What direction are commercial rents headed? Is the environment ripe for new construction?
A region’s industry mix often leads to a wide variety of answers to these questions at the local level. Commercial real estate (CRE) markets within the “Texas Triangle” (see “Texas Triangle”) are no exception. A comparison of actual and natural vacancy rates provides valuable insight for those who put their money in CRE.
Three CRE classes — office buildings, retail structures and industrial warehouses — accounted for more than half the value of all private, nonresidential construction occurring between January 1980 and July 2015. Because of their relative size, these three categories within the four major Texas MSAs are assumed to represent the bulk of Texas CRE.
The Austin MSA’s overall office market has continued to improve since vacancy peaked in fourth quarter 2009 (2009Q4). Vacancy fell steadily from a high of 16.9 percent in 2009Q4 to 10.4 percent by mid-2015 (Figure 1). This level is well below the average 14.3 percent observed between 2000 and mid-2015, the extent of available data.
Changes in demand are measured by net absorption, or the net change in square footage leased during a given period, including space leased in newly delivered buildings. Net absorption since 2011 has remained strong, moving closer to 2006 pre-financial crisis levels as the Austin office market continues to benefit from a resilient high-tech sector.
New relocations and existing firm expansions have steadily increased demand for Austin office space. Employment growth in the combined financial and business services sectors has averaged 4.8 percent annually between 2009Q4 and mid-2015. This is well above the 15-year average of 3.2 percent observed since 2000.
The real annual rental rate increased by an average of 3.5 percent in the three years since mid-2012, an impressive growth rate in real terms. On the supply side, new construction has begun to decline in the overall office sector (which includes owner-occupied space) as well as new buildings being constructed solely for lease.
DFW MSA office market vacancy most recently peaked in mid-2010 and was primarily hampered by the Great Recession (Figure 1). The DFW economy remains heavily tied to U.S. economic performance. As the U.S. economy picked up steam post-recession, DFW also began to experience stronger economic growth. The result was a fall in office vacancy from 19.7 percent in mid-2010 to 15.8 percent by mid-2015. Longer-term vacancy between 2000Q1 and mid-2015 averaged 17.4 percent.
Net absorption has sustained its positive growth trend since the recession’s end, increasing to levels not seen since the early 2000s. Corporate relocations and strong job growth continue to benefit the DFW office market. Significant corporate relocations include Toyota and Liberty Mutual Insurance.
DFW’s financial and business services employment grew at an average annual rate of 4.2 percent in the last five years to mid-2015, double the long-term average of 2.1 percent since 2000. Rents began to rise in real terms after 2013Q1, registering average annual growth of 3.5 percent from mid-2013 to mid-2015. New office construction overall has declined while rental space construction has remained quite strong since 2013.
Houston-The Woodlands-Sugar Land
The Houston MSA’s office market registered significant growth following its vacancy peak of 15.5 percent in mid-2010 (Figure 1). Vacancy fell steadily through the second half of 2014 when it bottomed at 12.7 percent. The strong showing was primarily the result of growth in Houston’s energy sector as oil prices topped $100 per barrel.
A steep fall in crude prices since the end of 2014 has begun to negatively impact the overall office market, with vacancy increasing to 15.2 percent by mid-2015. Long-term vacancy between 2000 and mid-2015 averaged 14.4 percent.
Houston’s net absorption has largely trended negative since 2015Q1, also attributable to falling oil prices. Expectations for any significant near-term improvement in the oil and gas sector are low. However, history has shown that crude markets can be extremely unpredictable.
Energy producers continue to downsize and consolidate operations. Although financial and business services employment grew at an average annual rate of 4.3 percent from 2010Q3 to mid-2014, it rapidly sank to 2.6 percent between 2014Q3 and mid-2015. Annual employment growth at mid-2015 remained above the 2000-to-mid-2015 average of 2.1 percent. Lower employment growth and office space demand should still be expected.
Inflation-adjusted rents descended from an average annual growth rate of 5.7 percent between 2013Q3 and mid-2014 to 4 percent in the year since. New overall office construction in Houston has fallen, as has construction of new buildings for lease. Although the upstream energy sector remains weak, a reduction in new office construction combined with a strengthening U.S. economy should mitigate any significant market breakdown.
San Antonio-New Braunfels
The San Antonio MSA office market has displayed more volatility than other major Texas MSAs. This should be expected in smaller markets. However, such volatility makes accurately anticipating future changes in the San Antonio market more difficult.
