Houston’s office space bubble is about to burst

Houston has more than 17 million square feet of new office space currently under construction, but that trend is about to end
Much of it is of single-tenant campuses — like Irving, Texas-based Exxon Mobil corp. (NYSE: XOM) and Hous ton-based ConocoPhillips (NYSE: COP) — and are often tenant-owned, and it seems as though many firms simultaneously developed an edifice complex.
The future occupants of this new construction are vacating a significant amount of second-, third-, fourthfifth- or even sixth-generation lease spaces. And there is still much speculative development underway with high construction costs. These projects will require high rental rates or new ownership with a lower cost basis.
Energy companies and those that serve them are focusing on cash conservation, balance sheet mending and meeting loan covenants. Eliminating or scaling back their drilling and production projects will significantly reduce office demand and has already halted new office building develop ment that has yet to break ground.
Adding fuel to the fire, the more cost-conscious oil service companies whose occupancy costs are much more sensitive to top-line reductions — were expected to expand in older, secondgeneration spaces. With the current landscape of excess supply and reduced demand, these companies have no intention of occupying any more space than they already do.
Tenants’ lease economics will improve as concessions increase, and tenant improvement allowances will rise. Rental rates will ultimately ratchet down and significant free rent will reenter lease negotiations.
While most landlords seem to think they are in decent shape, past energy price collapses indicate they are in de nial even though most submarkets are over 90 percent leased.
The new buildings will bring a dose of reality even though they average 70 percent pre-leased. Tenants in the market may opt to seek lower-priced alternatives. We have a significant bubble in the office space market, and rates will ultimately fall.
But landlords are like bankers: — fast to raise rates and slow to lower them.
The Houston real estate markets, particularly for office space, have seen all of this before. The current energy price slide is eerily similar to the mid-1980s in cause and magnitude. The effect of this slowdown on the marketplace, particularly on tenants, will not be as bad as the mid-1980s; developers are better capitalized and financed buildings at lower interest rates. Lenders are stronger and more geographically diversified. The market is extremely segmented with many buildings having diverse energy exposure and various lease terms.
Significant restructuring of existing leases in older buildings will occur as tenants look to blend and extend. Building owners may be willing to take back space and blend in existing contract rates if their tenants are willing to extend their lease term. This lease restructuring will allow tenants to rightsize, which will reduce their space and maintain their newly reduced headcounts at a more affordable payment.

If Saudi Arabia’s goal is to make shale fiscally infeasible, taking into account how long hedges last — most companies are hedged through 2015 how long they can operate in the red and how fast they can slim down, two to three years may be reasonable for the office absorption to turn positive. I think it will take longer.
Many of the latest buyers of Houston’s investment-grade office buildings weren’t taking into account oil’s historic price volatility when they did their due diligence and made their record-setting purchases based on low interest rates, compressed capitalization rates and $100 per barrel oil prices.
Mark my words: There will be blood.

This article first appeared in the Houston Business Journal, February 27, 2015.