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Office Lease Renewal – The Landlord is Not Your Friend

DON'T GAMBLE WITH YOUR OFFICE LEASE RENEWAL

One of the most common phrases I hear from office tenants is “the landlord is a friend” as reasoning why they don’t need professional representation. Ah, the Office Lease Renewal. Is there anything more misunderstood in commercial real estate? If you’re an office tenant considering going it alone I encourage you to re-consider. Below we’ll cover a few reasons why this is the case.

1. THE LANDLORD IS NOT YOUR FRIEND

Ok, maybe he is. Let’s draw a line of distinction here going forward. If you were not already friends with the building owner prior to leasing space there, the Landlord is Not Your Friend. His motivation for befriending tenants in the building is purely good business. By building a relationship with tenants the owner is able to change the dynamic from what it truly is – a business transaction. In a business transaction one would be primarily concerned with the financial impacts and wider implications for their operations. If the office lease renewal process is a chat among friends, this can re-frame the nature of the discussion entirely… entirely in the landlord’s favor.

2. THE UNREPRESENTED TENANT IS AN UNINFORMED TENANT

The tenant that does not seek a professional tenant rep to look after their interests will not be informed about the market. This unrepresented tenant may not even know what rental rates their building is quoting at the time of their lease renewal. If you don’t know the starting point during a negotiation how can you measure your results? How will you know if the deal on the table is a fair market deal? You won’t.

The friendly landlord would prefer this situation. The strategy of befriending the tenant means getting them to let their guard down. The tenant will develop a level of trust with the ownership. They will believe that the owner is looking out for their best interest. This can lead to the tenant making poor business decisions, such as representing themselves, not verifying the market conditions, and failing to check their deal against others in the building or in their area of town.

3. DON'T ADVERTISE YOUR INTENT TO RENEW

I regularly hear from office tenants that they plan to contact their landlord directly to initiate the office lease renewal process. Their intent is to secure a competitive deal on their own, and if that fails, to bring in a tenant rep to attempt improving the deal. Unfortunately, what this communicates to the landlord is that the tenant ultimately intends to renew the lease. Their intent to renew was so strong they did not even find it necessary to hire a broker. And now that the numbers aren’t attractive enough to them, they want to insert a broker. There is a right way and a wrong way to approach the office lease renewal. Can you guess which category this fall under?

Hiring a tenant rep broker at the beginning of the process would maintain the tenant’s leverage. The broker would ensure the tenant understands the market conditions, the rates for similar buildings, the vacancies in the area available for possible relocation. The broker would also ensure that the landlord understands this as well. The knowledge of the market and experience of the tenant rep broker will even the playing field for the tenant.

4. NEW TENANTS ARE GETTING BETTER DEALS

It is extremely common for new tenants in a building to secure more competitive deals than existing tenants. This is due primarily to the fact that existing tenants are statistically less likely to relocate. The landlord knows this and will use it to his advantage. Moving can be a hassle, and typically it is something to be avoided if possible. An unrepresented tenant will very likely leave money on the table because the landlord understands this. The tenant may focus exclusively on the rental rate, with little thought given to rental abatement, improvement allowances, master lease revisions, and other concessions which are typical for a new tenant to receive.

CONCLUSION

For tenants preparing to begin the office lease renewal process it might be useful to consider professional representation. You wouldn’t step in the court room to represent yourself with hundreds of thousands of dollars on the line – so we would you do it with the office lease? The landlord may be friendly, but the income of his asset (the building) is directly tied to the deal you agree to. His intent is to secure a higher rental rate, which is in direct opposition to your motivation as the tenant. As a tenant you may negotiate a lease once every 3-5 years. The landlord is doing this multiple times each year. Don’t go it alone, get representation.

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Contact us today if you’re dealing with a renewal proposal and would like advice or more information on the market.

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Should Office Tenants Hire an Architect?

When Should an Office Tenant Hire Their Own Architect?

As a tenant searching for new commercial office space the process can often be complicated and time-consuming. After hours of touring properties and narrowing down options the first phase of negotiations begins. With this phase comes an important decision to be made: Should the office tenant hire an architect or use one provided by the landlord? Several factors will determine whether this makes sense or not. These may include the overall complexity of the construction work required, and the desired amount of interior design needed to make the space ready for occupancy.

