Dr. Victor Calanog, Chief Economist and Senior Vice President, Reis
Ryan Severino, CFA, Senior Economist and Director of Research, Reis
Bradley Doremus, Associate – Research & Economics, Reis
In late January 2015, crude oil prices hit a 52-week low around $44.08 per barrel, capping off a staggering decline from a 52-week high of about $108 in mid-2014. Prices bounced back somewhat to above $50 in mid-February, fell again, reaching a new 52-week low of $44.02 per barrel. The massive decline in oil prices has already begun to reverberate throughout the economy, with different effects for various firms, industries, regions and, in the case of commercial real estate, property types. Much of the coverage and analysis surrounding the decline in oil prices has centered on Houston, the energy capital of the U.S. and one of the hottest commercial real estate markets in the country. But contrary to all of the doom and gloom underlying much of that coverage, we expect the impact of low energy prices on the multifamily sector in Houston to be minimal. On the other hand, the Houston office market is likely to feel more pain and indications are already pointing to that conclusion.
Not surprisingly, the decline in the price of oil will have a negative impact on energy-oriented economies around the country. However, at most this will slow growth in major metro areas, not drive them into recession. Texas is the state that will be most directly impacted by this. Other states that will be hit, but to a lesser extent, are North Dakota, Oklahoma, Colorado, New Mexico, Wyoming and, if oil prices remain depressed for a while, West Virginia (because of the price substitution effect between natural gas and coal). The areas in Texas that are under the most direct threat are smaller, less diverse metro economies such as Midland and Odessa. And yet even in the case of these two metros, any adverse effect on employment has so far been unsubstantial. Year-over-year employment growth in Midland was still 8.8% as of February and down just 50 basis points from the peak last October. In Odessa, year-over-year employment growth is down 130 basis points since October, but still registered a 7.6% increase as of February.
Among larger metros, Houston and, to a lesser extent, Fort Worth will be impacted because of the relatively high concentration of exploration jobs in those metros. Even though the oil price decline will mostly hit the exploration industry, there are also many professional services firms in the area that rely on business from the energy industry creating the potential for significant secondary employment impacts. Job growth in the oil and gas extraction industry has certainly slowed since mid-2014. As of February, oil and gas extraction payrolls expanded by 1.9% year-over-year, compared with 3.1% as of February 2014. Yet the rapid pace of job growth in this industry was already in decline in Houston well before the downturn in oil prices; after reaching a cyclical high of 12.6% in mid-2012, annual increases in payrolls have gradually slowed through early 2014. Since then, growth has been steady around 1%-2%. Overall, job growth has still remained positive. Houston actually registered an annual increase in payrolls of 3.4% as of February. This is down from the 3.8% increase as of December, but in line with annual job growth figures from late 2013 to early 2014. January did see the first monthly job losses in the metro since 2011, but January has been a weak month for job growth for several years. Moreover, job growth has been muted across the country during the first few months of the year.
On the bright side, the larger Texas metros are not as dependent on the energy sector as they once were, such as during the 1980s oil price decline, so they are better positioned to weather the downturn. In Houston, a greater presence from healthcare, research and professional services firms will help keep the metro’s economy growing. And in fact, payroll gains within Education and Health Services and Professional and Business Services has bolstered Houston’s recent job gains. Employment in the Leisure and Hospitality industry has also been solid. The state also benefits from very positive demographic trends. Houston’s population is projected to grow 8.7% over the next five years, driving an 11.0% increase in households. This compares to expectations of 5.3% and 7.5% growth in each respective category for the nation as a whole. This strong population growth should continue to support household formation and the demand for apartments.
As such, low energy prices have had little effect on our multifamily outlook for Houston. Let us be clear – we are not saying that the metro’s market will continue to do incredibly well. We are already calling for increasing vacancies and a moderation in rent growth through 2019 due to new development and the maturation of the multifamily cycle. It is for these reasons that we believe vacancy will rise in the coming years, not because of falling energy prices. Our preliminary first quarter results show that vacancy held steady at 5.8% but is up 20 basis points over the past 12 months. Quarterly rent growth was 1.0%, ranking 13th in the nation. Oil prices have been declining for nine months but the multifamily market has remained resilient. Household formation and population growth are strong while employment growth has held steady despite the hit to the energy sector. The vacancy will begin to rise, however, as more and more new supply is completed. In 2014, 10,065 units were completed, a 1.9% increase in inventory. Reis forecasts construction to total more than 18,500 units in 2015, increasing inventory by 3.4%. The current vacancy rate should also be viewed in context. The metro’s long-term average vacancy rate is roughly 9.2%. Without counting the 1980s, a decade of extreme overbuilding in the metro, long-term vacancy is about 7.4%. So even forgetting the recent fall in energy prices, the combination of below-average vacancy and a significant influx of new supply is already signaling vacancy increases over the next several years. The fall in oil prices will not have a serious impact on this market trajectory.
