Oil. Black Gold. Texas Tea. No matter how you describe it, the energy industry is once again propelling Houston's metro office market to heights not seen since the last oil boom some 25 years ago.

As the nation's fifth-largest office market, Houston absorbed 2.9 million sq. ft. of space in the fourth quarter of 2006 alone. A total of 5.9 million sq. ft. was absorbed in 2006 compared with 3.5 million sq. ft. in 2005 — a 69% increase — according to Colliers International. Meanwhile, citywide Class-A office vacancies dropped from 13% to 11.8% during the same period.

Robust job growth is fueling space demand, with 75,000 new jobs added to the metropolitan area in 2006, a 3.1% increase over 2005, according to the Texas Workforce Commission. Houston's unemployment rate registered 4% in December 2006, down from 5.1% a year earlier and below the national average of about 4.5%.

Not surprisingly, growth in energy sector jobs has outpaced other sectors, with 9,400 new payroll positions added in mining, oil and gas extraction for the 12-month period ending in November 2006.

“When you have a core industry like energy that's responsible for about half of your gross regional product, and that industry is having record-setting profits, you're very well-positioned,” says Alexander “Sandy” Paul, national research director for Alexandria, Va.-based Delta Associates, an affiliate of Houston-based Transwestern Commercial Services.

The oil industry is truly in the black. In 2006, Exxon Mobil Corp., the nation's largest oil company, earned net income of $36.1 billion, up 39% from $25.9 billion a year earlier.

But oil is a notoriously boom-and-bust industry, and Paul sounds two cautionary notes — overbuilding and the potential for a downturn in the energy sector. While neither may come to fruition in 2007, these two variables could come into play by 2008, he warns.

Houston faces another challenge — keeping its corporate community at home. In March, oil services firm Halliburton Co. announced it is relocating its corporate headquarters to oil-rich Dubai. In recent years, the Middle East has grown in prominence as a hub for trade, and more firms are eying locations there to be close to the perceived epicenter of future oil exploration and production.

Despite the city's affinity for boom-and-bust cycles, however, outside investors continue to circle potential deals in the area. “Houston has always been seen as a timer market where you've got to hit the window appropriately to do well,” observes Chip Clarke, president of the Gulf Coast region for Transwestern. “Because of its underlying strengths and economic drivers, Houston has broader investor appeal than it had in the 1980s.”

Rising from Enron's ashes

The downtown district, which is Houston's largest office submarket with 42.3 million sq. ft., continues to lead the city's office absorption race, with 1.8 million sq. ft. taken in 2006, according to Grubb & Ellis.

The road to recovery, though, was a long and painful one. After the terrorist attacks on 9-11 and the collapse of energy giant Enron in 2002 due to corporate corruption, downtown Houston's office market hit rock bottom. After bottoming out in early 2002, the price of crude oil rose steadily over the next four years, from less than $20 a barrel to as high as $75 a barrel in the summer of 2006, taking the CBD's real estate fortunes along with it.

A chain reaction of deals struck starting in February 2004 when Chevron Corp., formerly ChevronTexaco, bought Enron's former 40-story headquarters at 1500 Louisiana. Then in October 2006, New York-based Brookfield Properties Corp. partnered with The Blackstone Group to snatch up Toronto-based Trizec Properties Inc. in a $9 billion deal.

With the purchase, Brookfield gained ownership of seven downtown buildings, including the 1.2 million sq. ft. 1400 Smith Street, making it the largest office owner in downtown Houston with holdings of 7.4 million sq. ft.

Then came the topper: As part of the Trizec deal, Brookfield also negotiated Houston's largest office lease when it signed Chevron to take all of 1400 Smith.

Another mega transaction involved Enterprise Products Operating L.P. The energy company relocated from the suburbs to downtown in April 2006, taking 300,000 sq. ft. in 1100 Louisiana Street, a 55-story, 1.3 million sq. ft. tower.

“We all are a little surprised,” says Dan Bellow, president of Staubach Corporate Services in Houston and a 34-year veteran of the local market. “I don't think anyone will be so bold as to say that three years ago they saw this instant recovery coming. Things just started to pop.”

Bellow's team represented and relocated Total Petrochemicals from the suburbs to about 200,000 sq. ft. of downtown space. “Moves like that really changed the dynamic of downtown, and today there are four or five blocks of space greater than 100,000 sq. ft., but not many.”

Once again, the black gold was flowing downtown. “When energy companies decide to take space, they take it down in very big chunks,” says Transwestern's Clarke.

All of that activity has pushed rental rates up dramatically. As an example, Bellow cites a recent large downtown lease where the net effective rent has doubled in the same building over the past 15 months, from the single digits to $22 per sq. ft.

“It was like a stock or commodity going up quarterly at a rapid rate,” says Bellow. “It was an amazing year last year. Perception turned into reality. We all thought it was getting better, but the rates were lagging. All of a sudden the reality of the rates hit, and bingo.”

