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Houston has returned.

FIVE YEARS AGO, Phoenix Tower, a shimmering, but see-through office tower, stood as a humbling symbol of Houston's dramatic real estate depression. The decline had been brought on by overbuilding and the collapse of Houston's oil economy. Today, Phoenix Tower is nearly full and rents are steadily rising.

Houston is back.

After suffering possibly the worst collapse in modern U.S. history, Houston's real estate market has returned as one of the op investment and lending opportunities in the country. However, the recovery of real estate has been uneven, with dramatic variation in performance. This results in a market that may be the nation's most diverse. For the Houston investor, comprehension of the market's intricacies is a critical precondition to taking advantage of Houston's plentiful, quality, real estate opportunities.

Number-one employment growth

The city's economy is one of the healthiest in the country today and is set for a long, steady, up-cycle. Houston is at or near the top of U.S. rankings of economic statistics (see sidebar). For instance, Houston had the greatest employment growth of any U.S. metropolitan region for the 12 monhns ending MArch 1991 (Chart 1).

Houston's return to economic health did not happen overnight. The recovery phase began in early 1987; general recognition in the national media of Houston's turnaround came only as recently as 1989. By May 1990, Houston had regained the estimated 20,000 population lost in 1986 and 1987 and all the 212,000 jobs it lost in the 1982 to 1987 downturn (Chart 2). Since May 1990, a new phase of economic expansion has replaced the recovery phase.

Houston's economic profile attests to the region's health:

* The latest 12-month job-growth figure stands at 52,400 or 3 percent, compared to a negative 0.7 percent for the U.S. as a whole.

* In 1990, unemployment dropped below the national average--5.3 percent in Houston compared to 5.5 percent in the U.S. Through the first four months of 1991, Houston averaged 5.4 percent unemployment compared to 7.0 percent for the U.S.

* Retail sales rose 9 percent in 1990 versus 4 percent nationally.

* Population increased by an estimated 79,000 or 2.5 percent in 1990.

While the impact of the national recession has been far less dramatic in Houston than in most U.S. cities, it has slowed Houston's expansion. These statistics reflect a moderation in the economic performance from the preceding years.

Greatr diversity

Houston's recovery has occurred without much improvement in the oil industry. The region's economy has diversified significantly, developing a less cyclical, less-energy-dependent structure. In 1980, one could measure the city's economic health by the rig count. No longer. For most of the past four years, the U.S. operating rig count has remained below the 1,000 mark compared with more than 4,500 at the 1981 peak. In 1982, 84 percent of the economic base employment was derived from energy-related industries and a mere 16 percent came from non-energy related industries. Today, energy dependency has fallen to 60 percent, and 40 percent of Houston's basic economy is derived from non-energy industries.

In addition, the energy industry itself is much more diverse, no longer driven solely by high oil prices. There has been major restructuring from dependency on "upstream" operations (exploration and drilling) by diversifying into "downstream" activities (refining, marketing, and petrochemicals). The downstream component performs better with low oil prices, while the upstream component benefits from high prices--making the combined oil industry much less sensitive to prevailing oil prices.

ecovery from non-energy industries

Houston's non-energy-related industries play a much more important role in the economy today. Manufacturing, aerospace, engineering, international trade and health care have all become increasingly vital to the local economy. Houston has not garnered a large number of corporate relocations, but numerous small relocations combined with significant expansion of existing companies have fueled the up-cycle.

While the U.S. is losing manufacturing employment (at an annual rate of 4 percent currently), Houston is leading the country in manufacturing job credation, currently expanding at an annual rate of 2.4 percent. Houston's most visible high-tech manufacturer these days, Compaq Computer, has doubled its employment to 10,000 over the past five years and may double again by the year 2000.

Houston's aerospace industry is centered around NASA's Johnson Space Center (JSC). Twenty percent at NASA's budget is allocated to JSC and in turn, JSC contributes more than $1 billion to the local economy every year. Employment at JSC has risen an average of 10 percent annually for the past three years, and aerospace companies such as Lockheed, McDonnell Douglas, and Grumman continue to expand here as well. In addition, Houston visitors in 1992 will be able to "experience" space travel at JSC's new $70 million Disney-designed visitors center.

Houston is one of the two largest U.S. centers for international engineering and construction firms (the other is San Francisco, principally due to the presence of Bechtel). Many large engineering companies, including Bechtel, Brown & Root, CRSS Engineering, Fluor Daniel and M.W. Kellogg, are involved in designing and constructing projects from Baton Rouge to Kuwait. Brown & Root, which had to close its monolithic west Houston campus in the mid-1980s, reopened the facility in 1988 and today is at capacity. This large, upward swing in workload is typical of all the major engineering firms.

