In light of the economic environment, investors shied away from Houston. In 2015, REITs that had at least 10% exposure to Houston (CPT, CUZ, EGP, WRI) underperformed their respective sector benchmarks by 900 basis points (or bps) on average. However, as we argued in the May 2015 outlook “Drilling Deeper into Houston Space”, Houston’s economy is much more diversified than in past oil downturns. 2015’s Houston underperformance provided an opportune entry point for long-term investors, and, in 2016, the Houston-exposed REITs outperformed their respective benchmarks by 900 bps. Looking into 2017, the Greater Houston Partnership (or GHP), an economic development organization, forecasts that the city will create 29,700 net new jobs, with the healthcare and accommodation and food services sectors making up for jobs lost in the construction and mining and logging sectors. To many, the Partnership’s forecast may appear bold, but multiple economic indicators confirm that Houston may have reached its bottom and is already in the early stages of a recovery.
One of the more closely tracked indicators of the Houston economy is the Baker Hughes US Rig Count. It is used as an indicator of the health of the oil and gas industry as well as a read-through into Houston employment growth. The rig count has a 62% correlation to the percent change in Houston employment going back to 2007 (Figure 1).
As of February 24, 2017, the rig count is up an astounding +87% from its low of 404 rigs reached in May 2016 (though still off the 2014 peak of 1,931 rigs). The increase in rigs corresponds with the 26,000 net new jobs (seasonally adjusted) added since May, which followed a five month period where the city had lost 11,600 jobs.
The rig count is part of the picture, but to get a glimpse at how oil executives feel about their business, the Dallas Federal Reserve conducts the Dallas Fed Energy Survey, a quarterly survey of about 200 oil and gas executives. Executives are asked whether an indicator has increased or decreased with a positive index result representing expansion and a negative number corresponding with contraction. In the most recent survey (4Q 2016), the “business activity index”, the broadest industry health indicator, rose to 40.1, up from 26.7 in the third quarter and -42.1 in the first quarter. Additionally, several factors, including number of employees, employee hours, and wages and benefits, showed expansion for the first time in the year. The survey is relatively new, which limits our ability to put it in a historical context, but it is clear oil executives are sensing a turnaround in their companies that they did not feel a year ago.
Other indicators outside of the oil and gas industry are also pointing toward Houston having put the worst behind it. In January 2017, the Houston PMI (Purchasing Managers Index), a leading indicator for the economy, came in at 54.2, signaling expansion (a reading above 50) for the fourth month in a row (Figure 2).
Previously, the PMI had been sub-50 since late 2014, which corresponded with the negative GDP growth experienced in 2015. Also, despite layoffs and a sagging economy, home sales actually increased 3% in 2016 and were even 1.3% above the previous record set in 2014, when oil prices averaged $93.03/barrel! The market is expected to remain strong as inventory levels ended the year at 3.3 months, indicative of a “seller’s market”. Inventory has not been above 4.0 months since November 2012—a sign of the diversity and strength of the economy.
Much like a championship team that continually strengthens its roster, Houston has multiple projects, amounting to billions of dollars, that should enhance its performance for years to come.
The Port of Houston is the largest port in the United States based on foreign tonnage and the largest port on the Gulf Coast based on containers. 25 miles long, it is home to more than 150 companies and employs more than 56,000 people. Between 2012 and 2016, the port and surrounding industries received an estimated $35 billion in private investment, with the port committing another $1.6 billion over the next five years to expand the terminals and deepen the channels. This is in an effort to lure business from post-Panamax ships that can now travel through the recently expanded Panama Canal (see our April 2016 outlook “E-commerce: Shifting the Tide of Industrial Demand”). Maria Burns, the Director of the Center for Logistics and Transportation Policy at the University of Houston, believes that gaining traction with these new ships can have a multiplier effect on job growth. She claims that for every person working at the port, eight others are needed throughout the supply chain to support the movement of goods.
Houston is home to the second largest petrochemical complex in the world. The pain of low oil prices (for oil companies) has actually provided a boon to petrochemical businesses, so much so that over 250 new plants and other projects worth over $160 billion have been announced in the United States since 2013. Houston is expected to receive over $50 billion of the planned investments including $12 billion in projects from Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX) alone. These two projects are expected to create 10,000 construction jobs each and more than 4,400 related permanent jobs throughout the community. Though the projects should have a long term effect on employment, the immediate impact from construction workers is short-lived. Construction workers tend to be very mobile and will likely move on to other construction projects along the coast after the bulk of the projects are completed in 2017 (though some will last through the early 2020s). As a result, after a loss of 11,200 construction jobs in 2016, the GHP forecasts construction employment to lose another 16,000 jobs in 2017.
