Sub Market Report - Energy Corridor

1401 Enclave had two of the largest lease signings in 4Q 2010 with SK&C and Callon Petroleum

Overview:

Absorption: In 2010 the submarket netted over 700,000 SF of positive absorption with positive activity so far in Q1 2011.

Flight to Quality: Tenants who previously occupied Class B space have used favorable market conditions to upgrade into Class A assets.

Rent rates: Class A and Class B quoted rent rates have been trending lower, but fundamentals are enabling concessions to thin with a flatting of rates expected to follow.

Vacancy: Class A and Class B vacancy rates are decreasing , with no new construction coming online in 2011.

The Energy Corridor was the strongest submarket in Houston in 2010 and finished the year strong with a very positive Q4 2010. The submarket had over 700,000 SF of positive absorption in 2010 with a trajectory that seems to be continuing into 2011. A good percentage of the absorption is occurring in the Class A buildings with tenants in Class B buildings taking advantage of the market and upgrading into better assets. While this "Flight to Quality" is consistent throughout the broader market, it appears to especially be playing out in the Energy Corridor.

The big news of 4Q 2010 of course was when KBR signed a 78,000 SF 11-year lease at Eldridge Oaks. This November announcement (which was in process for most of 2010) was followed with the information that KBR will more than likely be taking down additional space in the building (potentially up to 200,000 SF).

KBR was a welcome sight for Eldridge Oaks

WorleyPraons also leased 60,000 SF at Energy Center II and Alta Mesa took 40,000 SF at Energy Crossing. Both tenants relocated from Class B buildings to newer Class A assets. In addition, the companies SK&E Co. and Callon each made full floor deals at 1401 Enclave in the fourth quarter of 2010. We expect to see more of the "flight to quality" as we progress into 2011. Energy companies are paying to be in top tier buildings -- which should be a positive indicator for Class A landlords in 2011.

The Energy Corridor sales market has seen positive activity as well. In the early part of 2011, The Opus Group sold Ten West Corporate Center II to an affiliate of ING Clarion Partners. The property is 100% leased to Mustang Engineering. For the more risk adverse buyer C-III has put 1200 Enclave on the market. The former home of Cabot Oil & Gas has good upside but is sitting at 25% occupancy (pricing is rumored to be in the $115 to $120 PSF range). On the other end of the risk spectrum is Younan Properties, Two Westlake. The 100% leased building (ConocoPhillips and BP) is rumored trade around $220 PSF.

Forecast:

For Energy Corridor Landlords, progressively strengthening fundamentals make the submarket a great place to be located -- especially for Class A owners. However when the newer and more vacant developments begin to compete there will more than likely be a downward pressure on rents. The other mitigating risk is the lingering effect of the drilling ban. While the moratorium has been lifted, there have been no new permits approved since the ban was removed. This is the greatest threat for Energy Corridor tenants and subsequently landlords. However due to unrest it the middle east oil prices are at does bode well for the industry as a whole. Regardless, the Energy Corridor should continue to strengthen and Class A owners should see the benefits. It is important for Class A landlords to be ahead of the curve to know when to pull back on concessions.

CRE Cliffnotes (2/12/11)

After I watched Mubarak step down this week (He is the Egyptian dictator version of Brett Favre (he’s out/he’s in/he’s out)), I turned my attention elsewhere and began reading the Winston Churchill biography, The Last Lion, and came across this quote from Churchill: “I like a man who grins when he fights.”

I do too Sir Winston.

As we go about our prospective challenges and opportunities in the upcoming week, it made me want suggest we do it with a smile. Here are some stories from this past week:

The Uneven Comeback
• Link
• Two Sentence Overview: A rather ominous WSJ article, describing bifurcation of return in values of CRE (Class A buildings in quality markets seeing values that have increased 30% from 2009 lows with some trophy assets even approaching 2007 bubble prices). The flip side is that Class B assets in secondary/tertiary markets are suffering driving CMBS delinquencies up to 9.34% from 1% in 2007 and keeping office vacancies at near high levels (18% nationwide).
• One Sentence Takeaway: Low interest rates and “pretend and extend” have caused this rise in Class A property values, but Sam Zell is right – increased interest rates (which is inevitable) is going to change the game in a big way.

Whose Market is it anyway?
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• Two Sentence Overview: Since 2008, there is no doubt tenants have had the leverage in negotiations with the ability to drive rates down and concessions up. As this JLL report indicates, the “tenants market” may be in its final hour (percentage of tenant favorable markets are projected to fall from 94% to 31% by 2012).
• One Sentence Takeaway: With very little construction in the past few years and decreasing supply of large blocks of space, we believe the Landlords will have a growing ability to decrease concessions and hold (even increase) rates for the larger contiguous blocks.

Top 10 CRE challenges in 2011
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• Two Sentence Overview: So many great points to highlight in just two sentences, but here are a few: we lost 8.4 million jobs during the 2008-2009 recession and only gained back 1.1 million in 2010 (we are growing but we have a long way to go to get to pre recession unemployment). QE2 and extension of Bush tax cuts provided a short term boost but higher government spending/mounting national debt/concern of higher taxes/declining dollar/rising inflation and the inevitable increasing interest rates are HUGE concerns going forward.
• One Sentence Takeaway: With “pretend and extend” and low interest rates, this recovery is quite a different scenario from the market clearing made possible by the Resolution Trust Corp. in the early 1990’s.

Hiring: All talk and no Walk
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• Two Sentence Overview: Even though hiring expectations are at near four-year highs, those good intentions are not translating into new jobs. Companies are opting to sit on record levels of cash, buy back stock, and continue to keep margins high by doing more with less.
• One Sentence Takeaway: This article doesn’t mention the uncertainty of health care costs that weigh on employers as well – hopefully some of these sentiments will translate into the type of job growth we need for a robust recovery.

Whose Market is it anyway?

We have great relationships with the tenant rep community here in Houston. One of the many great things about our job is the opportunity to be in constant dialogue with proven deal makers we respect. A conversation that seems to come up quite often these days centers around whether the market is beginning to turn in favor of Landlords. There is no doubt we have been in a protracted "tenant's market" with very generous concessions and falling rent rates in most Houston submarkets. However, we believe we see the tide beginning to turn in favor of office owners. It is all about supply and demand and given the supply and demand trajectories, we predict owners will begin to have more leverage in deals -- especially with the larger contiguous blocks of space. To give more color on the supply and demand dynamics, take a look at the limited supply of blocks over 100K SF by Houston sub market:

The trend for larger transactions is also a positive one. There were 16 transactions in excess of 100,000 SF in 2010 (Compared to 9 in 2009) with several large tenants currently believed to be in the market evaluating space options. All this is good news for landlords with large contiguous blocks. These owners should begin to take advantage of a transition of leverage in lease negotiations. We see the transition occurring in three stages:

The important factor for Landlords is to be ahead of the curve on this transition so they do not leave any value on the table from the yearly NOI to the exit value of the asset. Many smart tenants reps will begin to see the end is near and will try to lock in long term deals while the market is in a trough. Savvy owners will recognize this and begin to get a sense of the true leverage they have. As the progression begins, maximizing value is the name of the game for office owners.