We also believe that Houston’s diverse economy, resilient job growth and strong population growth will insulate the retail sector from any major negative pullback from low oil prices. Preliminary first quarter 2015 results further confirmed our outlook. Vacancy among Houston’s neighborhood and community centers fell 30 basis points in the first quarter to 11.3%, the eighth largest decline among Reis’ primary metros. Effective rents also grew 0.8% for the quarter, almost on par with rent growth exhibited in the multifamily sector. Annual rent growth is now at 3.1%, the tenth largest increase in the country.
Office and industrial properties in major energy metros are more likely to be directly impacted by oil price declines and the subsequent layoffs in the energy sector. Energy companies and supporting professional service firms are major users of both office and industrial space and attached to a significant number of projects in the development pipeline. With major energy firms like Schlumberger and Halliburton already announcing layoffs, many planned expansions may potentially be delayed or cancelled, depressing demand for commercial space. The key is that for more established companies, the break-even point for oil is far lower for fracking wells ($35 to $45 per barrel) than the new, highly-levered entrants that bought/leased land when energy prices were far higher ($75 to $85 per barrel). The newer, highly-leveraged firms are the ones that may go out of business. The bigger, monolithic firms will lay some people off, but this will mostly be confined to exploration. Still, our office and industrial projections for Houston have been reduced to account for the decline in demand.
The negative impact on the Houston office market was already evident in preliminary results for the first quarter of 2015. Net absorption was barely positive during the first quarter and was actually negative in February and March. Meanwhile, construction was relatively robust for the quarter, resulting in a 60 basis point increase in vacancy since the end of 2014. This was tied for the third largest increase in vacancy across the country. As a result the Houston market’s vacancy rate currently sits at 15.1%, the highest level since the third quarter of 2011. Moreover, the Federal Reserve Bank of Dallas noted in the March release of the Beige Book that some energy firms are seeking to sublet office space in Houston. And unless a large portion of projects are put on hold, there is more office space to be delivered in the near future. Over 7.5 million square feet of office space in Houston will likely be delivered in 2015, representing 19% of all projected completions due across the nation. In 2016, that figure falls to 16% but the actual amount of space to be completed is even larger, on the order of 7.7 million square feet.
For most other metros, a steep decline in oil prices will be a boon for consumers and businesses alike (particularly in energy-intensive industries), effectively acting as a tax break. This leads to a rise in disposable incomes for consumers and a decline in costs for firms. Retailers should benefit directly when more money remains in the hands of shoppers and leads to higher sales. This process was already underway as of late 2014; fourth quarter GDP figures indicated personal consumption grew at its highest rate in years, bolstered by the decline in oil prices. However, retail sales growth has actually turned negative in early 2015. Excluding autos and gasoline, sales were down 0.1% in January and 0.2% in February. Much of this decline can be attributed to severe inclement weather and below-average temperatures across a large swath of the country. Year-over-year figures (excluding autos and gas) are still in line with the latter half of 2014, indicating spending may not be suffering like headline monthly figures suggest.
The regions of the country poised to benefit most from the decline in oil prices are those that have underperformed since the beginning of the recovery, namely the Northeast and Midwest. Both regions have very little exposure to the oil industry compared to the South and West and stand to reap the benefits of falling oil prices without bearing the brunt of negative effects. Since energy costs are generally higher in the Northeast and Midwest, declining oil prices will have a greater positive effect than elsewhere. Moreover, the reliance on industrial production in the Midwest leaves the region susceptible to fluctuations of oil prices given their use as an input in the manufacturing process. Auto manufacturers, stalwarts of the Midwestern manufacturing industry, should gain two-fold from a decline in oil prices. Input costs decrease and boost profits while lower gasoline prices make buying a car more attractive.
We must be careful not to overstate the effect a decline in oil prices may have on the commercial real estate market. As we have noted, the major energy metro, Houston, has diversified its economic base significantly over the past couple of decades. The demographic trends in the metro are very favorable. Also, it is not a given that prices will remain at current depressed levels for an extended period. We are more than 9 months into the current downturn in oil prices. A recent analysis by the Federal Reserve Bank of St. Louis took a look at all major episodes of oil price declines in non-recessionary environments since 1983. They calculated the average duration of each of these declines to be 8.6 months, a figure that was heavily influenced by a 23 month-long episode in the late 1990s, with a median of just 6 months. While this by no means indicates we are at the end of the current decline, it is telling that we are already past the average duration of such episodes and well past the median. As of the writing of this article, the WTI spot price is in the low $50 range. At present, most forecasts call for oil prices in the $50 per barrel range by late 2015 and into the $60 range in 2016. This is still quite low, but remains comfortably above the $35 to $45 per barrel breakeven point for the larger oil companies.
The consequences of lower energy prices will mostly be felt by office and industrial properties. Any effect on the multifamily and retail sectors will be felt indirectly, but we believe neither will suffer any significant downward pressure on fundamentals. As such, our forecasts in Houston for these two property types have not changed much due to the decline in oil prices. Overall we are not saying that real estate fundamentals will continue to improve indefinitely for Houston multifamily: for a variety of reasons unrelated to low energy prices, we have already been forecasting a rise in vacancies and a moderation in rent growth over the next five years. However, to claim that the impact of low energy prices will be substantive, or changing our current view of the trajectory of fundamentals in a significant way, is an overreaction.