Before we dig into the reasons for and against hiring your own architect let’s review the basics of space planning.

What Is Space Planning?

Typically when a commercial office space tenant finds a vacancy they like the first step offered by the landlord’s broker is a space plan or test fit. The landlord will usually have a preferred architect to use for this. The cost for a basic test fit will be approximately $0.10-$0.15 per square foot. This usually includes a couple revisions to the plan as the tenant and architect fine tune the design. This cost is usually paid for by the landlord as an inducement to engage negotiations with the prospective tenant, and is considered a cost of doing business for them.

Below is an example of a simple space plan which illustrates how a tenant might occupy and utilize a prospective office space.

Reasons for Having Office Tenants Hire an Architect

So what are some reasons an office tenant may decide to hire an architect?

1. Guaranteed Impartiality: the Landlord will have no influence in the design of the space and specific elements of the design which can drastically affect costs.

2. Workspace Efficiencies: by definition, architects design workplace configuration. Using your own architect allows you to make your space a function of your organizational culture. Whether you’re looking for an open floor plan, office intensive layout, break-out spaces, etc, the architect is tasked with achieving your required needs within the most efficient layout possible. The square footage savings here can more than make up for the added cost of the architect’s fees.

3. Construction Scope Complexity: if the scope of the job is significant it can be very useful to have your own architect managing the details of the design process.

4. Optimizing the Tenant Improvement Allowance: all tenants want to maximize the value of any tenant improvement allowance provided to them. The architect can play a key role in ensuring these dollars are spent how the tenant desires.

5. Ensuring the Space Meets all Governmental Codes and Regulations: it is in the tenant’s best interest to ensure a new office space meets all necessary codes and regulations prior to accepting and occupying the space.

GUARANTEED IMPARTIALITY

When office tenants hire an architect they can be sure the design and specific elements contained within are aligned with their desired use. The landlord will not have control of the design process and generation of the construction plans. There can be opportunities to secure cost-savings which a tenant’s architect will be more motivated to identify and capture. The tenant can also be assured that the area calculations for the usable square footage are 100% accurate (which is not always the case).

WORKSPACE EFFICIENCIES

Many business owners want to strategically organize and plan their office space to impact the organizational culture and operations of the business. When office tenants hire an architect it can be a great way to work collaboratively to achieve this result. Whether an open floor plan is desired, or finding space for the right number of private offices, or building a large enough break area to give employees space to unwind, an architect can assist with all of these and more. Finding ways to organize a space layout efficiently can greatly reduce the square footage and therefore lower the monthly rental expense for the business.

SCOPE OF CONSTRUCTION REQUIRED FOR YOUR BUSINESS

If the current as-built layout for an office space is similar to the tenant’s desired plan, it may not be necessary to have office tenants hire an architect. With a small project scope for construction the work could be completed without detailed architectural and construction plans. However, this is often not the case, and as a result the complexity and cost of the deal will increase. A significant change to the space configuration is a key reason why office tenants hire an architect to assist them.

Relocating an office space is a lengthy process and can be disruptive to the business. For a move to make sense the new space should be efficient and laid out properly to accommodate the desired business operations. Changing the layout or configuration of a space can result in numerous construction updates, but may be necessary for the space to work.

OPTIMIZING THE TENANT IMPROVEMENT ALLOWANCE

One key component of any office space negotiation is the amount of tenant improvement allowance. This is the amount of money the landlord agrees to pay toward improvements for the space to make it ready for a new tenant. The space plan and construction documents prepared by the architect will greatly influence the costs bid to complete the construction work. It is crucial that tenants and their brokers review all elements of the plans to verify they match the desired outcome. Items missing from the initial plan may require costly change orders after the lease has been signed if the landlord ultimately agrees to turn-key construction. Alternatively, fluff items may have been inserted in the plan which inflate the project cost. The inflated cost will negatively impact the tenant’s bargaining position during negotiations, and the fluff items may be removed at a later stage to save the landlord money.

The tenant’s architect can help identify costly building materials and elements which may not be necessary. Removing these items early in the process can help optimize the improvement allowance negotiated and avoid surprises after the lease is signed.

