It's Been a Trying Time
For the Houston Market

Information on this page is provided by Commercial Property News.

Aug. 9, 2002 -- Houston has been shaken but not shattered by the recent upheavals at Enron Corp., Continental Airlines Inc., Compaq Computer Corp. and by a host of other corporate consolidations, mergers and downsizings.

"We're realizing that it's not as bad as it could be," said Jeff Munger, director of research for Holliday Fenoglio Fowler LP. "It's not a death knell."

While it is true that the Bayou City's office market has experienced increased vacancies and rental-rate decreases, most cities across the U.S. have suffered through similar downturns recently. And although the industrial and retail markets have softened over the past quarter, there is still enough activity to keep companies, retailers and real-estate professionals busy, said Bob Gulley, executive vice president of Henry S. Miller Commercial/TCN Worldwide.

Downtown Drama

Houston's central business district posted an occupancy rate of 90% for the first quarter of this year, which is somewhat surprising given that it recorded a negative net absorption of 881,000 square feet, primarily as a result of Enron's decision to vacate more than 750,000 square feet. But while occupancy remained strong, the CBD must take the blame for driving down rents marketwide, as it sustained rent loss in excess of $2.75 per square foot. Class A rents declined 5.2%, or $1.13 per square foot.

"Downtown is a little bit of a question mark because the full impact of Enron has yet to be seen," said David Baker, executive vice president of Transwestern Commercial Services. But one thing is certain: Large blocks of space are available in the CBD. According to Paul Layne, senior vice president of Trizec Properties Inc., Enron vacated more than 300,000 square feet of office space in 3 Allen Center, about 150,000 square feet in Devon Energy Tower (2 Allen Center) and about 300,000 square feet in 500 and 600 Jefferson.

"We expected to get back a lot of space from Enron," Mr. Layne said. "We just got it back sooner than we thought we would." However, he pointed out that Trizec is in a good position to lease the space quickly and at a good rental rate as well. "This provides us with the opportunity to take advantage of some pent-up demand," he said. "We're ahead of the new space, because [these are] the first big blocks of space to come onto the market." Since Enron returned the space, the REIT has signed about 400,000 square feet of leases to backfill the buildings.

Speculation abounds about the fate of the 1.2 million-square-foot Enron Center South, which is currently under construction and expected to be ready for occupancy later this year. According to many industry experts, several corporations are interested in purchasing the building. Duke Energy and Halliburton Co. are the names most often mentioned regarding an acquisition. "It's a good asset and will sell at a distressed price," said Clint Harrington, senior vice president of client services for Jones Lang LaSalle Inc. "Enron's extra space could create some great opportunities for companies to relocate their headquarters."

But some industry experts are concerned not just about Enron but about the domino effect the company's troubles could have on others. "A new pressure point is Arthur Andersen," noted Steven Burkett, senior vice president of the Houston office for the Staubach Co. The consulting firm has about 250,000 square feet of office space in Penzoil Place in the CBD, and many wonder if that space may soon be back on the market, adding to the 1.3 million square feet of new product that will enter the market over the next 18 months.

"[The CBD] is not in the tank, but the expectation is that it will get weaker once the buildings open," Mr. Burkett said. "When vacancies increase, landlords will get more aggressive on rental rates."

Currently, there are three speculative office projects under construction in the CBD: 5 Houston Center, a 32-story, 577,000-square-foot office tower scheduled for completion during the third quarter; Century Development's 36-story, 791,000-square-foot Reliant Resources Plaza set to open in March 2003; and the Hines development Calpine Center, a 32-story, 789,000-square-foot office tower located at the corner of Texas Avenue and Milam Street, which should hit the market during fourth quarter 2003. All three buildings have been significantly pre-leased.

Mergers and acquisitions that have occurred over the past several months have affected space needs in the CBD as well, said Mark Cover, senior vice president of Hines. For example, approximately 500,000 square feet of office space will become vacant in the Chevron Tower following the merger of Chevron and Texaco.

However, Mr. Cover does not view the large blocks of space as altogether negative. "Because space isn't as tight now, some companies are using this opportunity to regather groups that were splintered across the city," he said.

Suburban Slowdown

Houston's suburban office market also has seen its share of challenges, reporting a vacancy rate of 16.1% at the end of the first quarter, according to Grubb & Ellis Co. The Galleria and Westchase submarkets currently lead the city in vacancies, with 17% and 26%, respectively. Together the two submarkets accounted for 483,000 square feet of negative net absorption.

And with vacancies increasing for the past few years, landlords in the Galleria have become much more aggressive. "They're dropping rates by $2 or $3 from the quoted rental rate," said Bill Goeke, senior vice president & director of PM Realty Group's Central division.

Indeed, in submarkets such as the Galleria and Westchase, landlords are increasingly concerned about keeping current tenants. "Our ongoing challenge in the competitive market is to focus on keeping our existing tenants," said Peter Johnston, senior vice president of Equity Office Properties Trust's Houston region. "People are reacting to a more competitive marketplace." However, he noted that the city is not seeing as many concessions as Dallas.

