Houston’s energy industry impacts office rental rates

Office rental rates in Houston are about to skyrocket. In Houston, those rates correlate with oil prices almost perfectly, and recently oil prices have skyrocketed themselves. Although that’s good news, companies should still use caution when signing leases as more affordable office space becomes available.

That indicator has resulted in some significant real estate indicators. For instance, Hines Interests recently purchased 1100 Louisiana, its first repurchase of a building it originally developed and sold, for $163 per square foot. According to this cost basis, this project and other Class A projects Downtown will soon command rents, including operating expenses, of $27 to $28 per square foot per year.

In 1999, the office market was flat, with net absorption around 400,000 square feet. At that rate, this year will be a good year, and 2001 will be even better for landlords. That’s because of higher oil and gas prices and minimal inventory of large blocks of space. Nevertheless, technology is rapidly supplanting the need for large trading floors for oil, gas and electricity trading. This fact, combined with continued consolidations, will help keep the lid on.

OPEN MARKET

The collapse of the Commercial Mortgage Backed Securities market in 1998, coupled with paltry oil and gas exploration and production budgets that $11 barrels of oil called for, prevented a number of speculative office buildings from getting underway. Those buildings that broke ground in 1998 and delivered in 1999 — many of which are still largely empty — will have breathing room to lease up before they are faced with competition from new product.

Fortunately for office space users, the barriers to entry for office development in Houston are probably lower and fewer than anywhere else in the country because of no zoning, readily available land and readily available utilities. This serves as something of a cap on rental rates. That’s because if a landlord increases rental rates, it’s easier for someone to construct a new building because of the low barriers to entry in Houston.

OIL TOWN

Recall that oil prices were at a 10-year low of $11 in February 1999 but shot up to $27 in November. Oil and gas companies’ exploration and production budgets formulated in the third and fourth quarters with higher prices in mind are now being spent. The economic pundits talk of how Houston’s economy is now becoming diversified because of assets like the Texas Medical Center, the Houston Ship Channel and several of the country’s preeminent computer-related manufacturers. But make no mistake, despite a newly diversified economy, Houston is still directly dependent on oil and gas for 50 percent of its livelihood.

Though $31 to $33 per barrel oil prices is not expected to hold, there is little doubt whatsoever that oil prices will remain well above the $16 to $17 threshold. That means the difference between profit and loss. Prices are expected to settle in the $23 to $27 per barrel range. Though factors could change, the Organization of Petroleum Exporting Countries is expected to slightly increase production. Asia is expected to continue to recover unimpeded, and the European and the U.S. economies are expected to continue to hit on all eight cylinders.

Rising oil prices are decidedly a mixed blessing. They are a boon to Houston and a boon to Houston landlords. Many marginal landlords who were buyers of Class B and Class C properties now can either sell their properties at a profit or they can afford to renovate and thereby make the properties attractive enough to lease. It seems that the rising tide will lift all the boats.

GAINING LEVERAGE

So what should tenants do? First, realize that larger office space users in the resurgent oil, gas and energy industry look at office space as a commodity and are fully willing to pay market price. Smaller tenants, particularly those with right to relocate clauses, or without renewal or expansion options, are finding themselves at the mercy of their building’s larger tenants. Larger tenants with two years or less remaining on their lease, particularly those with expansion considerations, should attempt to blend and extend current rental rates with future rate increases.

Smaller tenants have less leverage and should typically be considering the future of their office location a year in advance of the lease expiration. Tenants who wish to remain in their existing leaseholds should pay specific attention to the lease’s notice provisions. The renewal or expansion options can be rendered worthless if not exercised in a timely manner.

Sophisticated tenants, large and small, realize that a “best in market outcome depends on developing real negotiating leverage. This leverage can best be brought to bear by retaining the services of a leasing professional. Even tenants with no intentions whatsoever of moving should go through the motions, for without alternatives, a company has no leverage whatsoever.

Remember, brokers are paid a percentage of the transaction and may not hammer out a better rental rate, try to whittle down the tenant’s size requirement, or seek to elongate the lease term. Rarely is it wise to sign a lease for longer than five years. In addition to the standard expansion and renewal options, demand cancellation and contraction options. Both the massive international company and the locally owned shop should approach renewal, expansion and relocation with a plan and a carefully chosen broker.