ADDING INTRINSIC VALUE AT THE COST OF THE TENANT

All commercial office buildings are assets to their owners. These assets have an intrinsic value which is affected, in part, by the value of the materials and finishes within them. Within any large-scale construction project to update a commercial office space there can be many decisions made that affect the value of the space and therefore the building. The key point here is to ensure that all of these decisions align with the tenant’s desired occupancy and use of the space.

ENSURING SPACE MEETS ALL GOVERNMENTAL CODES AND REGULATIONS

Another advantage to using your own architect is to ensure that the newly updated office space conforms to all applicable codes and ordinances. Changes can occur over time and some offices will need to be updated and brought back into compliance. The architect will have key knowledge regarding these necessary updates and how much they will likely cost. As the tenant it is in your best interest to have the space meet code to avoid any disputes with inspectors down the line.

Conclusion

Not all commercial office space tenants will choose to hire their own architect – and not all of them should. This decision comes down to the overall complexity of the work to be performed, the amount of tenant improvement allowance at stake, the quality of the building and materials finishes, etc. Generally speaking the larger the space and construction scope, the more to be gained by hiring your own architect.

Contact us today for a FREE, customized and tailored market survey report. We’re here to help you through the entire leasing process.

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Houston Office Market Report: Mid-Year 2018

Houston Office Market Report: Mid-Year 2018
Economic Indicators are Strong and Oil Market Continues Upward Trend.
Houston Office Market Update

As the 2017 calendar year came to a close, I noted the first glimpses of optimism within the Houston business community in a long time. The oil market was beginning to stabilize, and OPEC had recently announced an extension of its output restrictions through the end of 2018. Now, with half of 2018 in the rear-view mirror, we can safely agree on the fact that Houston’s office market has reached bottom. Growth is expected to occur slowly, and most in the commercial real estate industry admit that it may take 18+ months to backfill all the occupancy losses. Sublease space has continued to saturate the office market, especially in Q1 2018. In the 2nd quarter the available sublease space decreased by 700k sf and could mark a turning point. Tenant concessions are still quite strong across the leasing market, and it’s anticipated to remain a tenant-favorable environment through 2019.

The Strength of Oil & Gas

Today oil is trading consistently in the $65-70 per barrel price range, which is considered a comfortable price point for most in the industry. U.S. crude production has set new records on several occasions this year, most recently just a week ago reaching 11 million bpd. The U.S. rig count has consistently risen through H1 2018, and finally eclipsed the 1,000 mark for the first time since April 2015. There is certainly a feeling in the city that the oil market is back, and with it, the Houston economy. Of course this stabilizing market does not guarantee an immediate influx of hiring and job growth. Energy firms are beginning to hire, yet it is clear that new positions will be posted and filled cautiously on an as-needed basis. The trend prior to the most recent oil downturn was for energy firms to sign “large and long” lease agreements, and their hiring tended to follow suit. This time around we are noting a more measured approach to both hiring and leasing decisions.

Houston Office Market Report - By The Numbers

In the second quarter of 2018 the vacancy rate in the Houston office market decreased mildly from 16.7% to 16.5%. This equated to a net increase in occupancy of 202,720 sf for the quarter. With a total office market exceeding 325 million square feet, this rate yields upwards of 53-55 million square feet of vacant space citywide. When considering available space which is still occupied, but will soon be vacant, the rate exceeds 20%, or 65 million square feet. Despite a weak first quarter for Houston’s office market I do believe the bottom has been reached. Leasing activity seems to be trending upward, and there are a number of new start-ups and firms securing equity funding rounds at this time. Time will tell if this upward trend can continue, and if we will see any substantive reductions in the sublease market for H2 2018.

Rental rates decreased slightly in the 2nd quarter but are practically flat for the year. Across all building classes in Houston the average asking rental rate was $27.60 per square foot. Building owners have continued the strategy of providing more generous concession packages in the form of rental abatement, tenant improvement allowances, free parking, and other inducements as a means of avoiding rental rate reductions. We expect this to continue through the remainder of 2018.

The Houston office market now consists of over 326 million square feet of space and totals more than 9,000 properties. Class A buildings account for a staggering 45% of the total office market. Another 42% of the market is considered Class B, with the remaining 13% falling into Class C.