Although the Westchase submarket has seen some softening, Mr. Johnston noted that Equity Office's assets in the Westchase submarket continue to perform well. He added that the company has been able to keep the majority of its tenants. For example, Loomis, Fargo & Co. renewed the lease for its 30,000-square-foot headquarters at 2500 CityWest, a 25-story building. This lease, along with others, has allowed Equity to maintain an occupancy level of 90% to 91% in its 2.5 million-square-foot suburban portfolio.

Similarly, PM Realty Group has been able to maintain an occupancy level of 90% in its suburban assets. According to Mr. Goeke, his company has seen the most growth in the Katy Freeway submarket. The company has been able to secure a lot of renewals, including an 111,000-square-foot deal with Citicorp Credit Services Inc.

Industrial Outperforms

During the first quarter of this year, Houston industrial reported a marketwide vacancy rate of just 8.2% and posted a net absorption of 622,853 square feet, outperforming every other industrial market in Texas and other property types within the Bayou City, according to Tyndall Yaap, vice president of Grubb & Ellis, who was recently involved in one of the biggest industrial leases in Houston. Gulf Winds International Inc. leased an entire 345,000-square-foot building in the Southeast submarket. That was just one of several large industrial deals.

"For several deals of this magnitude to happen at the same time … it just doesn't happen here," said John Talhelm, senior director of Cushman & Wakefield of Texas Inc. "It's a big deal."

Many real-estate professionals are concerned about the impact the approved merger between Hewlett-Packard Co. and Compaq will have on the Northwest submarket. "There's some overbuilding, and 3 million to 4 million square feet of new product has hit the ground over the past several months. At current absorption rates, we have over three years of product," said Caleb Lawson, vice president of Caldwell Watson Real Estate Group.

Mr. Lawson noted that the HP/Compaq merger already has impacted the market, as one of Compaq's logistics vendors vacated about 400,000 square feet of bulk distribution space in ProLogis Park Jersey Village at U.S. Highway 290 and the Sam Houston Tollway. However, that space was quickly backfilled by Goodman Manufacturing Co., which signed a 403,200-square-foot, five-year lease to consolidate operations from two other facilities in the Houston area.

Earlier this year, Home Depot Inc. took possession of a 750,000-square-foot distribution facility at the Cedar Crossing Industrial Park in Baytown, a southeastern suburb of Houston. According to Mr. Talhelm, Houston competed against seven other states to attract Home Depot's regional distribution center. Mr. Talhelm noted that Houston's ability to provide rail, truck and container access put the Bayou City at the top of the list. "It's a real coup for us to get Home Depot," Mr. Talhelm said. "These types of facilities traditionally go into areas like Dallas or Atlanta." However, he believes that Houston is on its way to becoming one of the premier locations for regional distribution hubs.

Overall, most industry experts believe that the industrial landlords in Houston will become more aggressive. "The attitude from landlords is that occupancy is important," Mr. Lawson said. "They'll sacrifice on the rate side to have occupancy." He expects that over the next few months owners will become even more aggressive with rental rates and concessions. "It's not going to be 'take it or leave it,'" he said.

However, Mr. Lawson noted that deals are taking longer and that credit has become a bigger issue, perhaps even more so than in other cities across the nation. "We're more focused on credit because Enron happened right in our backyard," he said. "It's a bigger issue than ever before."

Retail Rocked by Closings

Just a couple of months ago, Houston, along with the many other cities, was hit with the news that Kmart Corp. would close several stores. But Houston was dealt another shock when grocer Albertson's Inc. decided to pull out of the city after entering the market less than four years ago. Albertson's had 35 stores across the Houston metropolitan area totaling about 2.5 million square feet, as well as an 800,000-square-foot distribution warehouse on the west side of town.

Even though the Kroger Co. plans to purchase 16 supermarkets and two vacant parcels of land from Albertson's, retail experts agree that the situation is cause for concern. "That's a big nut to swallow," said Tom Estus, president of ShelbyEstus Real Estate Group Inc. "It will have a ripple effect." He expects that the vacant boxes will have an impact on new development. "If a grocery store is looking at a new development, they now might choose to go to a vacant store," he said.

According to Grubb & Ellis, a number of retailers, such as Target Corp. and Wal-Mart Stores Inc., have vacated older buildings for larger-format stores. Target is midway through a program to close several Houston stores averaging 100,000 square feet, replacing them with 175,000-square-foot stores that can accommodate groceries.

"The big-box guys are driving the retail market from a new development perspective," said Ed James, senior vice president of Moody Rambin Retail Properties. "The dealmaking is more deliberate, but there's still activity. We're on the tail end of a very strong development cycle."

According to Grubb & Ellis Co., there are 4.3 million square feet under construction, with large projects underway in the Far Northwest, Far Southwest and the Near West submarkets. Retail absorption is expected to be soft for the first half of the year.

-- Ms. Duell is senior associate editor of Commercial Property News.

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