While the largest share of the projects conducted by these engineering firms still fall within the energy realm--both upstream and downstream--the firms have diversified into many other fields, including transportation, utilities and the rapidly growing area of environmental engineering.

Since the days of the Allen Brothers, who paddled up Buffalo Bayou in 1836 to found the city, Houston's waterways have held tremendous commercial value. Today, Houston's port is the third busiest in the U.S. and sixth in the world. The port has enjoyed three straight record years in tonnage handled, in part through imports of foreign oil for Houston's massive petrochemical production (nearly half of the U.S. production of petrochemicals is done in the Houston area). Capital investment in port improvements has given Houston a comparative advantage through its modern facilities and this investment remains vital to keeping Houston a primary U.S. port destination.

The port is symbolic of Houston's role as an international center. Dallas may have a reputation as the primary South Central city, but Houston is the region's undisputed capital of international trade.

Houston is home to the world's largest, and possibly best-known, medical complex, the Texas Medical Center. During the late 1980s, nearly $2 billion was invested in expansions to the medical center's physical plant. This growth helped to maintain the center's global prominence and was a vital contributor to Houston's recovery.

4.4 million population by 2000

Today, economic expansion does not mirror the wild days of the boom times when U-Haul trucks were driven into the city by the thousands. Projected growth rates for the metropolitan area portray the stability of a steady up-cycle. Even so, Houston will be one of the leading growth cities of the U.S. through the 1990s.

While the U.S. is projected to exprience an annual population growth rate of about 1 percent, Houston should grow by nearly 2 percent per year, a fairly remarkable rate for a metropolitan region of 3.7 million (CMSA). This translates into more than 70,000 new Houstonians every year during the next 10 years. By the year 2000, Houston's population should reach 4.4 million, and the metro area may very well move up to eighth among U.S. metropolitan regions from its current tenth place, surpassing Boston and Washington, D.C. More than half of the population increase will come from net migration.

Employment growth is expected to average about 2.5 percent annually through the decade, compared to 1.1 percent nationally. This rate is certainly not the 5-, 6- and 7-percent increases experienced during the boom years a decade ago, but it is impressive for a region of its size, and is a more manageable rate, given infrastructure requirements for supporting growth. At the projected rate, Houston will gain roughly 450,000 jobs over the decade.

Houston grows up

Houston's great growth spurt during the heady days of the oil boom in the late 1970s and early 1980s is analogous to a growing teenager. By the late 1980s, Houston had matured from gangling teenager to full-fledged adult, facing the complexities of a large metropolitan region. Planning, economic development and quality of life have become key concepts for Houston's political and business leaders.

One sign that Houston has matured is the recent adoption of zoning provisions. The "Z word" began to be whispered in the late 1980s and was finally spoken aloud in public forums by the end of the decade. In the end, support for zoning came from most sectors of the community, including real estate. Convincing evidence: among the residential and commercial real estate that fared the best during the downturn were properties located in masterplanned communities and other neighborhoods controlled by deed and other land-use restrictions. Zoning in Houston will be less restrictive than in many other cities, and it will take many years to become fully established.

The transportation infrastructure was one of the most daunting challenges to face. By 1980, Houston had a national reputation for traffic congrestion. Today, the city can boast that it is one of the few major U.S. cities to have made progress in increasing mobility. More than $10 billion was spent in the 1980s on extensive road improvements, and another $8 billion will be spent in the 1990s.

Improving the highway system alone will not be sufficient to take Houston into the next century, especially as the population surpasses the four million mark; mass transit must play a greater role in the region. A new commuter rail system--possibly monorail--is under design. While it appears to be stalled indefinitely in the planning stages, optimists believe the system will be online sometime in the 1990s. The initial phase will connect Houston's major business centers: downtown, Galleria and the Texas Medical Center.

Top potential

Four years ago, Houston's real estate market was devastated. Today, it is considered one of the best in the country. It is no surprise to knowledgeable Houston observers and players that numerous economic and real estate consulting firms place Houston at or near the top among U.S. metros in their real estate rankings (see sidebar).

Houston's real estate recovery is not fresh news. The upturn began in mid-1987 when absorption turned positive. With no construction activity, occupancy began to rise. By 1988, rental rates and property values started to show improvement, and a variety of investors began to comb the market for opportunities. The market recovery and investment activity has continued through today.

This is not to say that overall, Houston real estate has returned to 1982 performance levels. Average occupancies, rent and values still fall below early-1980 levels, and most properties are valued below replacement costs. The wealth in Houston's real estate--and its opportunity--lies with the rapid appreciation occurring in the market. Significant value has been created since the bottom of the cycle, and appreciation will continue through the 1990s, at levels higher than in most other U.S. markets.

