CBRE Houston ViewPoint DOWNTOWN HOUSTON: THE NEW GATEWAY MARKET? by Sara R. Rutledge Director, Research and Analysis INTRODUCTION Investor interest from both domestic and foreign sources has revived in Houston given its nation leading employment growth and tight office market conditions. This is particularly prevalent downtown where trophy asset trades have set total sale price and price per square foot records to date in this expansion. Given the near-term supply/demand outlook, Downtown Houston office market fundamentals likely have room for further improvement. Comparing these fundamentals, local capital market conditions and performance characteristics versus the core downtowns of the top four U.S. gateway markets New York, Washington, D.C., Los Angeles and San Francisco suggest that Downtown Houston deserves consideration as an emerging gateway market. STRONGEST U.S. METROPOLITAN ECONOMY Metro Houston employment trends in this cycle stand in stark contrast to the U.S. as a whole and the top four gateway markets. Since the Great Recession began in December 2007, Houston employment has increased 8.1%, adding 208,820 new jobs, as hiring soared past its October 2008 peak in the recovery. The Washington, D.C., New York and San Francisco metro areas experienced more moderate job growth over this period, at 2.5%, 2.5% and 2.6%, respectively. For Los Angeles and the nation as a whole, employment is still below pre-recession levels. Figure 1: Monthly Metro Employment Trends Employment Index, December 2007= Total Employment Index (Dec-07 = ) 110 105 95 90 85 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 U.S. Houston Los Angeles New York San Francisco Washington, D.C. Source: Moody s Analytics, CBRE Research, July 2013. Digging deeper into Houston s post-recession economic performance yields similar results. Metro employment is up by 291,200 jobs from the cyclical low in December 2009 through May 2013. This represents a 265% recovery rate for jobs lost during the recession or, said differently, equates to more than two and a half jobs added for each job lost during the recession. This pace is unmatched among the top four gateway markets. Figure 2: Percent of Jobs Recovered Through May 2013 Houston 265% Washington, D.C. 168% New York 153% San Francisco 127% U.S. 73% Los Angeles 44% 0% 50% % 150% 200% 250% 300% Source: Greater Houston Partnership, Moody s Analytics, CBRE Research, July 2013.
As the global headquarters for the energy industry, the rise of unconventional oil and natural gas production, such as shale gas and oil sands, is a key driver for the local economy. Upstream energy (i.e. exploration and related services) employment alone has increased 8.1% over the year ending in May to a new peak of 108,, which is 23% higher than the previous peak in 2008. Annual earnings in this subsector, averaging $140,500 in 2011 per the University of Houston s Institute for Regional Forecasting, are double the metro average for all jobs. Yet, this is not the only high-wage sector expanding in Houston. The Texas Medical Center is the largest medical complex in the world, occupying 45.8 million square feet of space and employing 106,000 people. With this anchor as well as regional and local service needs, the broad healthcare sector has steadily expanded for more than a decade with employment up 20.3%, or 49,500 jobs, since the recession began. In addition, professional and business services employment is up 8.8%, or 33,700 jobs, over the same period with robust expansions in engineering, accounting, computer systems design and management. Figure 3: Houston Population Change by Component Population Change (000s) 200 1 160 140 120 60 40 20-1998 1999 2000 2001 2002 2003 2004 Natural Increase Source: Moody s Analytics, CBRE Research, July 2013. Growth in high-wage occupations combined with a low cost of living pushed Houston to the top of the list for U.S. metropolitan pay per job in 2012 after adjusting for living costs 1. Thus, it comes as no surprise that net migration trends remained strong through the national recession and recovery, with net migration bringing in over 333,000 new residents since 2008. 