Houston Construction Activity

Commercial office construction activity remains light at this time, with only 2.6 million square feet in the works. Seven properties remain under construction in The Woodlands, accounting for 35% of the UC inventory in Houston. Overall, this construction space is 52% pre-leased at this time. Over half the properties currently underway will not deliver to the market until 2019. The construction activity for 2017 lagged behind the historical average of ~ 5 million square feet and 2018 will fall short of this number as well. As the market fundamentals begin to re-balance we expect to see an uptick in construction starts. The recent announcement by Hines that they will develop a new 47-story building on the former site of the Houston Chronicle is the first sign of this.

Best and Worst Performers

In the first half of 2018 three submarkets stood out for improved performance: Galleria/Uptown, The Woodlands, and the Katy/Grand Parkway area. Together these three submarkets accounted for over 700k sf of positive absorption. Overall, the South Main/Medical Center remains the strongest office submarket with a 4.1% vacancy rate, under-scoring the healthy performance of Houston’s medical industries. The Woodlands remains the strongest of the large markets at 9.1% vacant – well below the average. Sugar Land is a close second at 9.8% vacancy, and the FM1960/249 area is doing well at 10.4%, reflecting the fact that many Class B and C properties are managing to remain well-occupied.

On the other end of the spectrum we have Greenspoint/N Beltway, Houston CBD, the West Beltway, and Westchase submarkets rounding out the worst performers. Together these four submarkets accounted for over 1.3 million square feet of vacancy increases. Another 1 million square feet of vacancy was lost across 19 other submarkets in Q2 2018. Greenspoint/N Beltway is now 47% vacant, followed by Post Oak Park at 27%.

Summary

IAs you’ve read in this Houston Office Market Report, the local economy has been improving of late, due in large part to the oil & gas market rebounding. There are some economic headwinds on the horizon globally and nationally for the United States which could affect demand for the oil & gas market. Most predictions are considering a 24-36 month time period for that slowdown to materialize. The flattening yield curve, tumultuous stock market, rising interest rates, and the threat of inflation are certainly on investors minds. Here in Houston locally, there is renewed optimism about the coming recovery for our economy. With that recovery will come stabilization of the office market, though we expect this to be a long, drawn out climb back to reasonable occupancy levels.

Click here to view the full Oxford Partners Q2 2018 report.

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Can Commercial Real Estate Adapt to the Self-Driving Revolution?

Can Commercial Real Estate Adapt to the Self-Driving Revolution?
THE SELF-DRIVING REVOLUTION BEGINS

The advent of self-driving vehicles has been well-established, written about, and discussed at this point. It should be obvious to anyone with a pulse that autonomous vehicles are headed toward mainstream adoption. The rate of that adoption is up for debate of course.  The two biggest factors will be the pace of technology improvements and the speed and nature of government regulations enacted. Technology improvements will be critical to establishing trust with the public. Government regulations may be slow in becoming law because this would represent a massive shift in how many things operate in the US and around the globe. This article aims to provide insights into the coming self-driving revolution, and in particular, the most likely areas where office and industrial commercial real estate will feel the effects. We could extrapolate these predictions many years into the future, but I prefer to focus on the more tangible effects we could see in the next 5 years.

Let’s begin with office:

AUTONOMOUS VEHICLES AND THE IMPACT TO OFFICES

The obvious first area of impact for office buildings is parking. Let’s dig deeper into what that may really mean for owners of commercial office buildings and office tenants leasing space. There is momentum today behind the research and development of autonomous vehicles with virtually every major car manufacturer devoting resources to the cause. There are also a number of tech start-ups angling to get into the action, as detailed quite well in this Digital Trends review from CES 2018. It is clear based on the number of large companies invested in the development of this technology that many see the value and opportunities yet to be realized. With so many major players jumping in with significant investment amounts I think it also indicates that government will play ball in regulating the new technology as safety improves.

So in the near-term as self-driving technology undoubtedly improves and become more mainstream, how can we expect it to impact parking at office buildings across the United States? The impact on parking will depend heavily on how the adoption of autonomous vehicles unfolds. Some have speculated that the younger generations lack of enthusiasm for car ownership coupled with self-driving technology will yield a world in which most of our trips are handled through Uber, Lyft and other ride-sharing services. I personally think this level of adoption is decades away from reality. In truth the adoption will be much more gradual than that.