The outlook for the next several years is decidedly positive. It is predicated on the basic supply-demand equation: demand will continue to absorb excess space and new supply will remain at a minimum, well below demand. Excess real estate inventory will begin to disappear and shortages appear. The sustained improvement in performance leads to the conclusion: where else in the country can one state with certainty that rents and values will be higher next year than this?

Treacherous waters

Houston real estate is not created equal. There is extreme diversity, and performance reflects great variation by product, class and quality, location, ownership and management. For example, sales of newly constructed product are occurring for prices that are at or above U.S. averages, while lowest-quality product is often obtainable for rock-bottom prices but not worth buying at any price. quality investment and lending opportunities must be carefully sorted out from the multitude of potential deals that do not make sense. for many newcomers, deciphering the market's intricacies is a daunting task.

Investment today

Nationwide, caution and conservative underwriting characterize the 1991 lending and investment climate. There is a profound and ongoing shift back to the basics, a healthy return to fundamentals: economic reality, quality and market demand. The prevalent


attitude among underwriters is that "we can afford not to invest all of our money, but we can't afford to make a mistake."

The overall Houston market today has less risk and more upside potential than most U.S. markets, but the same conservative financing principles apply to transactions here. This has been the norm in Houston for several years. Conservative underwriting includes economic analyses based on today's rents (without trending) and other conservative assumptions, heavy equity requirements, well-established tenant credit and a successful track record for the borrower.

The conservative climate is curtailing the volume of financing transactions that are occurring in the Houston market and limiting the institutional lending and investment to only the higher-quality real estate. Yet, while capital is tight for Houston real estate, financing is available for the best deals with the best credentials. "A well-located, well-conceived project is financeable," comments Martin Fein, one of Houston's active developers with several projects in the pipeline, "especially those that stay within the parameters of closer-in locations."

The Houston market offers excellent opportunities for new development financings, but these deals will remain limited to the highest quality product developed by the most successful firms.

Most of the financing opportunities in Houston are found in acquisition loans and refinancings of renovated properties. These are opportunities that take advantage of value restoration from increasing rents and occupancies.

Another key to this market's upside appreciation is understanding that Houston's real estate economic have been rewritten. The current real estate economics have been reformulated on a new base line derived from the low numbers of the late 1980s' economics, rather than the early 1980s' boom economics.

Office performance up

While Houston's office market is clearly not "back," it is one of the top U.S. performers in terms of potential.

* Houston's net absorption in 1990 ranked third in the world (after Los Angeles and Chicago).

* The current occupancy of 78 percent has almost reached the U.S. average of 80 percent.

* Class-A office space occupancy is up to 86 percent with rents increasing at double-digit rates.

Houston's office market is still depressed by many standards. Its rents are about where they were in 1978--below the 1981 peak--and there is plenty of empty office space in the region, primarily in class-C and class-D buildings, which trail far behind in the recovery cycle. Many buildings will never fully regain their values, and many ill-conceived buildings may be best torn down.

By contrast, the office market segment in recovery is exemplified by Phoenix Tower. Located in Greenway Plaza, Phoenix Tower was purchased completely vacant in 1985 by Homart Development. after a major rehabilitation and new marketing campaign in 1987, the building has leased up to its current occupancy of 92 percent. Rents have risen almost 30 percent since 1987.

Texas Heritage Plaza is an even more dramatic example of office recovery. Purchased in 1988 by a group headed by Coventry Development Company, the 53-story downtown structure has risen from 7 percent to 70 percent occupancy.

The Galleria/West Loop market may be the "hottest" office sector in Houston. The high level of activity in this submarket reflects both the continued centrifugal forces at work in the American urban landscape--pulling business activity away from the central business district to new suburban nodes--and the excellent quality of the product.

Symbolic of the recovery in this submarket and of opportunities offered by rehabilitation is the 2000 West Loop Building purchased by Martin J. Fein Interests and Morgan & Company in 1990. The 370,000-square-foot, 20-year-old structure has been completely renovated and is being remarketed at rents averaging from $14 to more than $15, up from a low as $8 only a few years ago. Hewlett Packard recently signed a 60,000-square-foot lease here and the balance of the tenant tenants.

