The NHD CRE Market Report delivers facts, stats, and case studies about the shifts happening within our boundaries quarterly.
Q1 2024 Summary
Multi-family overview: On whole, a bullish outlook
This issue of Quadrants is focused on apartments in the North Houston District. For this month’s CRE report, we thought it would be appropriate to examine the headwinds and tailwinds in the multifamily market, with a special emphasis on the North Houston District market.
Macroeconomic Factors
All multifamily markets and submarkets are impacted by macroeconomic factors in the larger US economy. The biggest among these factors, often heard about, is interest rates. As we all know, inflation spiked shortly after the worst of COVID-19 passed, and this led the Federal Reserve to embark on one of its sharpest increases in Fed Funds rates ever between 2022 and 2023. Today, the Fed Funds rate ranges from 5.25% to 5.5%. This has caused – as intended – an increase in the entire rate regime, and today (March 4th, 2024), the 10-year rate sits at 4.2%. This is a crucial financing rate in the commercial real estate world, with many loans being based on the 10-year rate. This means that those needing to refinance an existing loan are paying more to do so, dramatically impacting returns – a serious headwind to such owners/investors.
But if you do not need to refinance a loan or pay cash for your property, this has not been a headwind and, in fact, over time, may become a tailwind. How so? The dramatic run-up in interest rates has put the brakes on apartment construction starts. In fact, starts in the Houston area in 2023 were at the slowest pace since 2017, as the chart shows below. Given development timelines of 18 to 24 months, new units coming on the market will likely slow significantly over the next two to three years, ultimately putting upward pressure on rents – a tailwind for current owners.
A related headwind due to the rise in interest rates is that transaction levels – the buying and selling of multifamily properties – have also slowed dramatically. According to CoStar, the number of properties traded in Houston in 2023 fell to its lowest since 2010. Hence, investors wishing or needing to sell multifamily properties have found few buyers, and spreads between asking and offering prices have grown. Overall, this has been a headwind for the market.
What does the future hold for interest rates? This much-debated topic breaks down along two general lines. The first is that rates will drop in the latter half of 2024, generally helping commercial real estate markets. The second view is that we are headed for a “higher for longer,” meaning rates may stay elevated for the short to medium term. This could be a headwind to the market. Few, however, see a return to the now abnormally low rates of the 2010s. This will force an adjustment to at least moderately higher rates than before.
Another key macroeconomic factor for the multifamily market is job creation. While Houston saw post-COVID spikes in job growth in 2021 and 2022, job growth is expected to return to more normal levels in 2024, likely in the 60,000 to 65,000 jobs-created range. This more normal yet strong job growth rate should prove a modest tailwind for future multifamily growth in Houston.
Relative to the North Houston District, these macroeconomic factors mean that the “renter-by-necessity” – Class B/C local submarket should maintain already lower vacancy rates than the market as a whole and that over time, rent growth should be positive, if only modest. With respect to transactions, for properties that did not trade at inflated values, as occurred throughout the market in 2021 and 2022, prices paid should rise modestly. Fortunately, the North Houston District market has seen a steady supply of new units added via low-income housing tax credit development, helping to replace over 800 units lost post-Hurricane Harvey to flood damage.
Summary
Overall, though there may be some fits and starts in the market as interest rates and inflation sort themselves out, the multifamily market in the North Houston District appears moderately bullish thanks to Houston’s steady job growth, a gradual near- and medium-term tightening in supply, and overall positive business climate.
Q4 2023 Summary
New Developments in the District – More Logistics On The Way
In the Fall 2023 edition of the NHD CRE Market Report, we noted how the District’s CRE profile has shifted from office to logistics, with the District now having approximately 18 million square feet of industrial/flex space as compared to about 10.5 million square feet of office space. This trend continues.
District staff constantly track new developments in the area, and most of these have been industrial/flex projects. The District is currently tracking five projects that have been announced or are in some planning stage. Four of these five projects are logistics-related, with the fifth being a new Yes Prep elementary school. They are also dispersed geographically, with two projects in the District’s northwest quadrant and one each in the northeast and southeast quadrants.
An interesting common feature of all four industrial projects is their size. Due to overbuilding and financing challenges, the days of projects greater than 500,000 sq. ft. are gone. More common are small to mid-size projects. The four current logistics projects tracked by the District fall into these categories. They range from a standalone 20,000 sq. ft. project to a mid-sized 378,000 sq. ft. project, and two right in the middle at roughly 150,000 sq. ft. Larget projects carry an expectation that they will be divided for multiple tenants.
This move to smaller logistics projects is also reflected in lower availability for smaller buildings than projects over 100,000 sq. ft. Data from CoStar (see below) shows availability for projects of 25,000 sq. ft. or less to be just above 6% as compared to the availability of just over 12% for projects over 100,000 sq. ft.
The projects in development also reflect the availability of developable land in the North Houston District.
While one of the five new projects is an office-to-industrial conversion, the other four are all occurring on raw land. While these developments take raw land off the market, significant tracts remain available for development in the District.
Office Re-Pricing and the North Houston District
As many who follow the office market know, and even those who read the business press, significant changes are underway in the office market. The combination of higher interest rates and fundamental shifts in how people work are sending reverberations through the office real estate market. Either of these factors alone would be hard for a market to absorb, but the two together will have profound effects.
Rates, of course, rise and fall and as of late we have already seen the 10-year Treasury Bond drop from just over 5% to about 3.9%. The rate of the 1-year treasury is a key rate in the world of commercial real estate financing. This is a welcome improvement.