CAN I REDEVELOP MY PARKING GARAGES NOW?

Since the adoption of self-driving technology will be gradual the opportunity for owners to simply demolish and redevelop their parking garages is absolutely overstated. The majority of tenant employees will retain ownership of a private vehicle for the foreseeable future . This means parking ratios will not see a significant decline until the mix of employees is weighted more heavily toward younger generations. However, that does not mean there will not be a huge impact on parking for office building owners in the near term.

Parking today is a key determining factor for many office tenants considering where to lease office space. Accessibility of the parking garage, size and spacing of spots, & overall flow and ease of navigation within the garage are all extremely important to office tenants. It is not uncommon for this single factor to cause a tenant to exclude an office property from their short list of options when evaluating an office relocation.

So how does this relate to the adoption of autonomous vehicles? If office tenants can be dropped off at the front door of their building and the car can park itself, this may alleviate many of the concerns tenants have with the parking facilities. Some buildings with less desirable parking arrangements may actually benefit from autonomous vehicles because tenants may not care as much about those issues in the future. Older properties with outdated garage designs could benefit greatly from this shift. This means in the near-term self-driving vehicles may level the playing field for certain office properties with less desirable parking arrangements.

OPPORTUNITIES FOR URBAN AREAS

There could be opportunities in dense urban areas for office buildings to lease or purchase offsite parking facilities for their tenants. Again, with office tenants being dropped off at the front door, as long as the offsite parking facilities are within a few minutes driving time from the building, this would not be a major concern for tenants. They could, for example, call their vehicle before leaving their desks, and the vehicle could be parked and waiting by the time they exit the elevators into the lobby. For some properties with high land value, this arrangement may make sense in order to allow redevelopment of the on site parking  garages. Over time, if car ownership actually does decrease, it would be very easy to reduce the number of leased spaces for a particular office property at the offsite parking lot. By arranging for offsite parking lot use, some urban office properties may be able to re-purpose or redevelop their onsite parking facilities sooner than their suburban counterparts.

For owners of office buildings it will be extremely important to stay ahead of the technology curve for adoption of autonomous vehicles to ensure parking garages are properly equipped and configured.  The process of tenant drop off cannot work properly if the self-driving vehicle is unable to navigate the parking garage and park itself. Similarly, office buildings will want to consider the flow of tenant employees and guests entering and exiting the building – especially during high volume time periods. Properties which are not configured to handle a high volume of drop-offs and pick-ups may want to evaluate ways to improve accessibility as this technology becomes more mainstream. Building lobbies may become a central waiting area for a larger portion of tenants so amenities and areas to sit and wait will be important attributes to consider.

 

WHAT ABOUT REVENUE FROM PARKING?

Another concern for office building owners is related to income received from parking charges. I don’t consider this issue of particular importance though. Properties that charge for parking today will still be able to do so when autonomous vehicles are roaming the streets. And again, if car ownership begins to decrease this will occur gradually over time, giving owners ample opportunity to review the trends and make plans for redeveloping or redesigning parking facilities to maintain economic benefits for their properties.

Office tenants may be able to secure offsite parking on their own at a cheaper cost than what their building charges. Again, since the car can be triggered by the employee and meet them at a designated pick-up area, this is entirely feasible.

Another consideration here for office tenants and landlords is that the parking lot is often used as a way to control the number of employees in a given office space. A landlord will use the building’s parking ratio to justify increasing the rentable square footage of a tenant’s space. The ownership might say, “if you need to accommodate 5 additional staff you’ll need to lease another 1,000sf because we are already over-parked here”. In the future, self-driving cars may give more control back to the office tenant. If they can negotiate an offsite parking arrangement those additional 5 employees could use the existing office. No need to increase the office size simply to align with a parking ratio.

