Third Quarter 2021
Economic activity within Texas improved during the third quarter, and strong growth is expected for the remainder of the year. Increased hiring in September resulted in solid third-quarter payroll expansion, although joblessness in the Lone Star State was still higher than the national average. Moreover, headline wage numbers accelerated in real terms despite rising inflation. Oil industry activity accelerated as oil prices increased and the global economic recovery continued. Meanwhile, retail sales surpassed a record-breaking $50 billion, but real commodity exports decelerated. Containment of the pandemic is vital as additional waves of infection, mainly from the Omicron variant, can weigh on consumer behavior and slow the return to pre-pandemic conditions.
The Delta variant appears to have reached its extreme point as the numbers of COVID-19 cases and hospitalizations continue to fall after peaking at the end of August. The announcement of a COVID-19 pill that reduces the risk of hospitalization and death has considerably reduced the uncertainty on halting the pandemic, improving future economic expectations. Still, the National Institute of Allergy and Infectious Diseases has expressed its concerns about a possible surge during the winter months as temperatures drop, and the appearance of the Omicron variant has increased preoccupations about future outbreaks. For additional commentary and statistics, see the Texas Real Estate Research Center's Outlook for the Texas Economy.
The Texas Nonresidential Construction Cycle (Coincident) Index, which measures current construction levels, slowed during September due to decreasing put-in-place construction values. The statewide Nonresidential Construction Leading Index overall trend points toward a future increase in nonresidential construction activity amid rising construction value starts and a decrease in the ten-year real Treasury bill yield. Austin's office and retail leading indexes reflected statewide movements, pointing toward increases in commercial construction activity in the near future as the value of construction starts increased, while the trend decreased for warehouse activity. DFW leading indexes point toward increased future activity in all three sectors: office, retail, and warehouse. Houston leading indexes, with the exception of office, signal higher construction activity going forward due to increasing construction start values. San Antonio leading indexes, with the exception of office, indicate less activity going forward. See Figures 1-5 for the Nonresidential Coincident Index and Leading Indicator for Texas and the four major metros.
Texas nonfarm employment added 95,800 jobs in September, rising 6.7 percent at a seasonally adjusted annual rate (SAAR). Based on the state's solid employment performance, the Dallas Fed forecasts annual employment to increase 5.1 percent in 2021, reaching 13 million workers by December. Hiring in Houston surged during the third quarter, recovering 51,400 jobs compared with the 23,500 positions added during the second quarter. Despite registering the highest number of job gains of the four major MSAs, Houston payrolls remained 3.7 percent below pre-pandemic levels. Austin added 34,000 employees, more than doubling employment gains from the second quarter as the metro benefited from its substantial high-tech sector, which can socially distance and has prospered during the pandemic. Employment increased precipitously in Fort Worth, gaining 30,700 positions after increasing payrolls by just 400 workers in the previous three months. Only hiring in Dallas and San Antonio slowed quarter over quarter, but the metros still registered quarterly increases of 36,000 and 9,300 workers, respectively. Payroll expansions across the major metros were largely concentrated in the professional/business services and education/health services industries, while goods-producing employment mainly elevated due to rising construction jobs.
Texas' goods-producing sector gained 26,500 jobs during the third quarter after losing 16,700 positions the previous quarter. Amid increasing oil prices, energy-related employment rose by 7,800 jobs but remained around 16 percent below pre-pandemic levels. Recovering global economic conditions supported the state's manufacturing industry, which added 12,000 employees, while durable-goods payrolls recorded a 6,100-job gain. Construction payrolls expanded this quarter, adding 6,700 jobs after losing jobs in four consecutive months from April to July.
Texas' service-providing sector recovered nearly all jobs lost due to the pandemic, adding 203,400 workers during the third quarter. Leisure/hospitality recouped 28,400 jobs, but arts/entertainment/recreation payrolls remained almost 15 percent below pre-pandemic levels. On the other hand, the transportation/warehousing/utilities industry added 31,400 positions, surpassing pre-pandemic employment by 2.6 percent.
Texas' unemployment rate decreased to 5.6 percent, still higher than the national rate of 4.8 percent. The size of the state's labor force expanded while the labor force participation rate reached 62.4 percent. Texas' major metros reported lower unemployment rates than the statewide average, except in Houston where joblessness fell to 5.8 percent. Unemployment inched down to 5 percent in Fort Worth and fell in San Antonio and Dallas to 4.9 and 4.8 percent, respectively. Joblessness remained lowest in Austin, where unemployment slid to 3.8 percent.
