halliburton, Schlumberger and Shell have announced job cuts, although, as Marcus & Millichap pointed out in a recent report, the extent of local reductions is unknown.

It is indisputable, however, that the Houston office market felt the pinch when the price of oil started its freefall last year. During the first quarter of 2015, vacancy rose 70 basis points year-over-year to 12.5 percent, according to Colliers International. Other fundamentals softened even more noticeably. Net absorption fell nearly in half year-over-year during the first quarter, to 1.2 million square feet.

Shadow Space
Another sign of the slowdown is a jump in sublease space, up 55 percent to 6.1 million square feet since last summer, according to Avison Young. The market has yet to feel the full effects, since only 1.8 million square feet of that sublease space was vacant by the end of the first quarter. Class A vacancy rose to 10.6 percent during the first quarter from 8 percent during the fourth quarter of 2014, while office vacancy overall edged up to 11.5 percent. Those increases had already been expected as new product came online and tenants moved out of shadow space, Avison Young noted. The retrenchment in the energy sector also appears to be slowing Houston’s development pipeline. Of the 12.7 million square feet of office space under construction, more than half will be online by the end of the year.

An equally telling, if more subtle, repercussion of the oil price collapse is its effect on Houston’s institutuional investment market. “It’s not like Houston is falling off the face of the Earth. The returns are still positive,” said Jim Valente, executive director & global head of real estate product management for MSCI Inc. Nevertheless, he said, “it has an impact on forward-looking expectations of investors. … The risk profile of Houston has certainly grown because of what happened.”

The shift is particularly startling because of Houston’s long streak of delivering outstanding returns. As MSCI recently reported, returns on unlisted assets in Houston averaged 10.4 percent on an annualized basis during the past decade, compared to 7.9 percent for other major metros. To put it another way, Houston’s returns beat the U.S. average by 252 basis points, far and away the nation’s best showing. Returns for runner-up San Francisco were 184 basis points above the mean, followed by New York City, a distant third at 60 basis points above.

But the steep drop in oil prices has abruptly ended Houston’s long run at the head of the pack, at least for the moment. By the fourth quarter of last year, returns there had slipped 31 basis points below the national average. A bright spot for investors could be Houston’s preponderance of long-term leases. The average time remaining on an office lease there is nearly six years. As a result, investors can typically look forward to a six-year cushion of cash before tenants renew or vacate. By contrast, the time remaining on office leases averages 4.5 years in Los Angeles and 4.7 years in San Francisco. Certainly, the longer timeframe in the Bayou City “gives a nice buffer to investors in that market,” Valente noted.

That said, the pace of transactions has slowed as investors pause for reflection. When an affiliate of Lincoln Property Group bought a 220,380-square-foot office building at 801 Travis St. in downtown Houston, it was the first significant deal of its kind in the city’s central business district since oil prices began their slide.

Cushioning the Blows
There is also reason to expect that Houston’s real estate market is in a better position to weather the recent price fluctuations than it has been in previous cycles. As Roger Gregory, president of investments for PM Realty, noted in a column for CPE in April, Houston’s market dynamics have changed significantly over the past generation. Houston is on track to deliver 24.4 million square feet of new office space across the four years spanning 2013 through 2016. That is a little more than one third of the 71.8 million square feet that came online from 1980 through 1985. Equally significant is the transformation of Houston’s employment base. In the mid-1980s, Gregory observed, the energy industry accounted for about 75 percent of the local economy; today, it is about 38 percent. During the same period, jobs in Houston have doubled, from 1.46 million to 2.97 million.

Gregory suggested keeping the energy industry’s recent travails in perspective. “While the upstream sector may be pulling back, it is certainly not shutting down,” he noted. “For example, energy companies are talking about cutting their 2015 capital budgets, but they are not eliminating them, and while U.S. rig count is estimated to decrease 40 percent from 2014 to 2015, it is expected to start increasing in 2016 as the supply-demand imbalance fades.” Moreover, energy companies are expected to trim office jobs by only 5 percent; by contrast, positions in the field may be slashed by one-quarter. “Energy executives are on record saying that cuts in specialized technical positions, such as engineers, are not expected, as these specialists can be easily transitioned within their own companies from upstream to downstream positions.”

Beyond the office sector, the impact of declining oil prices appears to vary. “Most service companies have pulled back on their need for additional space,” reported Trey Odom, president & CEO of Avera Cos., which specializes in industrial property investment and development. But the company’s distribution center business has barely missed a beat and is up on the order of 20 to 30 percent this year.

Other asset categories are feeling a ripple effect. Dozens of multi-family development deals are on hold, reported Kenneth Katz, a principal & co-founder of Baker Katz L.L.C., a tenant representation and development company. “As soon as oil prices collapsed, equity (investors) pulled back and said, ‘No more projects,’” Katz told CPE in mid-May.

Nevertheless, he sees a silver lining. Had oil prices slumped a few quarters later, developers would have been in the midst of building multi-family product for a much softer market. “It was a very good thing for Houston to experience this collapse in oil prices,” Katz said. “I think there is a sentiment that we avoided” a much worse outcome.

While some investors are responding to Houston’s downturn by stepping back, others are finding opportunity. In early April, a pair of non-traded REITs sponsored by Griffin Capital Corp. paid $135 million for Westgate II and Westgate III in the Park 10 Regional Business Center, a business park located on Katy Freeway in Houston’s Energy Corridor. Previously, another Griffin-sponsored vehicle bought the neighboring Westgate I.

Completed last year, Westgate II and III comprise about 412,000 square feet. They also have a strong link to Houston’s energy sector, serving as the headquarters of Wood Group Mustang, which provides engineering, project management and other services to the industry.

Griffin declined to comment for this article, but in statements made at the time of the most recent Westgate deal, the company hinted that investors’ worries had opened a door. “With these acquisitions, we believe that the REITs were able to capitalize on the market’s over-reaction to the recent sell-off in the price of oil,” explained Michael Escalante, Griffin Capital’s chief investment officer & president of Griffin Capital Essential Asset REIT II. “We have every confidence in the long-term prospects of the Houston economy and real estate market, and on the business model and competitive position of the tenant.”

Moreover, while leasing by energy companies in Houston has slowed, it has not stopped. In March, Swift Energy Co. renewed its commitment to Greenspoint Place, a 13.5-acre mixed-use development owned by Hines at the intersection of North Sam Houston Parkway and Greenspoint Drive.

By midyear, Swift is scheduled to relocate its headquarters from nearby Two Greenspoint Place to 120,000 square feet at Five Greenspoint. That 461,000-square-foot, 19-story building, in turn, served most recently as ExxonMobil’s headquarters. For its part, the energy giant is completing the move to its new 3 million-square-foot, 385-acre campus about 25 miles north of downtown Houston.