In Houston, as the nation struggles with job cuts and scarce credit, two sleek office buildings are galloping skyward, neck and neck, racing toward completion in a city that so far has managed to outrun the recession.

It is no coincidence that one of the two projects, the 29-story Hess Tower developed by Trammell Crow and Principal Real Estate Investors, will house an oil company, Hess Corp., since roughly half the city's economy runs on oil and gas. It's only a short drive from the refineries lining the Ship Channel at Houston's bustling port to the Energy Corridor on the city's west side.

Construction crews are hammering away at the 14th floor of Hess's newly leased, 845,000 sq. ft. global headquarters for exploration and production, on target for delivery in mid 2010. The choice downtown location is a stroll from Minute Maid Park, where the Astros play. A syndication of banks, led by Bank of America, is providing construction financing for the tower, says Adam Saphier, principal of Trammell Crow Houston. Contractors say the cost could exceed $300 million.

Blocks away, Houston-based Hines is developing the glass-sheathed, 46-story MainPlace tower, with nearly 1 million sq. ft. Hines landed KPMG, the audit and tax firm based in the Netherlands, as its first tenant with 110,000 sq. ft. and aims to complete the high-rise by early 2011.

The two towers symbolize Houston's vitality at a time when so many markets have been sapped by the country's crushing economic problems. In the fourth quarter, when the U.S. office vacancy rate stood at 14.5%, Houston's was 12.7%, reports New York-based data firm Reis.

When the national unemployment rate reached 8.1% in February, according to the U.S. Department of Labor, Houston recorded a healthier 6.2%, buoyed by the energy sector and a diverse economy. But for Houston, that rate represented a worrisome leap from 5.3% in December, recorded by the Texas Workforce Commission.

A lot has changed since the downtown projects began to rise more than a year ago. Credit tightened and oil took a hair-raising slide from nearly $150 a barrel last June to $48.14 on the New York Mercantile Exchange on March 18. “We don't believe there's going to be any more speculative developments coming out of the ground in the near future because of the turmoil in the capital markets, and even projects that have partial or full preleasing will have trouble getting financed,” says Saphier.

Over the past year, as the country absorbed body blows with the fall of Bear Stearns and Lehman Brothers, and credit sources dried up, Houston remained a bright spot, a thriving oasis of commercial real estate activity. But now, despite the 36 buildings totaling 7.7 million sq. ft. under construction, according to brokerage CB Richard Ellis (CBRE), there are signs of a serious pullback. No office projects broke ground in the fourth quarter, and few if any are expected in all of 2009.

What's more, the oil service industry is laying off workers and fewer property deals are closing, says Clay Peeples, principal at Boyd Commercial, a Houston brokerage. “We had tremendous job growth here, probably the leading job growth in the country from '06 to '08,” says Peeples. “The oil industry was so strong while the rest of the country was hurting we barely knew a recession had started,” the broker says. “It's finally caught up. We're feeling the pain now, too.”

Indigestion strikes the market

Houston's appetite for space seemed boundless as energy companies expanded and the office market absorbed a net 9.2 million sq. ft. in 2006 and 2007 combined. But leasing tapered off, and absorption shrank to just 588,000 sq. ft. in 2008.

The feast of new construction was too large even for a Texas-size appetite. A nine-year record of 3.5 million sq. ft. was delivered to the market last year, notes Grubb & Ellis, and more than 5 million sq. ft. will be delivered in 2009. Net absorption is expected to turn negative this year by 935,000 sq. ft., Reis reports.

Like Hess and MainPlace, many projects that broke ground last year were speculative. But not all developers will be as fortunate as Trammell Crow in reeling in a single company to lease the entire structure. Of the buildings under construction, 22.5% are build-to-suit, while 77.5% are speculative, according to CBRE.

Despite the influx of space, office demand remains relatively strong, says Saphier. “Clearly, the national economy is not well and we're just starting to feel the effects of that in Houston.” But occupancy and asking rents remain high, he says. “They haven't taken a significant hit yet.”

In the fourth quarter, asking rents for Class-A properties averaged $28.85 per sq. ft. in 2008, up from $26.29 per sq. ft. in the fourth quarter of 2009, Reis reports, while the Class-A vacancy rate rose to 10.6% from 9.1% a year earlier.

Craig Beyer, executive vice president at CB Richard Ellis in Houston, and head of its Global Energy Practice, agrees that 5 million sq. ft. of new space isn't cause for worry. “That's not much,” he says. “We're a 200 million sq. ft. market.”

Sublease space rises

What does give Beyer pause is the increasing amount of sublease space. "We are seeing a significant number of new subleases every week," he says. But with an average size of just 5,000 sq. ft., they have so far been inconsequential, Beyer adds. "Companies are right-sizing, they're not cutting any muscle."

But Derrell Curry, executive vice president and branch manager at brokerage Studley in Houston, sees it differently. "Over the last 120 days we've added about 1 million sq. ft of sublease space to the market. That's pretty dramatic. We're hopeful that's not going to continue, but it's a disturbing trend," he says.

Subleasing is going on all over town, Curry says, as some major oil companies and the petrochemical and engineering firms that contract with them cut back. "There's definitely retrenchment going on right now in the oil and gas companies. There are layoffs taking place today, and demand is way off as a result of it."

As head of CBRE's energy group, Beyer has seen some domestic facilities shut down. "A number of refineries have been mothballed," he says. "I would expect that with the economy down, you'll actually see some of them dismantled."

Houston-based energy company ConocoPhillips and oilfield services provider Schlumberger Ltd. are among the companies downsizing, reports note. Still, some global companies are expanding, and their rigs in the North Sea or Middle East continue to drill for oil.