LET'S NOT FORGET ABOUT THE TRAFFIC

Anyone that lives in a major metropolitan area can attest to the horrors of rush hour traffic. Some office properties can be greatly affected by the traffic conditions on the streets and highways surrounding them. Office tenants pay attention to traffic patterns, and will actively avoid relocating to a building that could adversely affect the commute of key decision makers or their staff. Autonomous vehicles may have an impact on this situation as well. Self-driving technology, in theory, should improve the flow and efficiency of traffic on congested roadways. Decreased traffic congestion and the ability to utilize commute time for more productive activities will result in less weight being assigned to traffic congestion in the immediate area of an office building. In other words, when tenants are considering where to relocate their businesses, traffic, like parking, may become a less important factor. Just as with parking, this means that in the near-term some less desirable office properties may see an evened playing field as tenants de-prioritize traffic concerns.

Let’s shift focus and consider how this technology may begin to impact industrial commercial real estate.

FREIGHT - THE LIFEBLOOD OF INDUSTRIAL REAL ESTATE

So what about industrial commercial real estate? The first major area of impact is freight – specifically LTL and TL trucking. The shortage of truck drivers is quite concerning – with a total industry population of around 500,000 and an anticipated driver shortage of at least 60,000 by year-end 2018! This issue has increasingly become a key concern for many companies that rely on long haul trucking for movement of products to and from their facilities. It is estimated that more than 70% of all goods are moved using the trucking industry at some point in their journey. The increased demand for truck drivers, coupled with a limited supply, has led to rising freight costs (up at least 6% year over year). Additionally, the implementation of stricter laws governing the number of hours a driver can work each day, and tighter requirements for documenting and tracking those hours are only adding to the problem.

These problems, however, create the perfect environment for technology disruption. Perhaps the first area we will see a significant impact from autonomous vehicles on industrial real estate will be the adoption of long haul trucks. As noted in this Wired magazine article from November 2017, some companies, led by Tesla, Daimler, and Embark are already putting self-driving trucks on the road. The technology needed to make autonomous vehicles work on highways is much less complicated than what will be required to navigate busy city streets in populated areas. Indeed it appears the technology available today in some of the earliest AV products could be sufficient to displace many truck drivers on long haul routes. It will take far longer for AV’s to conquer the “last mile”. But with the adoption of autonomous vehicles on long haul routes, driver shortages will be a thing of the past. Freight costs will plummet, and this will actually serve to lower last mile freight costs. This could yield huge benefits for e-commerce companies and any businesses with a significant portion of their product sales online (think Amazon, Walmart, etc). This prediction will be especially troubling to brick and mortar retailers because it could serve to accelerate their demise. Last mile costs are widely estimated to account for over a quarter of the total supply chain costs for products. If early adoption of autonomous vehicles fuels a steep reduction in labor costs for freight, we could see significant impact to retailers in the next 3-5 years.

LOCATION AND BUILDING DESIGN CHANGES

Another area of impact for industrial commercial real estate will be the location and design of buildings. As self-driving trucks begin to take hold of long-haul routes developers of industrial properties will begin to consider how their location selection process and design of buildings will impact the ability of companies to utilize this new service.

Many industrial properties are positioned in remote areas of cities and often are not as accessible. Land valuation will always play a factor here, but I believe developers will start considering how close to major highways and thoroughfares they can get with new buildings. If a property can be positioned closer to major roadways that can be easily navigated by an autonomous truck, this will be valuable to a future buyer or tenant leasing the building.

Just as location will be important, so too will the design and process flow of the building become a factor. As the technology matures we will begin to understand ways to design distribution and manufacturing facilities to accommodate self-driving vehicles. In the end this may lead to changes in how these buildings are developed.

CONCLUSION

In this article we’ve covered several key ways that self-driving technology will impact office and industrial commercial real estate. As noted above, the timing of adoption of this new technology will be critical in determining how quickly property owners adapt. The driver shortages affecting the industry today will be the single most important factor causing mass-adoption of this technology. it is a safe prediction that we will see long-hauling trucking disrupting first – and in a big way. With time and successful implementation of self-driving trucks we will see the trend spread to personal cars, and that will change everything.

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Houston Office Market Report: Year-End 2017

Houston Office Market Report: Year-End 2017
Houston Office Vacancy Flat, Oil Market Strengthening

With the second half of 2017 coming to a close there has been a renewed confidence in the Houston market. Disruptions to global oil supply including a leak in the Forties Pipeline system in the U.K., Iranian protests, economic uncertainty in Venezuela, and reduced output in the Keystone pipeline in North America contributed to higher oil prices. These supply disruptions, along with OPEC’s agreement to continue the 2% output restriction through the end of 2018 helped push Brent and WTI prices into a $60-70 trading range. At the same time, the global economy has been strengthening which has pushed the demand higher and helped draw on crude inventories. Crude inventory stockpiles have consistently dropped week over week for nearly a quarter, leading Goldman Sachs to forecast a balancing of the market by mid-2018.

