Houston's Tight Trophy Office Market Might Bring Class-B's Big Return

Houston office landlords are discovering that being second choice isn’t so bad.

Years after tenants began flocking to the newest, highest-quality buildings available in the city, a lack of new construction has allowed demand to gain on supply. Despite Houston having one of the highest office vacancy rates in the nation, its top-tier buildings are nearly full, pushing up rents and minimizing concession offerings.

That's finally forcing some tenants to consider the next best thing: older, well-located Class-A and some Class-B buildings. 

Houston office brokers say favorable occupancy and rental rates are trickling down, signaling a broader market recovery and benefiting landlords that were in a panic a few short years ago.

“It’s an interesting trend that we’ve seen. We are recipients of flight to quality in a negative sense,” said Margaret Hartman, chief operating officer of Hartman Properties, which acquired seven Class-B buildings in Houston’s Energy Corridor about eight years ago. 

After fixing the buildings up, offering small, ready-to-lease spec suites and capturing tenants that can’t afford top-tier buildings, the firm said it has increased the buildings’ occupancy rates by an average of 27%.

“As inflation increases and as rates stay high, we're able to push rates,” Hartman said. “It's penciling economically for us.” 

The latest data shows why subtrophy offices are getting another look. While the city's overall vacancy was 26.3% in the first quarter, Class-A properties built in 2015 or later had a vacancy rate of 11.7%, according to JLL.

The overall asking rent in Houston is $31.25 per SF, but Class-A properties are asking $36.14, pricing many out.

“Everyone’s been warned that this is happening, that there’s been rate pressure in terms of trophy, Class-A product,” said Anya Marmuscak, executive vice president and tenant rep broker for JLL. 

“It’s become more pronounced over the past year or so,” she added. 

Among Class-A offices, there is a vacancy rate spread of 18.4% between buildings built before and after 2015, she said.

The trend that helped fill up top-tier buildings disproportionately impacted Houston's Class-B office stock, which experienced 87% of the market's occupancy losses over the past decade, said Ariel Guerrero, leader of the Texas and Denver region’s insight team for Avison Young. 

But leasing momentum is building in lower-tier properties, and Houston saw a 7% increase in Class-B leasing activity over the past year. That was the fourth-highest rate nationally, according to an Avison Young report released last week.

“It’s definitely promising to see this because it’s been a very challenging period for Houston over the past 10 years,” Guerrero said. 

Astronomical concession packages that enticed tenants to lease office space during the downturn are becoming a thing of the past, said Katy Gragg, senior vice president and office agency leasing broker for Transwestern. Houston’s office down cycle started with the oil crash in 2014, then the pandemic lobbed another grenade. 

“Landlords were getting pretty desperate in a lot of cases,” Gragg said. “There were two years of free rent and TI packages that were just unprecedented, like over $10 per SF per year of term.” 

Many of those concessions never made sense economically but sold the potential of the building, she said.

“The music was going to stop anyway. … With the ownership market not supporting these deals and the supply and demand not supporting these deals, we’re finally getting some downward relief on concession packages,” Gragg said.

This new trend calls for education and communication between brokers and tenants on the hunt for space, she said. Despite about 50M SF of vacant office space in the Houston market, very little of that is in the most desirable office buildings. 

“I was on a tour representing the landlord the other week, and the tenant even made the comment,” Gragg said. “He was like, ‘I just couldn't believe there were so few options.’” 

Landlords like Hartman Properties are stepping up to capture tenants that can’t afford the top-tier buildings but still want a good location and a well-run building, Hartman said. 

“We’re reaping the benefits of our location,” she said.

As the buildings reach stabilization, Hartman Properties can push rents up by $1 to $2 per SF and have no trouble leasing at those rates, she said. 

Class-B offices tend to attract smaller companies with smaller leasing footprints, Guerrero said. While Class-A leases average 9K SF to 11K SF, Class-B leases average around 2,300 SF, he said. Hartman has also capitalized on that trend.

“Instead of focusing on attracting a large, new tenant, we've put in some leasing capital to break up the spaces and to deliver to the market ready-to-lease 1,500 to 3K SF spaces,” Hartman said. “What we've experienced is that those lease very quickly.” 

The Houston market has seen several big Class-B leases over the past year, which helped boost Class-B leasing activity year-over-year, Guerrero said. Those include Frazer’s 150K SF in Sugar Land, Ezee Fiber’s 94K SF in Southwest Houston and Blue Cross Blue Shield’s 135K SF, also in Southwest Houston.

It’s not all roses yet. Class-B leasing demand is still 24% lower than it was prepandemic, according to the Avison Young report. Class-B offices also had an average vacancy rate of 27.7% in the first quarter, higher than Houston’s average of 26.3%. 

But the relative tightness in top-tier buildings will push more tenants to consider Class-B properties, Guerrero said. Significant recovery will take time, though Houston could be ahead of the game. 

“Since we started the downturn earlier than most markets, I think that positions Houston well,” he said. “We’re going to be among the top markets when it comes to occupancy growth. It’s not going to be like what we used to see during the good times. But hey, I’ll take anything.”