What is staying the same is the occupancy of office buildings. Kastle Systems, a firm that provides security services to many commercial office buildings, has been producing a data series since COVID started that tracks the current rate of office attendance relative to pre-COVID days. While Texas cities top the list of major American cities with the highest return rates of workers to their offices, the bad news is that this rate is seemingly plateauing at roughly 60% (see below; Houston is in yellow). In practical terms, this means that when renewing their leases or moving to new buildings, firms don’t need as much room as before and are signing leases for smaller spaces. This has boosted the vacancy rate of office buildings. And most experts agree that this is a permanent change.
Given this, as office properties struggle with occupancy and higher financing rates, properties decline in value – in the parlance of commercial real estate, they “re-price.”
Re-pricing is just getting underway in several major metropolitan markets and is likely to be a years-long process. It is currently underway in Houston. CoStar data for the past year indicate that the rate of re-pricing has been greater in the overall Houston market than in the North Houston District. In the Houston market, Class A office market prices have dropped about 6.7%; in the North Houston District, they have fallen 4.3%.
In the larger Class B/C market, prices in the Greater Houston market have dropped 6.8%, whereas in the District, they have dropped just 2.5%. This is likely because many office buildings in the District were re-priced years ago when the area had the oil and gas slump of 2015/2016. Hence, office values in the District are holding up better than in the City overall. This relative price stability will hopefully mean a more sustainable office market.
Q3 2023 Summary
A Shift to Industrial/Logistics
In the late 1970’s and throughout the 1980’s Greenspoint, as the area was then known, developed into a major activity center in Houston, becoming one of the first live, work, play communities in the region. But as all neighborhoods and areas do, the Greenspoint area evolved and has moved away from being a major activity center to become one of Houston’s premier logistics and distribution centers. The North Houston District, as it is now known, has one-of-a-kind access to highways and Houston’s major international airport. It is this unique crossroads location that has led to explosive growth in logistics and distribution warehouses over the last decade.
Starting in 2014 a very distinct shift in the makeup of commercial real estate occurred in the District. That year, there was approximately 10.5 million square feet of office space in the District and just over 8 million square feet of industrial/flex space. At the close of Q3 2023 those numbers stood unchanged for office space (still approximately 10.5 million square feet), but industrial/flex space had grown to just under 18 million square feet. This distinct shift is strikingly evident in the graph below. During this time, such major logistics operations as Sysco Foods, Amazon and Coca-Cola Southwest Beverages have moved into the District. The vacancy rate at the close of Q3 2023 stood at just 3.9% with market rents reaching $8.56/sf.
The unique crossroads location will only get stronger in the coming decades. The Federal Highway Administration (FHWA), TxDOT, Harris County and City of Houston have recently come to agreement on proceeding with the North Houston Highway Improvement Project. This will reconstruct I-45 from Downtown to BW8 and will also carry the potential for bus rapid transit from Downtown to I-45 in keeping with METRO’s METRONext Moving Forward Plan approved by Houston area voters in 2019. But TxDOT recognizes that improvements cannot stop at BW8 and has recently completed the I-45N: BW8 to Loop 336 Planning and Environmental Linkages (PEL) Study. This will carry the NHHIP improvements north all the way to Conroe in Montgomery County.
The other major north-south roadway in the District, Harris County Toll Road Authority’s (HCTRA) Hardy Toll Road, is also slated for significant improvements in coming years. Presently the BW8/Hardy Toll interchange has just one connector from eastbound BW8 to northbound Hardy Toll Road. Before the end of the decade HCTRA has plans to build the other 7 needed connectors, ensuring greater BW8/Hardy Toll Road mobility. Together with the I-45 improvements, billions of dollars in infrastructure investments will ensure the one-of-a-kind unique crossroads that is the North Houston District.
Value Office Proposition
While office uses have been eclipsed by industrial/logistics use in the North Houston District, the District remains home to a strong value office market. With approximately 60% of its office stock rated B or C class, occupancy levels in these classes have held strong at 70% and rates are just below the Houston average, with market rents of $18.42/sf as of the end of Q3 2023. And for those interested in Class A office space, the North Houston District is home to several Class A buildings that have been successfully repositioned and are enjoying strong occupancies, providing tenants amenities they desire at Class A rates below those generally available in the market. Such Class A, B, and C office spaces complement office uses that support the growing logistics/distribution properties in the North Houston area.
Industrial Starts Slowing
CoStar reports that both nationally and in Houston industrial construction starts are slowing in 2023 after reaching multiyear highs in 2022. In Houston, after reaching just over 40 million square feet in industrial construction starts in 2022, year-to-date 2023 industrial construction starts are just under 15 million square feet. Starts have been limited not just by high-interest rates but also by rising construction costs and lingering supply chain issues. With construction timelines of about 14 months for larger industrial projects, the amount of new space hitting the market in late 2024 and 2025 may not be sufficient if average absorption rates hold. This could cause vacancies to drop and rates for existing space to rise. How long industrial construction starts remain depressed could even further impact 2026 and on.
Office-to-Industrial Conversion
With a local and nationwide weakening in the office market, conversion of poorly performing office properties in good locations for industrial/logistics uses is occurring. Just such a project is happening in the North Houston District. Brennan Investment Group has acquired North Belt Office Center V, a 135,000 square foot office building at 500 N. Sam Houston Parkway and has begun converting the site to a logistics use. Brennan intends to build on the site a spec 157,300 square foot distribution center for 1 to 4 tenants. The property is across the Beltway from Pinto Business park and adjacent to a recent Crow Holdings logistics development. Demolition is underway with completion expected in 2024.
To see the data from the Fall 2023 edition of Quadrants, flip to Page 6. Sign up for our direct mail newsletter and have the CRE Market Report mailed to you quarterly at northhouston/org.connect.