Although the energy industry in Houston is enjoying a resurgence, the office sector continues to lag the broader economic recovery with a metro vacancy rate of nearly 18%. But increasingly the market appears poised for a major turnaround. Soaring profits posted by energy firms and pent-up demand for space are signs that momentum is building in the office sector, say industry experts.

This newfound life follows a tumultuous period. The collapse of the infamous Enron Corp. and a downturn in the energy trading business in late 2001 led to pink slips for about 17,000 oil and gas workers, many of whom worked downtown.

High-flying Enron employed as many as 10,000 workers and controlled 9,000 miles of pipeline at one point and was also gobbling up real estate left and right during its meteoric rise in the late 1990s.

Barton Smith, a professor of economics at the University of Houston, says the employment deficit from five years ago has been wiped out. While job growth was flat from 2002 to 2004, Houston gained a little more than 30,000 jobs over the last 12 months, Smith says. Roughly 16,000 of those jobs are in the energy industry. In fact, energy firms and related companies make up 48% of Houston's economic base, with a total of 300,000 oil and gas jobs, not including jobs at engineering and other energy-related firms.

That growth is reflected in the latest office figures. The metro office vacancy rate registered 17.9% in the third quarter of 2005, down from 19.4% a year earlier. What's more, the metro market posted positive absorption for the sixth consecutive quarter with 450,478 sq. ft. of net absorption in the third quarter.

Several expansions by oil and gas companies expected to be announced in the near future stand to help the downtown market, which recorded an unhealthy 21.6% vacancy rate in the third quarter, but positive absorption of 94,996 sq. ft.

Real estate brokers say still other firms such as ChevronTexaco, Shell Oil and ExxonMobil are looking for hundreds of thousands of square feet of office space in the Central Business District — deals that could come to fruition in 2006.

The rebound has been steady — yet uneven — since the first quarter of 2004 when the metro area hit bottom with an overall negative absorption of 1.7 million sq. ft. Recovery first came to the western parts of the city — in the energy corridor, Westchase and Southwest freeway submarkets, all of which are located 12 to 20 miles west of downtown Houston.

Sanford Criner, executive vice president with CB Richard Ellis, says the softer Galleria and downtown submarkets are now beginning to share in the office recovery. “That's something new,” Criner says. “We've clearly seen a rebound in demand in markets that have been extremely soft.”

While the CBD is still struggling, posting a 21.6% office vacancy rate in the third quarter, the Uptown/Galleria area vacancy rate didn't fare much better at 20.1%. Mike Boehler, executive vice president with brokerage Staubach Co., ties future absorption in the CBD to the energy sector. “The oil companies are going to drive the recovery of downtown, no question about it,” he says.

One sign that the downtown market is on the mend: Rental rates are starting to rise. Asking rents for Class-A space downtown were $21.87 in the third quarter of 2005 compared with $21.77 a year earlier.

One of the first major landlords to raise rates is Trizec Properties, which owns 6.2 million sq. ft. of office space in downtown Houston. Paul Layne, executive vice president of the firm's western region, says he started quoting rates $1 per sq. ft. higher than normal during October and November 2005, and plans to bump them up another $1 per sq. ft. early this year.

“There is still a lot of vacant space downtown, but our properties are getting full enough where we can handle an increase in rental rates,” Layne says. “There is an absolute shift in thinking in what's going on right now. Rental rates will start moving up.”

Criner believes that higher rates will come first in the hottest submarkets and at well-occupied office buildings around town. As space begins to tighten, brokers expect new building construction, which could happen in 2006. “We'll absolutely see more office space constructed [in 2006], and much of that will be single-tenant buildings,” says Criner.

Tim Relyea, vice chairman with Cushman & Wakefield of Texas, expects construction announcements in the first and second quarters. “In the first half of 2006, you will probably see the announcement of several new build-to-suits driven by energy company needs,” Relyea says.

