Houston's Real Estate Risk: Does Perception Equal Reality?
When investors look at Houston, they see risk. There is no question Houston's office market is bearing the brunt of the slowdown. Since the beginning of 2014, vacancy has jumped 440 bps, sublease has increased by over 6M SF and construction activity has ground to a halt. But NGKF set out to determine if the perceived risk matched reality.
In brief: No, Houston's not as risky as outsiders fear.
Take A Full Picture
First of all, Houston isn't just an office market, and the other sectors are faring better. Overall vacancy rates remain below 6% for industrial and retail, as both segments have benefited from a population that has expanded by 736,000 people, or roughly 340 people per day, since April 2010. Occupancy in the multifamily sector has stabilized around 93%, which, according to Axiometrics, is in line with the 10-year average. The issue for Houston's multifamily market is tied to supply and its impact on the top end of the market. Luxury apartments are increasingly turning to concessions and even gifts like flat-screen TVs to stimulate demand. Despite efforts, occupancy for properties in lease-up stood at 54.22% as of June 2016, showing some weakness.
The Lending Landscape
Looking specifically at office, Houston's typical lender carries significance to the question. NGKF looked at $6B of office loans in Uptown and the CBD. In both submarkets, life companies maintained the largest market share: 52% in the CBD and 56.2% in Uptown. The find is noteworthy despite the small sample size, due to the risk-averse nature of life companies.
Investment Returns And Liquidity
Steady investment sales volume provides further confidence. Outside of a national recession, Houston has shown ample liquidity. Since 2001, investment sales volume has averaged $7.8B, including six years with volume in excess of $10B, according to Real Capital Analytics. Typically, the greatest amount of liquidity has been found in the apartment and office sectors.
And perhaps most compelling, overall transaction volume remains well above the long-term average in this down cycle. Despite some slowdown, transaction volume is expected to remain above average, considering the low-yield environment for investors and the expectation that foreign capital will continue to flow into the US.
Historical investments returns also provide clues to Houston's risk of collapse and overall real estate market. In the past 20 years, Houston real estate posted an average annual return of 11.2%, according to data from NCREIF. Annual returns turned negative only once, in 2009. Returns have been 95% positive over the past 20 years, almost regardless of economic cycles.
The perception of a development-friendly environment for the office sector matches the reality. However, as a construction hub, the real question for Houston is, "how disciplined are local developers?" Using the concept of price elasticity of supply—the average annual percent change in stock divided by the average annual percent change in rent—as outlined by TIAA-CREF, we got our answer. A value of less than 1.0 suggests discipline exists, as developers respond to rising rents, a function of demand. Using this metric, Houston has seen a dramatic improvement, particularly since construction is one of Houston's favorite pastimes.
Overall, while cap rates have expanded by 50 bps to account for additional risk, the real estate market is a long way from collapse. Confidence from the lending community, increasing discipline with regard to new supply, stable liquidity and a long track record of performance bodes well for what will soon become the nation's third-largest metropolitan area.
Special thanks to David Wegman at NGKF for assembling data.