As reported in the Houston Chronicle at the end of December, a survey of oil executives found that most believed a trading price of $60-65 per barrel would drive new drilling in 2018. At least half the executives surveyed believed the US rig count would continue to climb. US oil production is already approaching 10 million bpd and some are claiming production records could be set for the US and Texas in 2018.

There is certainly an excitement and optimism in Houston around the improvement of the oil & gas market, and by extension, the Houston economy as a whole. Economic indicators for the US look good, and the stock market rally continues. However, there still remains a potential for sharp price corrections in the short term. Some have questioned the level of speculation in trading recently, and if any negative indicators were to surface it could lead to a swift drop in price. Worse, if US production continues to climb and new well drilling picks up, OPEC and Russia may decide to halt the production freeze prior to year end. These risks are ever-present, but with strong global economic growth and demand leading the way, 2018 may be a strong rebounding year for the city of Houston.

What This Means For Houston Office Market

The citywide vacancy rate rose in Q3 by 0.3% but improved slightly by year end to 16.3%. This improvement in vacancy rate, a positive 769k square feet of office space being occupied, represents the only quarterly improvement of 2017. Though the economic indicators are strong it is clear that the office market will take awhile to re-balance. Developers have largely avoided new office construction projects over the last two years. This has helped to avoid adding too much new space to an already saturated market. If the Houston economy can continue to strengthen through 2018 we could see an influx of new oil & gas startups. Some sublease space may be removed from the market as firms adjust their staffing needs in the face of a potentially bullish market. The largest of the industry may even consider hiring in key roles to support growth initiatives. The office market would benefit greatly from these developments, and we could see the vacancy rate finally begin to fall.

For now though, let’s take a look back at the previous two quarters of 2017 and where things stand today.

Best & Worst Performers

The overall Houston office vacancy rate dropped slightly from 16.4% to 16.3% at the end of 2017. Some of the submarkets to reduce vacancy rates in the fourth quarter include: Downtown Houston CBD, Sugar Land, FM1960/Champions, Energy Corridor, The Woodlands, Westchase, and the Medical Center. It is interesting to point out that the largest oil & gas heavy office areas of Houston all improved in the final quarter of 2017.

Some of the under-performing submarkets which again increased in vacancy include: Greenway Plaza, Katy & Grand Parkway West, NASA / Clear Lake, West Loop, and San Felipe / Voss.

What About Rental Rates?

The average rental rate across all Houston office buildings increased slightly from $27.60 to $27.76. Though a very minor increase, these rates are aligned with a slight improvement in vacancy rates. The completion of several Class A properties joining the market likely also contributed to the increase. There are still many deals to be made out in the market today, but lease expirations toward the end of 2018 and into 2019 may face a shifting market from the tenant’s favor to the landlord’s. Vacancies are still high though, and it will take time to fill all that space.

Houston Construction Activity

The year 2015 was a busy time for commercial construction in Houston. The 12.6 million square feet of office space delivered that year represented the largest amount of space to hit the market in one year since 1984. Unfortunately that timing also coincided with the beginning of the oil & gas downturn. Predictably in 2016 construction decreased significantly to 6.1 million square feet. Still this number was higher than 4 out of the previous 6 years – due mainly to projects already in progress during the start of the downturn. In 2017 the number was halved again, down to 3.4 million square feet delivered. Just under 2.5 million square feet of office space remains under construction today. About half of this space is already pre-leased to tenants. Capitol Tower in downtown Houston CBD accounts for 700k of the space under construction, and another 6 buildings in The Woodlands account for 700k more. The rest is distributed across various other Houston submarkets.

