Busted! The Fate of Real Estate Empires Built on Crude Oil
Mention “energy crisis” and for many the 1970s come to mind. Angry drivers, shuttered service stations, lines of mustard brown Buick Skylarks jockeying for places at the pump. A crisis of high fuel prices, in other words—too much demand and too little supply.
Today, certain real estate markets are facing an oil crisis of the opposite sort. In June 2014, crude oil sat at around $108 a barrel. Today, two years later, prices are less than half, averaging in the low- to mid-$40-per-barrel range. Those falling prices have caused a slowdown in drilling and exploration and job cuts across the industry. And that, in turn, has led to struggles for commercial real estate markets with high numbers of energy tenants.
In Houston, Texas, for instance, where oil and gas jobs make up nearly 6 percent of the employment base, office properties are seeing rising vacancies and concessions and a significant increase in sublease space as companies try to shed space in the wake of downsizing.
Calgary, Alberta, has perhaps even more exposure to the energy business with tenants related to the oil and gas industry taking up around 80 percent of the city’s downtown office space. That city is also contending with rising vacancies and sublease activity.
Even harder hit have been smaller Bakken Shale oil towns in parts of North Dakota and Montana, where hotels and multifamily developments built to accommodate the shale oil boom are seeing vacancies rates above 50 percent, according to Robert Vrchota, a managing director in Fitch Ratings’ U.S. commercial mortgage-backed securities group.
Indeed, Vrchota’s colleague Christopher Bushart, a senior director at Fitch, shared the sentiment. He said, “In markets [like the Bakken region], where you had single-demand drivers, where oil was really making the economy or breaking it, that’s where we saw the impacts [of low prices] being felt almost immediately.”
In more diverse markets like Houston, on the other hand, the effects are less systemic and slower to manifest, he noted.
That’s not to say they aren’t noticeable, however.
“What we are seeing in Houston right now is that because of the consolidation among the energy companies, there is a ton of space that’s back on the market and a lot of space available for subleasing,” said Andrea Bryan, a managing director with NewOak Capital, specializing in CMBS and commercial real estate analysis.
This overhang is most prevalent in the city’s downtown and west side energy corridor, said Mike Adams, an asset manager covering the Houston, Austin and San Antonio markets for real estate firm Accesso Partners.
“For instance, BG Group has several hundred thousand square feet on the [sublease] market downtown, and BP has the same scenario out in the energy corridor,” he said, noting the challenge this supply of subleased space presents to conventional landlords.
“You are still competing as a landlord with a rate that you need to be able to achieve to make your deal work, whereas the tenant can just discount the space and make up the difference and get most of it off their books,” Adams said. “They are just trying to get some recovery of their monthly outlays, so they will sublease it for maybe half of what they are paying.”
Even so, firms are struggling to sublease large chunks of space, he said. In response, they’ve started offering it in smaller parcels in hopes of drawing tenants from outside the energy business.
“Once you start cutting it down it might make more sense for a midsize law firm to take one floor of a five-floor sublease or something,” Adams said. “So that is now starting to be offered.”
Landlords are competing with concessions like free rent and higher property improvement allowances.
For loans in CMBS securities, the concern is that buildings could be forced to re-tenant at rents too low to support the coverage ratios and debt yields required to refinance outstanding loans. That could prove a problem for properties with loans set to mature over the next few years, Bryan said.
Defaults are not widespread in Houston, but they are happening. This year, fund Behringer Harvard defaulted on a $21 million mortgage on Northborough Tower after losing the property’s sole tenant, Noble Energy.
Lenders have definitely become more skittish, Adams said. None of Accesso’s Houston properties are up for refinancing in the near term, but one of the company’s larger tenants is currently in Chapter 11 bankruptcy.
“Fortunately, we refinanced that building before the drop, and we were able to put some money in reserve,” he said. “But it certainly has lenders concerned. I’ve talked to lenders more in the last six months than I have in the last five years.”
Strong core assets will likely have little trouble refinancing, Bryan said, “because they are going to have very good sponsors and many lenders will be willing to give those sponsors the benefit of the doubt…It’s more the assets that have allowed themselves to become Class B [space] that struggle to get refinancing in these types of situations.”
“It’s a great time to be a tenant, a lot of concessions are being offered in the marketplace, but we aren’t really seeing distress in terms of banks foreclosing on assets and owners not able to cover their nut,” said David Luther, the regional manager in Marcus & Millichap’s Houston office. “We are talking about A-quality space, and the owners of these types of assets also own in other markets. And other markets are doing very well, so they are able to offset what pain they are experiencing here with the profits from other markets they are in.”
Cities like Denver, Pittsburgh and Dallas also have some energy industry exposure, but in these spots the effects are typically confined to “just an office building here or there, not across the entire market,” Vrchota said.
Bryan agreed: “We have seen situations where there were properties in Denver, for instance, that were highly occupied by large energy companies that are now experiencing vacancies. But it is not the [market’s] predominant business.”
Even in Houston, the energy fallout has been largely confined to a few property submarkets. Low oil prices have hampered the upstream drilling and exploration business but have helped downstream businesses like refining and petrochemical, which make up around 15 percent of the city’s energy-related industry, Luther said.
Meanwhile, some $50 billion in capital investments are planned for the Houston Ship Channel, said Robert Kramp, director of research and Analysis for CBRE’s Texas/Oklahoma region. “So those construction jobs that we are seeing in the Ship Channel are helping to mitigate some of the losses in mining and manufacturing.”
Additionally, he noted, Houston has become a global healthcare center. The city’s Texas Medical Center is the world’s largest medical cluster, and the health care industry is responsible for around 11 percent of Houston jobs.
“Each commercial real estate market in Houston moves in a different cycle driven by different dynamics, and so it is not a one-size-fits-all kind of category,” he said.
As of now, though, it is unclear if these other industries will fill the demand gap left by slumping energy firms if oil prices remain low for the next few years.
“Medical is a big driver,” Luther said, “but medical is most interested in areas like [Houston suburb] Katy, which is west of the energy corridor. That [energy corridor] pocket may stay soft for maybe the next couple of years if oil remains at these levels.”
“Some of the chemical companies are certainly expanding down by the Port of Houston,” Adams said. “Maybe that will translate into some office space absorption, but we haven’t really seen that yet.”
Bryan suggested that foreign money that has been priced out of places like New York City take a look at Houston’s office market.
“It’s conceivable that we may start seeing some of that capital go into places like Houston and buy assets at a discount, because that is likely to be patient money,” she said. “I could also see opportunistic hedge funds or private equity funds go in there and do a repositioning strategy. For instance, take an office building that was built for an energy company and reposition it to be more attractive to smaller types of emerging industries.”
Former boom areas in the Bakken Shale region could see something of the opposite process, with local buyers snapping up distressed properties, Vrchota said.
“If you look at the sponsors there, most of it was out-of-state money, investors coming in from New York, Colorado, California, Florida,” he said. “So it wasn’t the sort of smart money that had been through these oil boom and bust cycles before. Some of the borrowers that are institutional and savvy and have the assets and liquidity will ride through the cycle. Others I think will get foreclosed on or the asset will be disposed of in some sort of workout scenario.”
In many cases, the ultimate buyer for these foreclosed properties would be the original developers, Vrchota predicted. “We have already seen some inquiries from the original developers,” he said. “So some of these local developers who kind of got out at the peak are now interested in coming back in at a discount, and that discount may be 50 percent of what they sold it for. So there is rescue capital or borrowers out there that are interested in these assets, know the market and understand booms and busts.”