Who are the Big Winners in the Current Office Market?

It’s no surprise that Houston’s economy, while diversified, is still largely a marionette to crude oil prices and the oil and gas industry at large. Despite positive movement in the health care sector and several large distribution centers from companies like Amazon, Houston’s office market still faces significant challenges. As discussed in the Lee & Associates – Houston Office Market Brief, overall vacancy rates across all building classes moved up just 20 basis points during the period after a 90 bases point rise in Q1. At the midpoint of 2017, the overall vacancy rate stood at 16.1 percent, up from just 14.2 percent a year ago. Class A vacancy is highest at 19.4 percent, while Class B vacancy currently stands at 15.2 percent. It is important to note that subleases account for roughly one-third of current leasing activity, which exacerbates the vacancy problem and will play a larger role in the future as landlords are faced with the challenge of filling those spaces when the sublease terms end.

Given today’s current office market conditions, who is the greatest benefactor? There’s a silver lining for tenants with leases expiring in the near future, or those willing to add-on term and move forward with an early renewal. While building owners are looking to incentivize existing tenants to renew in place, opportunities abound for Class B tenants looking to upgrade to Class A spaces. In the past several years, Class A buildings have made significant capital improvements through lobby renovations, adding workout facilities with locker rooms, incorporating delis and restaurants, and including central conference centers for tenant use. The result of these upgrades is that tenants can offer amenities that help attract and retain talent.

For Class B tenants taking advantage of the current market conditions, what was once beyond their reach is now very obtainable. Tenants that are currently in the market for office space can take more time with their brokers to evaluate their options and determine the best course of action. Additionally, tenants with good credit will find that many landlords are flexible on the financial structure of the lease and willing to work with companies whether their business model is more accommodating of capital expenses up-front, or deferring to costs amortized into their rental rate as an operating expense.

If your lease is up in the near or immediate future, or you have a firm grasp on where your organization will be in the next five to seven years and are willing to extend your current lease obligation, you stand to capitalize on the current conditions.

So, who’s facing a challenge? In today’s tenant-market, the ones feeling the most discomfort are the landlords that delivered new office product in the last two years or purchased buildings at premium prices just before the Q4 2014 downturn. Also worth considering is that a large amount of the currently available sublease space will be coming back to landlords in the next 24-36 months. These spaces may currently be vacant, but landlords are still collecting rent checks for them. When the direct lease term ends for those spaces, instead of the problem belonging to the tenants that no longer utilize space that they are still paying for, landlords will see the payments cease and large blocks of space will fall back into their available inventory at a time when competition for tenants is aggressive. This will be additional inventory that the market will need to backfill before we begin to see positive absorption and the beginning of a swing back to a landlord friendly market.

The next couple of years could be rough for landlords, particularly in those submarkets that currently have unseasonably high vacancy rates or substantial sublease space available. The influx of available office space, and the competition for tenancy by landlords, will require concession packages from ownership that will directly influence the financial performance of the buildings.

Until oil prices stabilize at, or above, a price that causes significant and sustained job growth for a sufficient period of time to absorb the excess of office inventory, tenants will have the upper hand as they approach office lease negotiations with landlords.

Written by Rob Johnson, Director at Lee & Associates – Houston