"The large capital offshore, deep-water projects, you can't stop those things on a dime," Curry says. "It takes five to seven years for oil to be produced for drilling." Oil executives know that prices are cyclical, he says. A $10 per barrel rise by summer wouldn't be surprising, and it could spur hiring and office demand.

Power shifts to tenants

For now, as companies shrink and new space invades the market, power in dealmaking has shifted from landlord to tenant. Tenants are flexing new clout by demanding concessions and getting them. That's a far cry from just two years ago, when landlords wielded clout with a take-it-or-leave it attitude.

"I'm looking at a 200,000 sq. ft. deal, and I was verbally offered a year of free rent and a significant increase in the concession package," says Beyer, who represents tenants. In a normal market, he would expect a $35 per sq. ft. tenant improvement allowance and a couple months of free rent. Even with a $45 per sq. ft. allowance offer, his client walked, reasoning that with plenty of space available, there was no need to rush.

Meanwhile, at Boyd Commercial, Peeples pressured a landlord to lower the rate for an architectural firm leasing Class-A space in Westchase. The landlord had demanded a renewal rate of $20 per sq. ft., far more than the tenant was willing to pay. "I said, ‘Look, we're not trying to beat you up, but make it worth our while and we'll stay.’"

Peeples negotiated a 12,000 sq. ft. sublease with a title company for five years at $12 per sq. ft., with cubicles and furniture. "That was a heck of deal," he says. The market rate was $18 per sq. ft., and the furnishings made the deal irresistible.

In this new negotiating climate, some tenants have abruptly canceled deals at the last minute, as signing was imminent, brokers say. Some were oil-related firms swept up in a mood of fiscal caution.

Brokers turn to sale-leasebacks

On the sales side, few deals are being made, and these are tough times for brokers. "Honestly, there haven't been any big sales," says Richard Rudd, managing director of capital markets at Jones Lang LaSalle in Houston.

So his firm got creative, negotiating sale-leaseback transactions, or single-tenant transactions featuring a tenant on a long-term lease.

"It's easier to get debt because you have the tenant's credit and the long-term lease to support the debt," says Rudd.

Through the rest of 2009, sales are expected to remain problematic. Office inventory will climb, as companies downsize. Some investors fear Houston may face days as dark as the 1980s, when an oil crisis brought the city to its knees as savings and loans failed, but that scenario seems far-fetched.

"Houston remains one of the nation's strongest office markets," notes Grubb & Ellis in its 2009 forecast. The city's diverse development, from the Texas Medical Center to the Port of Houston and industries such as aerospace, exerts a healthy demand for office space.

Bradley Freels, chairman of Midway Cos., which is developing the $500 million mixed-use CityCentre project with 425,000 sq. ft. of Class-A office space, says capital will be available for good projects.

Because the city resisted the temptation to overbuild on the massive scale that occurred in some other markets, the commercial real estate market is well positioned for recovery, he says. "I'm glad I'm in Texas, and more importantly, I'm glad I'm in Houston. I think if we're going to weather a storm, I'd like to be sitting exactly where I'm sitting."
Denise Kalette is senior associate editor.

HOUSTON - BY THE NUMBERS

LARGEST PRIVATE EMPLOYERS

  1. Wal-Mart
    29,400 employees

  2. Administaff Inc.
    22,475 employees

  3. Memorial Hermann Health Care
    19,986 employees

Source: The Houston Chronicle

CITY POPULATION 2.2 million
Source: U.S. Census Bureau

UNEMPLOYMENT RATE: 6.2%
Source: Texas Workforce Commission

METRO AREA VITAL SIGNS

(Note: All rents are effective rents)

Office:

12.7% vacancy, 4Q 2008
11.4% vacancy, 4Q 2007
$20.66 rent per sq. ft., 4Q 2008
$19.21 rent per sq. ft., 4Q 2007
Source: Reis

Multifamily:

10% vacancy, 4Q 2008
8.8% vacancy, 4Q 2007
$715 monthly rent 4Q 2008
$685 monthly rent 4Q 2007
Source: Reis

Retail:

13.2% vacancy, 4Q 2008
12.1% vacancy, 4Q 2007
$13.85 rent per sq. ft., 4Q 2008
$13.99 rent per sq. ft., 4Q 2007
Source: Reis

Industrial:

9% vacancy, 4Q 2008
8.1% vacancy, 4Q 2007
$5.52 rent per sq. ft., 4Q 2008
$5.28 rent per sq. ft., 4Q 2007
Source: Marcus & Millichap

Hotel:

70.4% occupancy, 4Q 2008
62% occupancy, 4Q 2007
$102.49 average daily rate, 4Q 2008
$93.59 average daily rate, 4Q 2007
Source: Smith Travel Research

MAJOR PROJECTS

MainPlace: On the 39th floor of the 46-story downtown high-rise, a sky garden will be visible from the street. Recessed into the building, it will have planted terraces and a five-story atrium. Developer Hines is building the project through its Hines CalPERS Green (HCG) fund, which focuses on sustainable office buildings.

Developer: Hines

Completion: 2011

Cost: $360 million, estimated

CityCentre: The mixed-use development on 37 acres in Houston's Memorial district will have 425,000 sq. ft. of office space, as well as 400,000 sq. ft. of retail space, with restaurants and a 140,000 sq. ft. fitness center. The developer also plans 375 multifamily units, and a 245-room luxury hotel. The project, located in one of the wealthiest zip codes in Texas, is being built near the intersection of Interstate 10 and Beltway 8.

Developer: Midway Cos.

Completion: 2009

Cost: $500 million