Vacancy increased fairly rapidly, reaching a peak by mid-2009 in the midst of the Great Recession, improving the following year but weakening again through 2012 (Figure 1). The San Antonio MSA has been heavily impacted, both negatively and positively, by the federal government. Changes in military budgets during the past decade have been a major factor.
The office market has shown progress as the U.S. economy has improved. Luckily, San Antonio only took a glancing blow from the energy sector slowdown, as the Eagle Ford Shale’s influence in local CRE markets was late in coming.
By mid-2015, San Antonio’s vacancy rate had reached 11.9 percent, slightly higher than the ten-year average of 11.6 percent from mid-2005 to mid-2015. CoStar’s office data for San Antonio only extends back ten years. Net absorption, although still positive, slowed after mid-2014.
Employment in financial and business services has been robust, registering a healthy average annual growth rate of 5.4 percent by mid-2015. This is well above the historical average of 2.5 percent observed between mid-2005 and mid-2015.
Annual office rent growth in real terms measured 1.5 percent in mid-2015. Office space supply in the MSA is increasing slowly, both overall and in lease space.
The Austin MSA’s retail vacancy peaked in 2007Q3, steadily improving since then, reflecting the dynamism of the Austin economy (Figure 2). Vacancy fell to a low of 4.5 percent by mid-2015, well below the average of 6.2 percent between 2006Q1 and mid-2015. CoStar’s retail data is not as historically deep as its office data.
Net absorption has remained positive since the second half of 2011 and continues to grow. Retailers continue to expand in the region, increasing the demand for retail space.
The average annual growth rate of retail sales increased 5.2 percent in real terms in 2014, higher than the historical average of 3.5 percent registered between 2006 and mid-2015. Alternatively, retail employment has slowed since 2014Q1, registering a 2.1 percent annual growth rate by mid-2015 compared with a historical average growth rate of 3 percent between 2007 and mid-2015.
The Austin retail CRE market remains strong, registering average annual real rent growth of 4.2 percent quarterly in mid-2015. On the supply side, new retail construction overall is declining as are rentable buildings under construction.
The DFW MSA’s retail vacancy has steadily declined after reaching a peak in 2010Q3, and continuing to tighten through mid-2015 (Figure 2). Similar to the office market, the strong retail showing is heavily tied to the MSA’s solid economic growth post-recession. Vacancy rates had fallen to a historically low level of 7.6 percent by mid-2015, lower than the average of 9.4 percent between 2006 and mid-2015.
Net absorption in DFW is impressive, continuing to show strong positive gains since the depths of the Great Recession in 2010. Positive growth in the retail sector has led to solid retail employment gains that reflect an increased demand for retail space.
Retail employment registered a 3 percent annual growth rate between 2014 and mid-2015. This is significantly higher than the historical average of 1.1 percent growth from 2007Q1 through mid-2015.
Retail sales averaged 6.4 percent in real terms during 2014. This is in sharp contrast to the mere 0.8 percent average increase between 2006 and year-end 2014.
Real annual rent growth averaged 1.9 percent from the beginning of 2014 to mid-2015. Retail space is increasing overall as new construction continues, although rentable buildings under construction is showing a slight decrease. This bodes well for continued strength in the DFW retail sector.
The Houston MSA’s retail market continues to show signs of staying power. Retail vacancy peaked in mid-2011 but began to decline as the energy sector blossomed (Figure 2). The relationship between Houston retail activity and the energy sector has been asymmetrical during the recent contraction. The fall in oil prices has not yet deteriorated the retail market.
Vacancy fell consistently from 11.1 percent in mid-2011 to 8 percent by mid-2015, below the historical average vacancy rate of 9.7 percent registered between 2006 and mid-2015. Net absorption is still positive but began to trend downward in mid-2014.
Positive conditions in the retail market are partly driven by continued population growth. As a result, retail employment growth and retail sales have been strong. Retail employment registered average annual growth of 2.9 percent from the beginning of 2014 to mid-2015. This is above the historical rate of 2 percent between 2006 and mid-2015.
Retail sales have started to slow. Rent growth registered an average annual quarterly real increase of 2.8 percent in mid-2015. New retail construction overall remains positive while rentable buildings under construction have started to decline. The decline may be due more to a lack of desirable sites than the recent fall in energy prices.
