Restructuring among factors shaking up office market

Houston’s office market is still heavily weighted in tenants’ favor. Big picture: The market will continue to soften, even as leasing activity (coming back from deeply depressed levels) picks up.

Huh? Let me explain. Last year, we were left with 230,000 feet on the market after the implosion of Stanford Financial. More vacancy is looming on the horizon as merger and acquisition activity, primarily consolidations in the exploration and production and oil service sectors continues: Baker Hughes/BJ Services have reunited; Schlumberger announced its acquisition of Smith International, Apache just announced its takeover of Mariner Energy, Nabors announced its acquisition of Superior Drilling, Seadrill will acquire Scorpion Drilling, Halliburton will acquire Boots & Coots, etc. The dominos in the next major wave of consolidation in the oil patch are starting to fall with a vengeance.

On the non-energy side, there’s the consummation of the merger of Continental and United Airlines. Although Houston will undoubtedly remain a major hub, the combined airlines headquarters will move to Chicago. Continental’s HQ departure will leave in its wake hundreds of thousands of square feet of space downtown. Add to all that the recent announcement that RRI and Mirant are going to merge and save their way to prosperity (good luck, by the way, with that guys). More office space on the market, and NASA’s downsizing/restructuring cannot help but be detrimental to the Gulf Freeway/Clear Lake office markets. There is no doubt whatsoever that most of the job loss hits coming at NASA will take place in “Red” Texas rather than “Blue” Florida.

Troubled building owners may start keeling over as well as their CMBS (Commercial Mortgage Backed Securities) financed building loans come due and they are unable to refinance or recapitalize via the “REIT Route.” My prediction: New ownership will ultimately come in with a dramatically reduced cost basis and reset rates lower than the existing market. According to the latest Fitch Ratings, 11 percent of over $536 billion of these loans will be at least 6 months past due by year’s end. My prediction is Fitch’s estimate will prove to be low — way low.

We are also seeing a restructuring within the energy industry and a reshuffling of assets. In the weeks before the Deep Water horizon disaster, Devon sold its offshore interests to BP, and has since put 410,000 square feet on the sublease market downtown and will apparently be moving to Oklahoma City. Downtown employers Chevron and Shell are both in the process of reorganization and are putting space on the sublease market as well. In the meantime, KBR has postponed its plan to build a Westside campus and is staying downtown, but is adding another 220,000 square feet, so there is a smattering of good news. Exxon Mobil is rumored to have acquired property up north to build a new Exxon-owned campus. Hopefully, the Fairfax County, Va., Mobil contingent of Exxon will be coming our way.

Fortunately, Houston is not grossly overbuilt as we have been in past real estate “boom/bust” cycles. But much of our building stock dates from the late 1970s and early 1980s, was built of less expensive materials (elevators, HVAC, etc.), and much of it was built by so-called “merchant developers.” Theirs was sort of a “Field of Dreams” philosophy: “Build it, lease it (they will come), sell it.” Thus, most of our suburban inventory is not truly “institutional” in quality and is “long in the tooth,” with dated mechanical systems and less efficient floor plates (and often deferred maintenance). Thus newer, more energy- and space-efficient buildings warrant a premium.

Not to be discounted in looking at the macro Houston office space situation are the opportunities born of the mistakes of others. Some of the most sophisticated developers in the country have fallen prey to bad investment decisions and a number of their properties are now on the watch list — they are in distress. In real estate, timing is key; you make your money on the buy, not necessarily on the sell. Financing is critical too. Many “bullet” real estate acquisition loans are ricocheting. There will be many dead, and many more wounded. Be careful which landlord you do business with.

Unfortunately, our political climate is not helpful. In a great article by Jerry Seib in the WSJ, he wrote, “Both political parties need to confess their sins for the budget problems.”

Moral of the story: Read, study, think. Pull back the blinders. Seek out alternatives. Make the desire for your office tenancy a horse race. There are some great opportunities out there, but understand that the office market is not rational right now. Each building stands alone. Seek competent counsel. If you had a complicated medical issue or legal issue, you would seek a number of opinions. Office space is no different. With the government’s printing presses running nonstop 24/7/365, the debasement of the dollar will continue, and though temporarily the dollar appears to be the “best of the worst” from a micro perspective, I predict that ultimately oil prices will rise. Thus, it is only a matter of time before our moribund office market resurrects and rental rate inflation kicks in with a vengeance. But my bet it that it gets worse (from a landlord’s perspective) before it gets better.

This article originally appeared October 22, 2010 in the Houston Business Journal.