Perhaps most startling to real estate visitors these days are the cranes erecting new office towers. While no truly speculative office construction is occurring, there are four new office buildings under construction (or in the final stages of planning) for individual corporate users who were unable to find large blocks of space suitable for their needs. Included among these are Anadarko Petroleum's new headquaters, a 450,000-square-foot building being constructed by Friendswood Development in Greenspoint (a market which maintains occupancy in the 90s) and BP Exploration's new 500,000-square-foot headquarters, which will be built in the "energy corridor" in West Houston. Additionally, Exxon Chemical, which is moving its headquarters from Connecticut to Houston, should break ground next year on a new structure also located in the energy corridor.

Institutional interest in Houston's office market is less than in other product types, primarily due to the national aversion to office investment. Yet, some of Houston's best real estate investment and lending opportunities may be found in the office market; 1992 may be a peak year for Houston office investment. One basic reason: Houston office buildings are still cheap by U.S. standards and are trading far below replacement costs.

Industrial build-to-suits

The industrial market recovery during the late 1980s was perhaps the most dramatic and successful of all the four major property types. And today some of Houston's prime lending and investment opportunities are found within this market.

* From summer 1987 to the end of 1989, city-wide occupancy of Houston's 268 million square feet of industrial space rose from 81 percent to 88 percent.

* Rapid rent increases followed occupancy gains.

* The strongest component in the market today is bulk warehouse space. Occupancy for bulk warehouse space is estimated to be in the low 90s.

The rapid market recovery in the late 1980s was fueled by expansion in many of Houston's major industries: manufacturing, port shipping, other distribution, aerospace and petrochemicals and refining. Although the market is still improving, it has assumed a slower pace. Occupancy hovers at between 88 and 89 percent; rents continue to rise, but at a more moderate rate.

The vacant space that remains in the market is basically non-competitive space, such as old manufacturing facilities, physically and functionally obsolete structures and other space that does not meet the needs of today's user. The shortage of suitable buildings has resulted in a multitude of build-to-suit facilities. Over the past three years, an estimated 2.5 million square feet of industrial space has been constructed in build-to-suit facilities.

For example, the Carton Sales Company, a local manufacturer of custom packaging products, required a larger production facility. Existing industrial space options did not meet the needs of the firm. "Analysis of the relocation options revealed the advantages of a facility designed to meet the company's specific requirements," stated developer Nat J. Davis of Davis/DeBlanc & Co., which just completed construction on a 51,000-square-foot building for Carton Sales.

Portfolios of industrial space are attractive debt and equity opportunities but are limited in number and dollar size. Built-to-suit facilities have also attracted investors underwriting quality real estate.

Retail anchors

Houston's retail market is lagging behind other property types. Yet, despite the disappointing overall occupancy and absorption, rental rates are rising and the market has major strengths.

* Occupancy is relatively flat at the current level of 79 percent.

* Rental rates rose 12 percent in 1990.

* Houston area retail sales have climbed an average of 9 percent per year for the past three years. In 1990, Houston maintained this 9-percent gain, far ahead of the national average of 4 percent.

The contradictory occupancy and rent statistic are reconciled by the tremendous diversity within retail space. "The market is very healthy for the right product, but the overall numbers are skewed due to the great amount of area in ill-conceived projects which should not have been built in the first place," concludes retail expert Ed Wulfe of Wulfe & Company. The research firm of O'Connor & Associates suggests that such centers total 10 million square feet and that overall retail occupancy would be 89 percent if these centers were excluded.

Grocery-anchored centers far outperform the market and represent some of the best financial opportunities in Houston today. All Houston retail centers anchored by a major grocery store are currently enjoying an overall 90 percent occupany according to the 1991 survey conducted by Holliday Fenoglio Dockerty & Gibson, Inc. and Property Research and Investment Consultants, Inc.

National retailers are expanding aggressively in the Houston market. "Most mass merchants--the value-conscious retailers such as electronics companies, wholesale clubs, discounters, etc.--are aggressively seeking locations in this market," adds Wulfe. The past four years have seen numerous new retailers, such as Phar-mor, Office Depot and Circuit City, going into multiple locations.

Retail construction is minimal today, but what is being built is successful. Annual construction levels are averaging about one million square feet and nearly all of these new centers were significantly preleased, enjoy prime locations and are anchored by a major tenant, quite often a grocery concern.

An excellent example of the retail construction that characterizes Houston today is Shepherd Square. This 143,000-square-foot center was developed by Wulfe & Co. and Friendswood Development. The center, which opened in early 1990, is anchored by Houston's leading grocery chain--Randalls. It enjoys virtual 100-percent occupancy with rents at the top of the market.

Apartments reach new heights

The recovery in Houston's apartment market has been remarkable.

* City-wide occupancy is up to 92 percent from 81 percent in 1987, with today's level only marginally below the U.S. average of 93 percent.

* Occupancy for the highest quality apartments are averaging in the mid- to high-90s.