Energy factor

After watching the bottom fall out of the energy industry in the 1980s, Houston's energy execs have evolved into a conservative breed that doesn't take action at the first sign of a financial upswing.

Roughly 220,000 Houstonians lost their jobs between 1982 and 1987 when the oil market went bust. By 1990, all of those jobs had been restored. The industry continues to experience ups and downs as market forces and the political climate change.

Because of the industry's volatility, record profits as a result of a sustained period of high oil prices have not been enough to convince some gun-shy oil and gas firms to expand their operations.

Boehler of Staubach says many of the executives who are running oil companies today are the same ones hurt by the economic downturn in the 1980s that severely damaged the energy industry. “A lot of these oil companies are holding back,” says Boehler. “The oil companies are expanding, but very cautiously.”

Oil and gas firms already possessed quite a bit of shadow space — square footage leased but not occupied. Brokers say energy companies needed to backfill vacant space before considering taking additional square footage.

“A lot of the shadow space and the sublease space has been eliminated because of growth by companies and relocations resulting from Hurricane Katrina,” Trizec's Layne speculates, adding that “55% of the office market is generally thought to be energy-related business.”

The energy execs aren't talking, but Houston's brokerage community is all abuzz about what's going on behind the scenes and the large transactions that are about to take place. As energy companies outgrow their existing spaces, they will have to enter into new lease or purchase agreements that will be made public, forcing the firms to finally tip their hand. Some of the deals are expected to begin taking place in the first quarter of 2006.

“The market's percolating steadily right now,” says Steve Burkett, executive vice president/partner with the Staubach Co. “Overall, the energy market is strong.”

Oil and gas companies posted such high profits in the third quarter that five top executives were summoned to Washington, D.C. in November to answer questions from lawmakers, some of whom were calling for a windfall profits tax.

ConocoPhillips of Houston reported a profit of $3.8 billion on revenue of $49.7 billion for the third quarter. The oil major announced plans in late 2005 for a $35.6 billion acquisition of Houston-based Burlington Resources. Following the merger, Burlington employees who occupy 300,000 sq. ft. at 717 Texas downtown could move to the energy corridor where ConocoPhillips is located.

“Almost every single energy company has expanded within the last six months or is working on an expansion now for the first quarter of [2006],” says Layne of Trizec Properties. “They finally have opened the floodgates for expansion.”

Mega deals

Office leasing and purchasing activity also is on the upswing by the oil and gas companies. An affiliate of Houston-based EPCO Inc. purchased the 1.3 million sq. ft. office tower at 1100 Louisiana last November in downtown Houston as a way to consolidate a group of companies controlled by billionaire Dan Duncan, the majority shareholder in privately held EPCO, says Randy Fowler, EPCO's senior vice president and treasurer.

The EPCO affiliate acquired 1100 Louisiana from National Office Partners LP, a joint venture of the California Public Employees Retirement Systems (CalPERS) and Houston-based Hines. Terms were not disclosed.

However, EPCO owns a 34% stake in Enterprise Products Partners LP, and an 84% stake in Enterprise GP Holdings LP. Employees of those two Houston-based companies are expected to fill 325,000 sq. ft. in 1100 Louisiana.

The list of tenants who lease the remainder of the 55-story building are welcome to stay awhile, according to the new landlord. But as tenants move out over time, more EPCO-related operations could replace them, including TEPPCO Partners LP, a publicly traded oil and gas pipeline company, currently located outside of the CBD.

The EPCO deal followed an October announcement by Marathon Oil Corp. of Houston that it would stay put in its Galleria area office building. After considering changing addresses for more than a year, Marathon signed a 15-year lease agreement for roughly 600,000 sq. ft. of space in the 1.1 million sq. ft. building at 5555 San Felipe, also known as Marathon Oil Tower.

The publicly traded oil giant has occupied offices in the 41-story tower since it was constructed in the early 1980s. The building currently houses 1,100 Marathon employees and 300 contract workers.