2005 2006 2007 Net Migration 2008 2009 2010 2011 2012 1 Kotkin, Joel and Mark Schill (2012, July 9). Metropolitan Pay Per Job 2012 Adjusted for Cost of Living. NewGeography.com. Retrieved June 4, 2013. LOW, COUNTER-CYCLICAL VACANCY Class A vacancy in Downtown Houston exhibited a counter-cyclical pattern during the Great Recession with support from the energy industry. Even the District in Washington, D.C., where the metro area had a relatively shallow decline in employment, experienced a cyclical rise in vacancy that peaked in Q4 2009 amid ill-timed new supply. As a result, Downtown Houston was the tightest market among this group for the two years ending in Q3 2010. Figure 4: Downtown, Class A Direct Office Vacancy Direct Vacancy Rate 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Houston Los Angeles New York San Francisco Washington, D.C. In early 2011, vacancy rose to a post-recession high of 9.5% with the delivery of BG Group Place. Vacancy recovered quickly, though, as BG Group Place was occupied by its namesake tenant, Latham & Watkins, KPMG and several smaller tenants. Hess Tower also delivered in 2011, but did not increase vacancy as Hess occupied the entire building upon completion. Vacancy, at 6.5% as of Q2 2013, is back below its five-year average and the second lowest among these markets, at only 20 basis points higher than Manhattan. RENT STABILIITY In addition to Downtown Houston s strong relative supply/demand fundamentals through the recession and recovery, asking rent trends were favorable compared to the top gateways. Class A asking rents fell 8.1% in the recession, from a peak of $40.14 per square foot in Q3 2008 to $36.87 in Q4 2010. Rents have recovered quickly and, as of Q2 2013, average $40.13, nearly equivalent to their prior peak. Page 2
Figure 5: Downtown, Class A Direct Office Asking Rents Rent Index, Q4 2007= Asking Rent Index (Q4 2007=) 120 110 90 70 60 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Houston Los Angeles New York San Francisco Washington, D.C. Across these five downtown markets, Downtown Houston is also notable for its Class A rent stability during this period. While Downtown Los Angeles Class A asking rents experienced the lowest standard deviation through the recession and recovery, rents remain 5.3% below their previous peak. Washington, D.C. is generally known for stability through economic cycles, yet rents in the District were more volatile than Houston in this cycle and have slipped from the peak achieved in Q3 2012. Manhattan and Downtown San Francisco experienced the greatest rent fluctuations with 33.4% and 31.2%, respective peak-to-trough declines in Class A asking rents during the recession. The recovery in these markets have brought Manhattan rents to 13.5% below their previous peak and San Francisco rents 13.2% higher, as of Q2 2013. LIMITED SUPPLY Despite strong fundamentals, new supply in Downtown Houston has been constrained in the current cycle by conservative credit underwriting standards that encourage developers to wait for a lead tenant before moving forward. Two projects appear likely to break ground by year-end 2014. Hines planned tower at 609 Main Street, at roughly 0,000 square feet and at least 40 stories, is expected to start early next year and deliver in 2016, even though no tenant commitments have been announced. In late 2014, Chevron is expected to break ground on an owner-occupied, 50-story tower on Louisiana Street adjacent to its two existing buildings, creating an urban campus with new common amenities and a conferencing center to accommodate more than 1,700 new employees. Assuming the Hines building delivers vacant, the current pipeline is still 60% pre-committed. Q2 2013 Construction and Near-Term Pipeline Square Feet (000s) 25,000 20,000 15,000 10,000 5,000 0 Figure 6: Downtown Office Development Houston Los Angeles New York San Francisco Washington, D.C. Pre-Leased Construction Uncommitted Construction 2013-14 Projected Starts Among the top four gateway markets, Downtown Los Angeles has the least development activity, although demolition work is clearing a site to accommodate a new 400,000-square-foot tower for Korean Air. The District in Washington, D.C. may be nearing the end of its recent construction cycle with less in the planning stages than currently underway, while Downtown San Francisco activity is picking up. Manhattan is the stand out with 11.6 million square feet underway, including One World Trade Center, and 9.5 million square feet expected to break ground by year-end 2014. PRICING AND PERFORMANCE ADVANTAGE Cap rates for Class A, downtown Houston office assets are higher than those found in the top four gateway markets, providing a comparative pricing advantage. The February 2013 CBRE Cap Rate Survey, the latest available, reports a 5.5%-to-6.0% cap rate range for Downtown Houston and transaction cap rates for Class A assets through mid-year 2013 average 5.77%, Page 3