* Average sales price per square foot rose 9 percent from a year ago compared to the national average of under 1 percent.

* Annual rent increases have averaged 11 percent for the past two years.

* New apartment communities are leasing at an average of 40 units per month.

Houston's apartment market was devastated from overbuilding and the economic collapse in the mid-1980s. By mid-1987, occupancy had fallen to a low of 81 percent; rents fell 40 percent from 1982 to 1987.

Against that backdrop, the market recovery from 1987 has been very impressive. Fueled by city-wide economic and population growth, absorption rebounded and occupancy rose steadily. Rents have now surpassed the former 1982 peak (although when adjusted for inflation are still below the 1982 level). Concessions fell out of fashion more than three years ago. Even with rents rising at double-digit levels, Houston still has some of the lowest apartment rents in the country, thereby allowing greater latitude to increase rent over the next few years.

Average sales prices for Houston apartments remain well below the U.S. average but are rising at a fast pace. The National Real Estate Index, published by Liquidity Fund, calculates that the average price for a higher quality garden apartment in Houston has risen 30 percent since 1988. The comparable rate for the entire U.S. was 11 percent. From the first quarter of prices rose 9 percent compared to the national average of 0.3 percent.

Rehabilitation of apartment communities is a major portion of the apartment activity in Houston today. Numerous projects, many once boarded up, have been modernized and successfully reintroduced to the market. Holliday Fenoglio Dockerty & Gibson, Inc. recently surveyed 30 rehabbed properties in West Houston, where most of this work is occurring, and found an overall occupancy of 97 percent. Rents increased 35 percent from pre-rehab to post-rehab.

Many geographic submarkets are significantly outpacing city-wide performance. The sectors that exhibited the earliest recovery and which are the healthiest today include the closer-in and more affluent areas of Galleria, Greenway Plaza and Medical Center. Clear Lake also falls into this "strong and stable category." More recently, West Houston and the Northwest markets have been showing significant gains.

Apartment construction began again cautiously in 1988 and 1989 when a handful to units began leasing. 1990 was a more active year with the completion of 2,530 units. However, this total still pales compared to the average 28,000 units built annually during the boom from 1977 through 1983. Another 1,900 units will open in 1991, and 2,900 are projected for 1992.

New projects starts are being restricted by the difficulty in obtaining construction financing combined with much tighter underwriting requirements for permanent loans. The market could justify a greater number of new units were more capital available.

Evidence supporting this conclusion comes from the rapid lease up of new product, averaging 40 units per month, per property, and several of the new communities have monthly lease-up rates of more than 50 units. The 581-unit Pin Oak Green leased up in eight months--72 units per month. At The Inverness, the 204-unit community in Greenway Plaza developed by Martin J. Fein Interests and the Morgan Group, preleased to 50 percent before the first residents took occupancy; the balance of the units were leased in less than three months. Nearby, at the 221-unit CityWalk Apartments, developer Trammell Crow raised base rents 13 percent through the lease-up period last year from the 83 cents on the pro forma to 94 cents per square foot.

Investment outlook

Houston's real estate market is still characterized by great variation in performance--variation by product, class, geography and other criteria. Successful investment and lending here requires patient, a seasoned guide and much research to understand the intricacies of the marketplace and to identify the quality opportunities.

Yet the overall message is unambiguous. Houston is clearly up and off the bottom. There is little downside risk here in contrast to most U.S. markets which are still softening, their trend lines still heading towards the bottom of the cycle.

The chief attraction is the market upside appreciation. While Houston real estate is still cheap by national standards, rapidly rising rents and occupancies are creating greater income and value. Yet, Houston is no longer the contrarian play it was a few years ago. Investors looking for institutional quality, contrarian, real estate opportunities here may be disappointed.

Many measures of Houston's current real estate performance are now back on par with national levels. And through the 1990s, Houston's economic and real estate strengths will continue to propel this market upward.

With continued demand and limited new supply, Robert H. McNaghten of Nationwide Insurance Company, one of the more active lenders in Houston, concludes, "Houston is one of the best markets in the country today. The market will get stronger and stronger--the upside is terrific with little downside." The real estate climate has improved to the extent that Houston is now one of the leading U.S. markets where one can find superior financing and investment opportunities.

Jeanette I. Rice is the vice president of research and analysis for Holliday Fenoglio Dockerty & Gibson, Inc., a Houston-based commercial mortgage banking firm with an office in Boca Raton, Florida and affiliate offices in Buffalo and Albany, New York.
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Title Annotation:recovery of Houston's economy and real estate market
Author:Rice, Jeanette I.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:The ABCs of apartment lending.
Next Article:The rise of the banker/developer.

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