The Texas Medical Center (or TMC), located just southwest of downtown, is the largest medical complex in the world and employs over 106,000 people. The center has over 50 million developed square feet (or sqft), 12 health systems, and 21 hospitals. On its own, the TMC equates to the 8th largest business district in the country. Currently, $3 billion in construction projects are underway with a goal of increasing collaboration/research and keeping Houston on the leading edge of advancing life sciences. In 2016, healthcare employment increased by 11,500 jobs, or 3.6%, versus 0.5% for Houston overall. The GHP forecasts that the industry will be the leading job producer in 2017, adding 9,800 jobs.
Houston (along with Dallas) has also been selected as the site for the nation’s first high speed rail. President Trump even highlighted it as one of his 50 targeted infrastructure projects. The plan, being privately led by Texas Central Partners, is to take up to 400 passengers by train from Houston to Dallas (240 miles) in 90 minutes while traveling 205 miles per hour. The train should have numerous indirect impacts to both cities, not only giving a boost to the immediate areas selected as the stations for the rail, but also through the promotion of commerce between Texas’ two largest metropolitan areas. Directly, however, the train is estimated to have a $36 billion economic impact over 25 years, while creating 40,000 construction jobs and 1,000 high-paying permanent jobs. The project is projected to cost $10 billion and be completed by 2023.
Houston’s major real estate sectors have all been impacted to different degrees by the oil downturn due to differing demand drivers, duration of leases, and the amount of new development. The outlook for the economy may be somewhat brighter, but similar to the downturn, Houston’s commercial real estate sectors will recover at different paces. Below we analyze how the Houston apartment, retail, office, and industrial sectors have fared and their respective outlooks based on a Houston recovery.
For the apartment sector, the oil downturn came at an inopportune time during the cycle. Houston’s economic expansion from 2010 through 2014 produced over 450,000 jobs, but housing was not enough to meet demand. In 2013, home prices were up 10.3% and apartment rents for Camden Property Trust’s (NYSE: CPT) Houston portfolio increased 9.7%. Developers saw the pick up in demand as an opportunity to build. In 2014 alone, the city issued 25,000 multifamily permits. At Houston’s long term average job to supply ratio of about five jobs needed for every one new apartment unit, this would require 2015 employment growth to match or exceed 2014’s growth of ~120,000 jobs. However, the oil downturn made sure those jobs never came, and the market became almost immediately oversupplied. In 2016, fundamentals remained difficult; Houston delivered 22,471 new units versus 14,400 net new jobs, equating to a 0.6:1 ratio.
Currently, substantial concessions of 2-3 month’s rent are common, as newly delivered apartments lease up. As a result, Camden forecasts -4% revenue growth in 2017 for the company’s Houston portfolio (13% of NOI), down from +2.8% in 2015 and -1.2% in 2016. However, 2018 could mark a turning point. Capital has become more difficult to obtain, which has reduced the expected new deliveries in 2018 and 2019. So far, Camden estimates only 6,800 apartments will be completed in 2018. Paired with a recovery in employment, the apartment market could see stabilization, as only 34,000 jobs would need to be added using a 5:1 jobs to supply ratio. As of February 28, 2017, Camden trades at a 5.0% discount to NAV as compared to a 4.3% and 1.2% discount for the sector and REITs in general.
Retail has been the most resilient of the four major sectors—partly due to development not keeping up with population growth (Figure 3). In fact, retail square footage per capita decreased 6% from 2010 to 2016.
However, strong demand from retailers expanding in the market is also responsible for the stable environment. Houston retail finished 2016 with over 4 million sqft of net absorption (net change in occupied space, including recently delivered supply), which drove occupancy to an historic high of 94.3%, while occupancy rates within prime, high-quality urban markets exceeded 98%!
Weingarten Realty (NYSE: WRI) has 16% of its annual base rent (or ABR) in Houston; however, most of its Houston portfolio is located within the city’s super zips—zipcodes known for high income levels and college graduation rates—which has insulated the portfolio from a potential negative impact from demand. At the end of 4Q 2016, WRI’s Houston portfolio was 98% leased and rent growth was 15.7% above 4Q 2015.