The decrease in unemployment after 2Q2020 is important for commercial vacancies given the relationship between unemployment rates and vacancy rates. The longer unemployment rates remain elevated, the stronger the negative impact on vacancies and rents. As would be expected, the increase in the unemployment rate in 2Q2020 pushed up vacancy rates in the major metros and the declining unemployment rates since have alleviated some of the pressures on rising vacancy rates. Still there seems to be a disconnect between office vacancy rates and unemployment rates that started after 2Q2020 when the pandemic shut down the economy. This disconnect is a result of the hybrid working environment that has demonstrated that employees can be productive working from home. The disconnect has been reinforced by the postponed return of employees to the office as new variants of COVID-19 have caused outbreaks, increasing uncertainty surrounding future office demand (Figures 6-9).
With monetary policy possibly normalizing, starting with the Federal Reserve Bank's tapering of bond purchases, economic growth forecasts for the coming years point to a slow return to the long-run structural trend as the initial and strongest stage of recovery likely reached its peak. It's becoming clearer that inflationary pressures will be permanent. The ten-year U.S. Treasury bond yield decreased to 1.5 percent during 3Q2021 but was down from pre-pandemic levels of 1.7 percent in 4Q2019. The spread between commercial capitalization rates and the ten-year Treasury yield increased during 3Q2021 after decreasing from 1Q2021 to 2Q2021. The increase in the spread was due to a decline in the ten-year yield. Rising inflation expectations and the Federal Reserve's tapering of assets purchases should push up interest rates in 2022. As a result, the spread should decline somewhat next year.
After decreasing during the first half of 2021 in Texas' major metros, office cap rates increased during 3Q2021, with the exception of Austin (Figure 10). The uncertainty surrounding the return of employees to the office contributed to the increase in cap rates and a decrease in the ten-year U.S. Treasury bond yield. Austin was the exemption due to positive expectations surrounding the local office market due to the presence of the technology industry and the movement of companies to the Texas Capital. San Antonio and Houston continued to register the highest cap rates, followed by DFW and Austin. The office cap rate spread with the ten-year Treasury bill increased during 3Q2021 after decreasing since the start of the pandemic in all Texas' major MSAs. Austin was the least risky market for office real estate during the nine months of 2021 based on the spread with the ten-year Treasury bill.
Retail cap rates (Figure 11) increased during 3Q2021 after decreasing since 2Q2020 in three of Texas’ major MSAs; Houston was the exception. The spread between retail cap rates and the ten-year Treasury registered an increase in the third quarter in all four major Texas’ MSAs due to the decrease in the ten-year yield. Although Houston’s cap rate decreased during the third quarter, it could not overcome the fall in the ten-year Treasury yield. The overall decreasing trend in the spread reflects the change in sentiment regarding future expectations for the retail sector from devastating to a relatively more positive one. Austin and San Antonio are the least risky and lowest-return markets for retail real estate.
Industrial cap rates (Figure 12) increased during 3Q2021. San Antonio and Houston recorded the highest cap rates. Similar to the other two markets, the spread between the ten-year Treasury increased during 3Q2021 in all four MSAs. DFW is the least risky and lowest return market for industrial real estate based on the spread with the ten-year Treasury bill.
The Texas Real Estate Research Center estimated 2021, 2022, and 2023 vacancy rates and asking rent percent changes for the different commercial markets and major MSAs (Tables 1A -3).
Office Class A Tenants by Industry
To better understand how economic expansions and recessions will affect demand for commercial space in a particular location, it is important to know who the tenants are and what industry they belong to. This allows one to estimate the industry mix and the market's diversity from a downturn in a particular industry.
The importance of the technological industry to Austin is apparent in the high percentage of tenants that belong to the computer and processing sector encompassed by the business services sector (Graph 1). This industry has performed relatively well during the pandemic. Working from home will have consequences on future office space demand. (Look at the outlook box for further comments on this).
Financial industry tenants play an important demand role in all markets, especially in DFW (Graphs 1-4). This industry has been able to socially distance and has done a good job of managing the transition of working from home. With the exception of Houston, the financial industry in Texas' major MSAs has returned to pre-COVID employment without returning to the office. There is a disconnect in the relationship between employment growth and office demand. This has implications for future office space demand.
In addition, engineering, accounting, research, management, and related services is another sector with a strong demand for office space (Graphs 1-4). This industry has also recorded strong job growth without employees returning to the office. It is unclear how the hybrid work model in this sector will affect future office demand.
Houston's concentration of tenants in the oil industry stands out. Around one-fifth of the occupied space is from tenants in this industry (Graphs 3). This probably underestimates the number of tenants that are part of the oil industry since it doesn't include services provided to the oil sector, such as engineering services. The oil industry faces strong headwinds due to movement from carbon-based energy to a cleaner, renewable energy. This structural change facing the oil industry will affect office demand.
A significant share of the tenants in San Antonio belong to the health services sector (Graph 4). This industry's demand for office space is expected to continue since health services require social interaction.
For an analysis of Austin's, DFW's, Houston's, and San Antonio's commercial markets (including tables and figures), download the full report.
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