according to Real Capital Analytics. Averages for yearto-date Class A office transactions in Manhattan and Downtown San Francisco were considerably lower at sub-5%, while the District in Washington, D.C. averaged 5.2%. Figure 7: Downtown Office Transaction Cap Rates February 2013 CBRE Cap Rate Survey with YTD 2013 Average Transaction Cap Rates 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% Houston Los Angeles New York San Francisco Washington, D.C. Survey High Survey Low Weighted Average of YTD 2013 Transactions An analysis of investment returns for Downtown Houston office is difficult due to limited representation in the NCREIF Property Index (NPI). Downtown Houston had a brief NCREIF history with data from 2000 through 2005 with a break in the series until Q2 2012, when renewed institutional investor interest increased the property count. Yet, we can discern some return trends by examining performance of large Houston office buildings built within the last 20 years because these assets reflect the high-quality properties attracting investor interest downtown. For Period Ending Q1 2013 Source: Real Capital Analytics (RCA), CBRE Research, July 2013 Note: No transaction cap rates available from RCA for 2013 Downtown Los Angeles office transactions. Figure 8: Annual NCREIF Total Returns Annual Total Return 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1-Year 3-Year 5-Year 10-Year NPI Office Houston Office Houston Office, Built 1993+ & K+ SF Source: NCREIF, CBRE Research, July 2013. During the recession, values peaked in Q2 2008 for this subset and bottomed out in Q4 2009, losing 11.9% of market value. These loses were fully recouped over the following year. For a longer-term view, this subset exhibits strong outperformance versus the office NPI over the past one-, three-, five- and 10-year trailing periods ending in Q1 2013, the latest data available. Houston office as a whole also outperforms the office NPI over the one, five and ten year trailing periods and trails by about basis points over the past three years. For additional context, the top four gateway markets represent 49% of the total market value in the office NPI. THE NEW GATEWAY Houston is the nation s strongest job market with yearover-year employment rising by,000 new jobs since July 2012. Although not likely to maintain this pace into perpetuity, the Greater Houston Partnership expects sustainable growth of 60,000 to 70,000 new jobs per year to emerge, as the expansion matures. This strength has supported office market fundamentals with downtown, Class A direct vacancy nearly back to prerecession lows and on par with Manhattan. Meanwhile, asking rents for this space held up remarkably well through the recession and are close to their prior peak. Also, with limited supply in the pipeline, downtown office market conditions are expected to remain tight through at least 2016. When coupled with the pricing advantage from high Class A cap rates, it is clear why investors, both foreign and domestic, have turned their attention to Downtown Houston. It is this unique combination of positive relative trends in the local economy, office market fundamentals and capital market conditions that indicate Downtown Houston is deserving of this new moniker. Page 4
contacts For more information about this Local ViewPoint, please contact: Sara R. Rutledge Director, Research and Analysis t: +1 214 979 6389 e: sara.rutledge@cbre.com Analee Micheletti Research Analyst t: +1 713 881 0977 e: analee.micheletti@cbre.com FOLLOW CBRE CBRE is an integrated community of preeminent researchers and consultants who provide real estate market research, econometric forecasting, and corporate and public sector strategies to investors and occupiers around the globe. Additional research produced by can be found at www.cbre.com/researchgateway. Disclaimer Information contained herein, including projections, has been obtained from sources believed to be reliable. While we do not doubt its accuracy, we have not verified it and make no guarantee, warranty or representation about it. It is your responsibility to confirm independently its accuracy and completeness. This information is presented exclusively for use by CBRE clients and professionals and all rights to the material are reserved and cannot be reproduced without prior written permission of the CBRE Global Chief Economist. Page 5