Investors move in

National investors have taken notice of Houston's healthy office climate, particularly downtown, hoping to capitalize on rising rents and increasing demand for space.

Wells REIT II purchased the 581,000 sq. ft. 5 Houston Center downtown in December 2005 for $166 million, or $286 per sq. ft., a record for an office building sale in Houston.

“The investment market is still awash in cash,” according to Bob Cromwell, managing director and partner with Houston's largest independent commercial brokerage firm, Moody Rambin Interests.

Wells' purchase was not its first foray into the Houston market. In February 2004, Wells REIT II made its initial property acquisition with a $40 million deal for the 260,000 sq. ft. Weatherford Center in West Houston, which is 96% leased to oilfield services firm Weatherford International.

“Houston is one of the top 10 population centers in the country, [with 5.3 million people] and it makes sense to be there when you layer in the fact that while the economy is still dominated by oil, it has become more diversified over time,” says David Steinwedell, president of Wells Fund Management.

Steinwedell cites the city's growth prospects and favorable comparison to the central business districts of other major cities in the South. So, is he looking for more to buy? “Sure. We've kicked the tires on a few other deals, and if the right thing came along for us we would definitely buy it.”

Wells is not alone. Atlanta-based Goddard Investment Group purchased downtown's landmark Heritage Plaza, a 20-year-old, 1.1 million sq. ft. tower for $114 million in 2005. At the time, the building was 40% vacant, but in January 2007, Deloitte & Touche signed the largest lease of the year to date, a 12-year, 300,000 sq. ft. commitment for 10 floors in the building.

“Like most tenants downtown, [Deloitte & Touche] saw the market timing and wanted to go ahead and strike a deal,” says Steve Devinney, a principal with Goddard. Chevron is scheduled to vacate 85,000 sq. ft. in the building at the end of 2007, but Goddard signed boutique energy investment firm Tudor Pickering & Co. to 40,000 sq. ft. on the top two floors of the building in March. Tudor Pickering is relocating from the Galleria area.

“If 2006 was a great year for the CBD in terms of rent growth and activity and absorption, 2007 will be an even better year,” says Transwestern's Clarke.

According to a Grubb & Ellis forecast, Class-A office rental rates in Houston should increase 6% to 8% in 2007, while absorption will slow to a still-healthy 4 million sq. ft.

Here come the cranes

Unlike in past boom-and-bust cycles, new construction starts have been held in check, but downtown will see at least one new office building break ground this year. Brookfield Properties plans to build a 750,000 sq. ft. tower on land it owns around its Allen Center complex downtown, with a groundbreaking tentatively scheduled for the third quarter of 2007.

Obviously Brookfield needs a lead tenant, and according to Cromwell it could pick one out of its existing tenant base. Still, it will have to achieve high rents — in the mid-$30s — to pencil out, says Cromwell.

That would be slightly higher than today's average downtown rents, which have grown from $20 per sq. ft. to an average closer to the $30 mark. “We haven't seen low-$30 rates downtown in 25 years,” says Cromwell.

Those rents have other developers eager to dust off their building plans. Trammell Crow has two major projects for downtown on the drawing boards, but continues its quest for lead tenants before finalizing plans. “Unless they announce a lead tenant, I don't see them starting without some ink on a lease,” says Cromwell.

With construction costs rising more than 10% over the past year, according to New York-based Turner Construction, plans for copious amounts of speculative construction have been stymied. With less new supply, the landlord-dominated market continues to hold rents at levels high enough to give many tenants sticker shock.

What new construction is in the pipeline will take years to come to market, so overall rents are not likely to ease anytime soon. “Since the construction cycle is so long downtown, it's going to be very difficult for that market to be changed like it once was in the late '70s and early '80s,” says Cromwell. “You don't see three structures all in excess of 1 million sq. ft. coming out of the ground at the same time competing for tenants.”

Large blocks of contiguous space — 50,000 sq. ft. or so — are in short supply, presenting a catch-22 for prospective tenants. “Companies have to plan a little further out for new product to be built. They can't just tour 10 buildings that are all empty and pick one,” says Bellow.

West Side story

Houston's West Side markets — the West Loop/Galleria, Westchase and Energy Corridor — have been a popular magnet for office users, historically providing a healthy stock of Class-A space, mixed-use developments and high-end executive housing.

Overall, though, the West Side office market is tight. According to CB Richard Ellis research, the West Loop market, the second largest in the city, absorbed 408,000 sq. ft. in 2006 and now stands with a modest 11.68% vacancy rate. Still, there is little new construction in sight.

Most of the real construction action is in the Energy Corridor, so named for its penchant to attract tenants in the energy-related industries. In November 2006, Trammell Crow Co., in partnership with Principal Real Estate Investors, broke ground on a 330,000 sq. ft., 13-story office building in Woodcreek Park. The Energy Center is scheduled for completion in December 2007. The Crow partnership also has a companion 12-story, 300,000 sq. ft. building on the drawing board.