Another large transaction is on the horizon from an unlikely source — oil and gas giant ChevronTexaco Corp. It's unlikely because the company had already made a major move in the office arena.

Chevron U.S.A., which is a subsidiary of ChevronTexaco, bought a brand new 1.2 million sq. ft. office building in March 2004. Located at 1500 Louisiana, the downtown office tower was originally developed by Enron, but never inhabited by the bankrupt firm.

ChevronTexaco, based in San Ramon, Calif., said at the time that it would consolidate much of its Houston operations into the 40-story office building. The consolidation was to include most of ChevronTexaco's 3,700 Houston employees and contractors, as well as 500 employees from outside the city.

The firm planned to give up several buildings around town, including the 1.2 million sq. ft. 1301 McKinney, which it sold to Fort Worth-based Crescent Real Estate Equities Co. in 2004 for an estimated $105 million.

In fact, ChevronTexaco's consolidation strategy seemed to be working out just fine until it hit one little snag: Space in the Class-A tower wasn't large enough to accommodate all the workers. Now ChevronTexaco is back in the market looking for another large block of space.

ChevronTexaco executives will not say how much space they need, or if they intend to include employees of a newly acquired company in the consolidation. In August 2005, Chevron merged with Unocal Corp., which also has a major operating division in the Houston area.

While several large blocks of space are available downtown, 1400 Smith might make sense for ChevronTexaco. That happens to be the address of Enron's old headquarters building, which has stood mostly vacant for two years.

It just so happens that when ChevronTexaco bought 1500 Louisiana, it also acquired the rights to a pedestrian walkway that connects the new Enron building with the old Enron building.

The real estate rumor mill is also swirling with hints of new leasing by a number of other energy firms. Sources say Shell is looking for 300,000 sq. ft. to 400,000 sq. ft. Meanwhile, ExxonMobil Corp. is reportedly looking for 300,000 sq. ft. downtown for late 2006 or mid-2007. In addition, sources say Baker Hughes Inc. is looking for space downtown, and BP has outgrown its digs.

Jennifer Dawson is a Houston-based writer.

HOUSTON - BY THE NUMBERS

POPULATION OF METRO AREA: 5.2 million

Source: State of Texas, January 2005 estimate

UNEMPLOYMENT RATE: 5.5%

Source: Texas Workforce Commission

LARGEST EMPLOYERS:

  1. Administaff
    16,668 employees
  2. The University of Texas M.D. Anderson Cancer Center
    13,400 employees
  3. Shell Oil
    12,200 employees
  4. Halliburton
    12,168 employees


Source: Houston Business Journal

METRO AREA VACANCY RATES

Office:

17.9% vacancy, 3Q 2005

19.4% vacancy, 3Q2004

$21.13 rent per sq. ft.: 3Q 2005

$20.96 rent per sq. ft. 3Q 2004

Source: Grubb & Ellis

Multifamily:

9.4% vacancy, 3Q 2005

12.4% vacancy, 3Q 2004

$0.80 rent per sq. ft.: 3Q 2005

$0.79 rent per sq. ft.: 3Q 2004

Source: O'Connor & Associates

Retail:

16.9% vacancy, 3Q 2005

17.9% vacancy, 3Q 2004

$18.14 rent per sq. ft.: 3Q 2005

$18.00 rent per sq. ft.: 3Q 2004

Sources: Marcus & Millichap Real Estate Investment Brokerage Co.

Industrial:

6.3% vacancy, 3Q 2005

7.9% vacancy, 3Q 2004

$4.60 rent per sq. ft.: 3Q 2005

$4.32 rent per sq. ft.: 3Q 2004

Source: Grubb & Ellis Co.

Hotel Occupancy:

87.2%, 3Q 2005

64.1%, 3Q 2004

$95.53 Average daily rate: Oct. 2005

$84.92 Average daily rate: Oct. 2004

Source: PKF Consulting

MAJOR PROJECTS:

Memorial City Redevelopment, a lifestyle district located within a 200-acre site. The project will include a luxury hotel, mid-rise apartments, townhomes, upscale retail space, movie theater and several restaurants.