Summary

The talk all throughout 2017 centered around when the market would hit bottom. Finally we are seeing some indication that it may have been reached toward the end of the year. Entering 2018 we see strong economic fundamentals here in Houston, in the United States, and globally as well. The oil & gas recovery is just beginning, and there are several risk factors to watch including recovery of supply from recent disruptions, retracting of the OPEC production freeze prior to year end, and speculative trading which could cause an imbalance in the financial markets. The rapid increase in U.S. shale production will need to be watched closely as well. As crude inventories continue to decline we will all be watching for market equilibrium to occur. If oil can continue trading in the $60-70 price range consistently we believe hiring will begin and new companies will start-up. The words today are “cautious optimism”, and that probably describes the feelings of the majority of Houstonians very well.

 

View and download the full report here.

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Add On Factor: Why Office Tenants Pay for Space They Don’t Use

Add On Factor: Why Office Tenants Pay for Space They Don't Use

Rentable and Usable Office Space

When leasing office space in a multi tenant office building it is important to understand the difference between rentable and usable square feet.  Some office tenants are not familiar with these terms.  Tenants unfamiliar with the concept of an add-on factor may be confused about how much space they truly need. Essentially as an office tenant you are paying rent based on the “rentable” size of your space. The rentable square footage is not the actual size of your office space.  Let me tell you a story about just how unbalanced that difference can become…

Energy Corridor Case Study

Recently I worked with a client in the Energy Corridor in Houston looking for new office space. He expressed strong interest in a property which had recently converted from a single tenant corporate use to a multi-tenant layout. This means the property was designed originally for one company – think of an office campus setup. Since the conversion was not yet complete the floor plates and common areas were under construction and not fully determined. During construction the new ownership would be making decisions about which common area corridors, restrooms, lobbies and other common area elements would remain. As a result the leasing agent was unable to provide the true add on factor at the time we toured the property.

What Is An Add-On Factor?

As a quick refresher, the add on factor (sometimes referred to as core factor) is the amount of a commercial building taken up by common areas such as hallways, restrooms, elevators, the lobby, etc. The add on factor will typically fall between 15-20%. This means the usable square footage of a company’s office space will be inflated by 15-20% to account for the common area space in the office building. In this way each tenant pays for their share of the common areas they may use throughout the building.

Back To Our Story

After touring the property with my client we began discussions with the leasing broker. Upon receiving an initial proposal we discovered an add on factor in excess of 60%! Understandably this was not an acceptable calculation for my client. Imagine leasing an office space consisting of 3,000 actual square feet, but paying rental expense on 4,800sf – out of the question. After much discussion and negotiation we were able to reduce the add on factor to 37%, but ultimately this was not enough to make a deal.

It is not uncommon to find re-purposed office buildings with a high percentage of common areas. With the headwinds facing retail developments and malls we may see this trend continue to grow. Typically landlords will opt to use a “market factor” which is artificially lowered to compete with other properties in the area. In this situation the landlord was attempting to secure lease agreements with an add on factor 3 times the market rate. I advised my client throughout this interaction and we decided to pursue alternative options in the area.

Relocation to Multi Tenant Office Space

One important thing to mention is that most types of commercial real estate do not use an add on factor. This type of calculation is typically exclusive to multi-tenant office buildings. This means if you are a tenant in an industrial, flex office, retail or single-tenant office building you are not paying for an add-on factor. Tenants in these types of properties have a rentable and usable square footage which are identical. This can lead to some confusion for tenants looking at relocation to a multi-tenant building. These tenants may expect that the 5,000sf they currently occupy will be the same 5,000sf they need upon relocation. But again, this is 5,000sf usable, and with the add-on factor included they will require at least 5,750sf – and possibly more.

At Oxford Partners we will frequently begin the process of working with a new client by preparing a minimum space analysis. This allows the client to visualize all the necessary space elements for their office, and understand how much space will be required. Part of this assessment is an estimation for add-on factor. You can access our free Space Planning Tool here. Contact us directly for more information about the minimum space analysis if you’re interested in learning more.

Conclusion

Companies leasing space in a multi-tenant office building must always be aware of the add on factor used in their building. At some point a tenant will want to relocate, and it is key to know the exact usable space required for their operations. It is also important to ensure the rentable square footage for your lease agreement is calculated correctly. There should be a clearly identified common area markup listed in the lease. When considering a relocation verify these numbers ahead of time to ensure a market factor is being used. This will help avoid paying for space you don’t use and likely will never see.