In November 2006, Dallas-based Granite Properties started a 14-story, 318,000 sq. ft. office tower known as Granite Westchase II in the Westchase submarket. The building is 40% preleased and is scheduled for completion in spring 2008.

Also in the Energy Corridor, Core Real Estate has unveiled plans for a speculative office building with 285,000 to 370,000 sq. ft. of space. So far, no tenants have signed on to the project.

Investors have taken notice of the Energy Corridor as well. In December 2006, a joint venture between Fort Worth-based Crescent Real Estate Equities Co. and a General Electric Pension Trust affiliate sold the 415,000 sq. ft. Three Westlake Park for $87.3 million, or $210 per sq. ft., to London-based Strategic Real Estate Advisors. Only three months earlier, Crescent sold Four Westlake Park, a 561,000 sq. ft. office building, for $122 million or $217 per sq. ft. to the same entity.

How long will it last?

Houstonians are keen to avoid past mistakes, namely boom-and-bust cycles. But with an economy still largely built on the energy industry and its tenuous relationship with world supply, that is an ongoing challenge.

In 1982, the last time there was a significant run-up in the Houston office market, oil peaked at $30 a barrel before dropping to $12 a barrel seemingly overnight. The energy economy lost 250,000 jobs while some 50 million sq. ft. of speculative office space was under construction.

“This is probably the fifth cycle I've been in, and it's so hard to predict how long it will last,” says Bellow of Staubach. “I like where we are and where we're headed. Barring anything big, we're in a steady growth cycle, but I know there will be another national recession out there on the horizon, probably a couple of years out.”

Paul with Delta Associates agrees that this time around, oil's price stability appears more assured. “When you look at global demand for oil and you look at the uncertainty that persists in parts of the world that have a lot of oil, it seems highly unlikely the price would drop to $40 a barrel or below,” says Paul. “We're more likely to see the reverse, with prices continuing to rise over time.”

If that holds true, Houston office tenants will have to endure higher rents and fewer space options for some time to come. Bellow represents tenants working on several big deals for downtown space, and this landlord's market is not working in his favor. “It's interesting to see how the dynamic of negotiation has changed, the posturing and who's going to end up with the deal.”

Cromwell senses there is more leverage for landlords on the other side of the negotiating table. “I know a lot of the tenant reps right now are telling their clients to lock in long term because they don't see any falloff in the rates. I don't think it's going to be a two- or three-year blip,” Cromwell insists. “I think it's going to be more sustainable, and we're not going to see a sharp decline like we have always had in the past.”

Ben Johnson is a Texas-based writer

HOUSTON - BY THE NUMBERS

METRO POPULATION:
5.28 million

Source: U.S. Census Bureau

UNEMPLOYMENT RATE: 4.0%
Source: Texas Workforce Commission

LARGEST PRIVATE EMPLOYERS:

  1. Wal-Mart Stores
    29,554 employees

  2. Administaff
    19,851 employees

  3. Continental Airlines
    19,661 employees

  4. Exxon Mobil Corp.
    19,732 employees

Source: Houston Chronicle

METRO AREA VITAL SIGNS

Office:

11.7% vacancy, 4Q 2006

14.5% vacancy, 4Q 2005

$19.26 rent per sq. ft., 4Q 2006

$18.35 rent per sq. ft., 4Q 2005

Source: CoStar Group, Delta Associates

Multifamily:

8.17% vacancy, 4Q 2006

11.54% vacancy, 4Q 2005

$708 avg. effective rent, 4Q 2006

$696 avg. effective rent, 4Q 2005

Source: O'Connor & Associates

Retail:

14.25% vacancy, 4Q 2006

13.56% vacancy, 4Q 2005

$19.08 rent per sq. ft., 4Q 2006

$18.96 rent per sq. ft., 4Q 2005

Source: O'Connor & Associates

Industrial:

6.6% vacancy, 4Q 2006

6.6% vacancy, 4Q 2005

$4.57 rent per sq. ft., 4Q 2006

$4.36 rent per sq. ft., 4Q 2005

Source: CoStar Group, Delta Associates

Hotel:

63.8% occupancy, 4Q 2006

74.8% occupancy, 4Q 2005

$89.24 average daily rate, 4Q 2006

$83.45 average daily rate, 4Q 2005

Source: Travel Research, Torto Wheaton Research, PKF Hospitality Research

MAJOR PROJECTS:

Energy Center, a 330,000 sq. ft., 13-story office building in Woodcreek Park in the Energy Corridor, broke ground in November 2006. Trammell Crow Co., in partnership with Principal Real Estate Investors, is developing the property, which will include a companion 12-story, 300,000 sq. ft. building in the future.

Developer: Trammell Crow Co.

Completion: 2007

Cost: $135 million

Granite Westchase II, under development by Dallas-based Granite Properties, is a 14-story, 318,000 sq. ft. office tower in the Westchase submarket. The building is 40% preleased.

Developer: Granite Properties

Completion: 2008

Cost: Not disclosed