Lending constraints and construction costs have helped keep retail construction in check, but new supply is needed to support the growing population. An estimated 5 million sqft of retail will be built and opened in 2017 (1.7% of supply), up from 4.5 million in 2016. Additionally, 90% of the space under development is pre-leased! Demand is coming from a diverse base of tenants. 23% of the space will be leased/occupied by supermarkets such as HEB, ALDI, Walmart (NYSE: WMT), Kroger (NYSE: KR), Target (NYSE: TGT), Costco (NASDAQ: COST), and 365 by Whole Foods (NASDAQ: WFM). Home improvement stores, fitness centers, theaters, discount retailers, among others make up the remainder. As of February 28, 2017, Weingarten trades at a 7.2% discount to NAV as compared to a 5.3% and 1.2% discount for the sector and REITs in general.
New office supply has come to a screeching halt with only 2.2 million sqft (2% of existing supply) expected to be added in 2017, of which 51% is preleased. Unfortunately, about 25 million sqft has been delivered since 2013. During the oil boom years, tenants were growing quickly and leasing additional space. However, the downturn in oil prices led to layoffs and companies consolidating space requirements. As a result, the vacancy rate spiked to ~16.5% at the end of 2016, up 550 bps from 2014. The availability rate, which includes sublease space, is even higher at 23%, but sublease space still pays rent to the landlord and can disappear off the market relatively quickly.
As bargaining power has shifted toward tenants due to high vacancy rates, asking office rents have declined 3.7% from the peak in 2Q15, while actual net effective rents are likely much lower due to concessions such as free rent and above average tenant improvement allowances. The amount of sublease space should continue to put pressure on rent growth over the next few years, making the outlook for the average landlord bleak.
The most defensible position in the struggling office market would be to own high-class assets in the most desirable submarkets that are attractive to a diverse tenant base. Parkway (NYSE: PKY), a spinoff of CUZ’s Houston portfolio, fits this bill. The company is the largest Class-A office landlord in Houston, owning space in three of the more desirable submarkets. Additionally, 84% of PKY’s tenants are either investment grade rated or non-energy customers, further insulating the company’s ability to weather the storm.
On February 17, 2017, Parkway announced it had reached an agreement to sell a 49% interest in Greenway Plaza (57% of total company square footage) at a ~7.1% cap rate for $512.1 million or $210 per square foot. This compares to PKY’s implied cap rate (the cap rate implied by the company’s stock price) of 9.6% at the time. As of February 28, 2017, PKY trades at a 12.6% discount to NAV as compared to a 4.5% and 1.2% discount for the sector and REITs in general.
The health of the industrial market is strong with market-wide occupancy at 95%, though there are some soft patches across various submarkets. New construction has almost come to a standstill. Only 455,000 sqft began construction in 4Q 2016, a five year quarterly low. Current construction is over 60% preleased, which equates to only 1% of existing supply. Additionally, most of the new supply is targeting southeast Houston, which is benefiting from port and petrochemical investments.
Private market pricing of Houston industrial assets reaffirms the strength of the market. Through the first half of 2016, which included the low water marks of both the price of oil and rig count, EastGroup (NYSE: EGP) was able to sell some of its lowest quality properties at cap rates ranging from low-5% to mid-6%. This compares to EGP’s current implied cap rate of 5.6%, as of the end of February 2017.
As illustrated by the industrial market’s resilient fundamentals and private market pricing, the Houston industrial market is stable. Any pick up in the rig count, e-commerce demand that we have witnessed nationwide, or boost to population growth (expected to grow 7.5% by 2020), would simply be an added bonus. As of February 28, 2017, EGP trades at NAV as compared to a 1.0% premium and 1.2% discount for the sector and REITs in general. Houston is 18% of EGP’s portfolio.
After two and a half years, Houston appears to have stabilized and has many positives in both the near and long term; however, risks to a complete near term recovery still remain. The price of oil is derived from numerous inputs, but none are under the control of Houston-based companies. The value of the US dollar, OPEC oil output, and foreign crises all play a substantial role. This has the potential to create both winners and losers within the oil and gas industry that could lead to a return of low oil prices and additional job losses through bankruptcies or further consolidation in the oil patch. However, just like the Patriots in the Super Bowl, we believe in the Houston comeback. The recovery timelines for Houston’s real estate sectors may vary, but the economy has shown signs that it is past the bottom and primed for victory.
Blane T. Cheatham, firstname.lastname@example.org, (713) 243-3266
Matthew R. Werner, CFA, email@example.com, (713) 243-3234
Bruce G. Garrison, CFA, firstname.lastname@example.org, (713) 243-3233
Parker Rhea, email@example.com, (713) 243-3211
RMS: 1970 (2.28.2017) vs. 1904 (12.31.2016) vs. 346 (3.6.2009) and 1330 (2.7.2007)
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