Low Oil Prices, High Development Volumes Threaten Houston Apartment Market Fundamentals

During 2011 through 2014, Houston made headlines for record job growth stemming from the oil and gas boom. On the back of a strong economy, apartment developers raced to meet the massive wave of new demand pouring into Houston’s Energy Corridor and urban core. Early cycle fundamentals supported that aggressive apartment development. But today, as the pace of development has continued to ramp up, developers are arriving to a much different landscape in Houston. Plummeting oil prices have eroded apartment demand in the key Energy Corridor and urban core submarkets and sent shockwaves through the metro’s overall economy. And the ongoing supply wave has added to concerns for apartment market fundamentals.

Houston’s economy has evolved since the 1980s oil bust but energy remains the driver of Houston’s economy, with direct and indirect influence across employment industries and pay grades. The energy boom helped support 334,700 new jobs from 2011 through June 2014, when Houston regularly ranked as a national leader for job creation. Much of that growth came as oil hovered around $100 or more a barrel and occurred in the Mining/Logging, Wholesale Trade and Professional/Business Services employment sectors, hiring bolstered by energy firms headquartered in Houston’s urban core and Energy Corridor.

Since June 2014, however, energy prices have declined more than 60%, falling to levels not seen since mid-2004. In tandem with falling energy prices – oil has dipped below $30 a barrel in recent months – job growth has also slowed considerably. Metro Houston reported a net addition of just 23,000 jobs in 2015, nearly an 80% decline from 2014, according to the Bureau of Labor Statistics. Furthermore, those jobs came in sectors unrelated to energy. Job change in Mining/Logging and Wholesale Trade has slipped into negative territory while hiring in Professional/Business Services has stalled.

Apartment Performance

Apartment performance followed a similar trajectory. Houston posted strong revenue growth during the 2011 to mid-2014 time frame, bolstered by the urban core and Energy Corridor submarkets. Those submarkets, from downtown Houston to the western areas along I-10 and Westpark Tollway, averaged annual revenue gains around 6% to 8% throughout 2011 and mid-2014, outperforming the suburbs by roughly 100 to 300 basis points over much of that time.

Since mid-2014, however, revenue growth in the urban core and Energy Corridor has steadily fallen, landing at just 0.7% in 2015. Performances in the suburbs have picked up since mid-2014, but not enough to prevent Houston’s revenue growth from slipping to 3.2%, the lowest level since 2010. In addition, the urban core and Energy Corridor submarkets underperformed the suburbs by as much as 600 basis points over much of the past six quarters. And as revenue growth fell in the urban core and Energy Corridor, occupancy also declined. Average occupancy in those submarkets has fallen 160 basis points since mid-2014, erasing the premium over the suburbs that reached 340 basis points in 2011.

The energy-fueled revenue growth from 2011 through mid-2014 lured developers to the urban core and Energy Corridor in droves. However, as oil prices dove, projects that broke ground during the energy boom began to complete, driving up supply volumes and further dragging down apartment fundamentals. The urban core and Energy Corridor have gained roughly 13,000 units since mid-2014, a 9.3% inventory expansion and 14.6% of Houston’s total completion volume over that time. Since then, construction volumes have continued to climb, as projects either broke ground or cleared the permitting process as oil prices began to slide in late 2014. At the end of 2015, the urban core and Energy Corridor saw 17,500 units under way, nearly two-thirds of Houston’s total construction volume.

For perspective, urban construction has grown the development pipeline in Houston to one of the largest in the nation. At the end of 2015, Houston ranked third nationally for units under construction, behind only New York and Dallas. Such elevated levels of construction are set to ignite delivery volumes in 2016. Supply is expected to peak in 3rd quarter 2016 at around 23,000 units annually, the highest volume in Houston since 2000. A majority of that supply (62%) is set to be delivered to the urban core and Energy Corridor. With a still-struggling energy sector, this threatens further erosion of apartment fundamentals.

Such robust levels of new supply have softened occupancy at the top end. Class A occupancy began declining nearly two years ago, in tandem with the pick-up in deliveries and decline in oil prices. Meanwhile, among the existing apartment stock, the impact of weakening job growth and downward pricing pressure from supply have trickled into lower-tranche units. Furthermore, nearly 30% of construction volume in Houston are high-rise units, projects with traditionally longer lease-up periods. And of those new high-rise units, 92% are being built in either the urban core or Energy Corridor. The loss of high-paying energy jobs has led to a drop in income levels among new residents, according to lease-transaction data pulled from actual rent rolls utilizing RealPage software. New renters in 2015 reported incomes 4.2% below those in 2014. Elevated supply also will likely continue to put downward pricing pressure on apartments throughout 2016.

Multifamily Real Estate Returns

The good news is that underlying real estate drivers remain on solid ground in metro Houston. Cheap oil prices, while putting a drag on the energy sector, appear to have provided a net benefit to another area of the local economy – consumer spending. Decreased energy costs have provided households with increased discretionary income. The effect is especially pronounced in the retail sector, where consumer spending has yet to see a slowdown.

Despite underlying drivers, multifamily returns have seen some volatility recently. The instability is especially pronounced in the urban core and Energy Corridor. Volatility of overall apartment returns in Houston are the product of three forces: shrinking market liquidity, volatility in the urban core and Energy Corridor and elevated apartment supply.

Market liquidity is shrinking as transaction volumes have slowed considerably. Just over one year ago, the Houston market was at the top of the list for commercial real estate investors. But instability in the price of oil has induced uncertainty in Houston’s economy, including the apartment market. The latest data from Real Capital Analytics (RCA) shows that trading volume has declined on an annual basis four consecutive quarters, shrinking liquidity. Simultaneously, the average price per unit has slid to a multi-year low of about $81,000 per door. Terminal cap rates, while compressing on an annual basis, remain at the highest levels among the major Texas metros. The latest reading shows exit cap rate around 6.5%. Meanwhile, Dallas, Fort Worth, Austin and San Antonio have all reported cap rates in the low 6%’s and mid 5%’s.

The second headwind facing the Houston apartment market is the volatility of returns in the urban core and Energy Corridor. The NCREIF data conveys the same trend in those areas of Houston. Capital returns in the Houston apartment market took a hit in 2nd quarter 2015 as a result of pessimistic valuations. Meanwhile, income returns remained largely consistent across the board. When taking a closer look, NPI returns in the urban core and Energy Corridor were most volatile. These submarkets are the areas with the greatest vulnerability to new supply and the energy sector. Meanwhile, quarterly returns in the sprawling suburban submarkets remained mild but consistent. But despite the swings in the urban core and Energy Corridor, total returns were still comparatively higher on a trailing four-quarter basis.

Looking Ahead

The question remains as to how much apartment fundamentals and valuations will continue to be negatively impacted from the trickle-down effect of low oil prices and the competitive impact of new supply.

While the Houston apartment market is entering a time of transition caused by energy sector volatility, elevated supply and capital market uncertainty, the impact is likely limited. Private-sector employment, while historically reliant on the energy sector, has become more diversified. The broadening employment base will dilute the negative impact of the shrinking energy sector, especially upstream activity. Impacts to capital markets will likely constrain apartment returns as elevated supply in the urban core and Energy Corridor continue to go through the lease-up phase. Apartment occupancy will likely backtrack in 2016 as supply peaks before returning to the mean in 2017. Overall, cheap oil prices, while adversely affecting energy sector employment, have a limited impact to the Houston apartment market. The biggest uphill challenge in the multifamily sector during the coming year will be absorbing the massive amount of new supply. And decreasing liquidity trends are a sign that many investors are likely lengthening their hold periods to realize a healthier return.