Cost: $500 million

Developer: MetroNational Corp.

Completion: 2012

Wal-Mart Distribution Complex, which spans 4 million sq. ft. in two buildings. Wal-Mart reportedly plans to route between 20% and 28% of its container traffic through Houston, a decision that is expected to change U.S. shipping routes and prompt other big-box retailers to establish distribution hubs nearby.

Cost: $100 million

Developer: Wal-Mart Stores Inc.

Completion: June 2005

The Promenade Shops at Shadow Creek, an 800,000 sq. ft., open-air mall in the suburb of Pearland.

Cost: $150 million

Developer: Poag & McEwen Completion: Fall 2007

New life for excess Enron space

Enron Corp.'s downfall had a more devastating impact on Houston's downtown office market than any other event in recent history. The energy giant and its subsidiaries went from posting revenues of $101 billion in 2000 to filing for bankruptcy protection in December 2001. What the firm left in its wake was millions of square feet of empty office space.

During its heyday, Enron controlled a total of 3.27 million sq. ft. The company occupied 1.27 million sq. ft. in its company-owned headquarters building located at 1400 Smith and was in the process of constructing the 1.2 million sq. ft. Class-A tower at 1500 Louisiana when it began to plummet. The firm also leased a total of 800,000 sq. ft. nearby in 1200 Smith, 333 Clay and 500 Jefferson.

In contrast, Enron today only inhabits 155,000 sq. ft. of leased space in 4 Houston Center, located at 1221-1331 Lamar St. in the CBD.

A group of investors led by Dr. Antonio Pacifico, a Houston cardiologist, bought 1400 Smith out of bankruptcy in December 2003. The new building at 1500 Louisiana was sold to Chevron U.S.A. in March 2004. And Enron employees have vacated all of the 800,000 sq. ft. space that was leased at 1200 Smith, 333 Clay and 500 Jefferson.

As part of its reorganization, Enron leased 240,000 sq. ft. two years ago in 4 Houston Center. The lease allows Enron to give space back as it sells assets and curtails operations. The firm has given back 85,000 sq. ft. over the past two years, leaving it with just 155,000 sq. ft. to go.

The leasing activity at 1400 Smith — or lack thereof — has been the topic of speculation since the facility changed hands two years ago. The building's fate was plunged into uncertainty Nov. 5, 2005. Pacifico, the buyer, was killed when his twin-engine Cessna crashed at Hobby Airport in Houston.

The 50-story building could be in limbo until the majority owner's estate is settled. Since the purchase, the tower has not been able to secure any major tenants and has sat virtually empty — except for an unnamed tenant that has leased 10,000 sq. ft. there since May 2005.

Pacifico hired a leasing broker for a while, but did not renew the professional's contract when it expired. One reason it may have been difficult to lease space was that the building did not offer any parking. Pacifico let his lease on 1,500 parking spaces lapse in 2004.

Before his death, the cardiologist was working on a unique solution. Pacifico was taking steps to convert the building's bottom floors into a parking garage. Between 20% and 25% of the structure could be converted, leaving roughly 1 million sq. ft. of office space to lease.

Bill Donovan, the building's manager, says a feasibility study shows the parking garage idea makes economic sense. The reconstruction effort is moving forward, despite Pacifico's death, Donovan wrote via e-mail in November.

“[We] developed a cost-effective and definitive design for the exterior ramp, its vertical interface with the existing structure, its placement on the site and its relation to adjoining streets,” Donovan wrote. “The design also takes good care of the Nevelson sculpture off Smith Street by preserving its location and using finish materials in the background to complement the art.”

Donovan says eventually a real estate professional will be hired to lease space in the building, but a timeframe has not been established for that move.
— Jennifer Dawson