Results from the San Antonio retail market are mixed. Vacancy showed upward momentum after its peak in mid-2009 (Figure 2). The vacancy rate fell from 7.7 percent in mid-2009 to 5.8 percent by mid-2015. That is below the historical vacancy rate of 6.7 percent between 2006 and mid-2015. In contrast, net absorption had showed good gains since the end of 2011 but turned negative by mid-2015.
Retail sales registered annual growth of 5.7 percent at the end of 2014. However, retail employment has begun to trend downward, recording an annual growth rate of 1.4 percent in mid-2015. New retail construction and rentable buildings under construction have both begun to decline since mid-2014.
The Austin warehouse market continues to improve. Vacancy has steadily declined from 14.4 percent in 2009Q3 to 7 percent by mid-2015 (Figure 3). Net absorption has remained positive since 2009Q3 as well, further strengthening since 2014Q3.
Employment in transportation and warehousing continues to grow, recording an annual increase of 3.4 percent by mid-2015. This is above the historical average of 2.7 percent between 2001 and mid-2015. The average annualized real rent increase had reached 13.3 percent in mid-2015. New warehouse construction overall has continued to register positive growth, while rentable square footage under construction remains positive as well. Both have shown a slight slowdown in momentum since the beginning of 2015.
The DFW warehouse market continued to perform well even though global demand for goods dropped as the U.S. dollar appreciated. A stronger dollar makes U.S. (and Texas) goods more expensive in other countries.
Vacancy has recently begun to increase after reaching a historical low of 7.2 percent at the end of 2013 (Figure 3). However, its rate of 8.7 percent by mid-2015 is still below the historical annual average rate of 10.9 percent calculated between 2000 and mid-2015.
Net absorption continues positive, achieving historically high levels of late. This is reflected in strong employment growth in the transportation and warehousing sector. The average annual increase of 6.1 percent between 2014Q3 and mid-2015 is much higher than the historical average of 0.8 registered between 2001 and mid-2015.
Even though demand for warehousing space remains strong in the DFW MSA, inflation-adjusted rents have started to decline. In a sign that the market may be slowing, a negative real annual growth rate of –0.1 percent was calculated for mid-2015. The supply of new industrial space in both new construction overall and rentable buildings under construction has begun to trend downward in 2015, a positive sign for long-term market stability.
Despite the fall in energy prices, the Houston MSA’s warehouse market continues to perform well. Vacancy fell to a significantly low 5.5 percent by mid-2015, well below the historical average of 7.7 percent from 2000 to mid-2015 (Figure 3).
The strength of Houston’s warehouse market is also revealed in its real rent growth, posting an annual increase of 9.3 percent in mid-2015. This is much higher than the historical average of 0.8 percent between 2001 and mid-2015.
Net absorption continues positive, nearing pre-Great Recession levels. However, low energy prices have started to weigh on Houston’s transportation and warehousing employment, registering a mere 1.1 percent annual rate of growth in mid-2015. This rate is still above the historical annual average of 0.8 percent between 2001 and mid-2015.
Construction of warehouse space overall continues, while rentable buildings under construction registered a positive growth rate as well.
The San Antonio MSA’s warehouse vacancy began to increase after mid-2014, rising to 12.1 percent by mid-2015 (Figure 3). This is above the historical average of 11.8 percent from 2005 to mid-2015. Even though vacancy had trended up, net absorption actually turned positive for the first half of 2015.
Employment in transportation and warehousing continues to expand, registering an average annual growth rate of 4.3 percent in mid-2015. This is significantly better than the historical average of 1.8 percent from 2006 to mid-2015. Employment growth has remained positive since San Antonio began to emerge from the Great Recession in 2010.
Supply of new warehouse space is declining. New warehouse construction began to decline in 2015 while rentable square footage under construction remained basically flat since the beginning of 2014.
Natural Vacancy Rates
The natural vacancy rate can affect numerous CRE market participants. When actual vacancy in a local market falls below (rises above) natural vacancy, building managers begin to consider increasing (decreasing) rents.
The same logic can be used by developers to estimate the relationship between changes in vacancy rates and the construction of new lease space. For tenants, actual vacancy falling below natural vacancy is a signal that rents should begin to increase in the near future.
Natural vacancies were calculated for the major Texas MSAs. Aggregate natural vacancy in an overall market may not reflect the trigger vacancy rate an individual CRE professional uses to make decisions affecting a specific property or project. However, they are a good indicator of the direction rents and new construction activity are headed overall.
Office Sector Natural Vacancies versus Actual Vacancies
Calculations for the Austin office market reveal a natural vacancy rate of 13 percent while actual vacancy as of mid-2015 is significantly lower at 10.4 percent (Table 1). Based on that difference, along with the downward vacancy trend exhibited in Figure 1, future increases in Austin office rental rates should be expected.
The potential for new office development in Austin is even higher, as exhibited by the even larger difference between natural and actual vacancy displayed (Table 2).
The DFW office market registers a 17 percent natural vacancy rate compared to 15.8 percent actual vacancy (Table 1). When combined with the downward vacancy trend observed in Figure 1, DFW remains a good candidate for future rent increases.
A possibility for additional DFW office construction remains as well (Table 2).
Houston’s office market registered a 15 percent natural vacancy rate against 15.2 percent actual vacancy in Table 1. While these two values are almost equal, the upward trend in historical vacancy displayed in Figure 1 leads to the assumption that rental rates should be facing future downward pressure.
The same conclusion can be drawn for the possibility of new office construction in Houston because Table 1 and Table 2 values are identical.
San Antonio posted a 12 percent natural office vacancy rate compared to an 11.9 percent actual rate. These rates are also identical to those in Table 2. When combined with the relatively flat historical vacancy trend (Figure 2), little change in future office rents should be expected. Expectations should also be low for any new office construction.
Retail Sector Natural Vacancies versus Actual Vacancies
The Austin retail market’s natural vacancy rate was calculated at 6 percent compared with 4.5 percent actual vacancy (Table 1). When combined with the downward trend in vacancy (Figure 2), future increases in retail rents should be expected.
The potential for new retail development in Austin is somewhat less favorable, although still positive. Table 2 reveals a narrower difference between natural vacancy (5 percent) and actual vacancy (4.5 percent).
Natural and actual vacancy rates for the DFW retail market (Tables 1 and 2) are identical. Actual vacancy (7.6 percent) is below natural vacancy (9 percent). There is a strong downward trend in historical retail vacancy (Figure 2). As a result, the environment for future rent increases and new construction is quite positive.
For Houston, there is a slight difference between natural vacancy (9 percent) and the actual rate (8 percent) (Table 1). Historical vacancy continues to trend down. Future increases in retail rents should be expected (Figure 2).
Natural and actual vacancy rates (Table 2) are identical for the Houston market at 8 percent. With the strong downward trend in historical vacancy, future new development should be expected. However, Houston’s dearth of available retail sites remains a limiting factor.
San Antonio’s difference in natural vacancy (6 percent) and actual vacancy (5.8 percent) is the same in both Table 1 and 2. When combined with the relatively flat trend in historical vacancy, the possibility for significant rent increases and new construction should be quite low.
Warehouse Sector Natural Vacancies
The Austin warehouse market’s natural vacancy rate of 11 percent varies widely from its 7 percent actual vacancy. The disparity is also identical in Table 1 and 2. When combined with the strong downward trend in historical vacancy (Figure 3), an increase in warehouse rents and new warehouse development should be expected.
A similar trend is observed in the DFW warehouse market, with natural vacancy at 12 percent versus 9.5 percent actual vacancy. Both Table 1 and Table 2 have identical values.
When Figure 3 is factored in, mixed signals in the DFW warehouse market result. Historical vacancy has begun to increase of late, with the latest trend showing a leveling out. As a result, expectations for both rent increases and new development should be lower than a year ago.
Houston’s warehouse natural vacancy rate of 8 percent is higher than the actual vacancy rate of 5.5. If the downward trend in vacancy rate is added in, both a rise in rents and new construction should be expected.
San Antonio’s natural vacancy rate (12 percent) and actual vacancy (12.1 percent) are extremely close. Values in Table 1 and 2 are the same. When the upturn in historical vacancy displayed is added in, a possibility for future rental rate decreases seems plausible (Figure 3). Conditions are not favorable for future new construction.
Overall Market Trends
Demand for new commercial space requires an economy that leads to business expansion and generates more jobs in the process. As shown in this article, the performance of CRE markets in the state’s major MSAs should be expected to vary widely.
Although the future seems brightest in regions least affected by the recent downturn in the oil and gas sector, it should not be considered a determining factor in all cases going forward.
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Dr. Torres (firstname.lastname@example.org) and Dr. Hunt (email@example.com) are research economists with the Real Estate Center at Texas A&M University.