Revamps of offices no longer big wins

Houston’s office market has long been bifurcated into the haves and have-nots. Newer buildings account for the lion’s share of office leasing, while high vacancy rates plague older buildings.

The trend is so pronounced that the industry has a name for the phenomenon: flight to quality. And that flight has only sped up in this era of hybrid work.

Houston landlords poured millions of dollars into renovating old office buildings that, until the pandemic, could have helped them compete with newer buildings.

But in an analysis of 47 office buildings in Houston and 200 buildings across Texas, real estate firm Partners found that the returns on the renovation investments aren’t as strong as they once were. As a result, real estate investors might have to rethink what was once a solid strategy for maintaining their bottom lines.

The value of office buildings has declined by an average of about 30% across Houston and the country since the Federal Reserve started raising interest rates in March 2022, according to Partners. And that threatens to shrink Houston’s property tax base, a key source of revenue for the city.

The study analyzed the impact of major renovations of office buildings with more than 50,000 square feet, including 18 in Houston updated in 2016 and 2017. In the two years after renovations, occupancy rates in those buildings jumped by nearly 3.8 percentage points on average. Rental rates rose an average of 53 cents per square foot, according to Partners’ analysis.

But major renovations completed in 2020 and 2021, during the height of the pandemic, did not prevent occupancy rates in the updated buildings from declining by an average of about 5 percentage points by the end of 2023. The decline in occupancy rates at renovated buildings was less severe than the dips in occupancy seen in buildings that were not renovated. Rental rates did rise — by 32 cents per square foot on average — but that was substantially less than rent increases in buildings renovated before the pandemic.

“In the past, when properties

were renovated, it was pretty much a home run (for landlords). But what the data shows as far as the past two years, it’s not that slam dunk that it was pre-COVID,” said Steve Triolet, senior vice president at Partners who authored the study.

The same pattern was also found in Dallas, Austin and San Antonio, Partners found.

That doesn’t mean, however, that landlords should ditch plans to renovate office buildings, particularly those considered to be “trophy” assets and in desirable locations, Partners argued.

“I think before a lot of times when you were renovating, you were trying to just check all the boxes to make sure you had whatever your (competitors) had,” said Vince Strake, a senior vice president at Partners who works with office landlords. “Now it’s not just about checking boxes, you’re trying to find what are the one or two key differentiators that you can have in your building to help incentivize tenants to come.”

In many cases, landlords still have to update a building just to stay relevant in today’s competitive market, Strake said.

That’s because the flight to quality trend isn’t letting up.

Last year nearly 68% of all office leases in Houston were signed for Class A buildings, according to real estate firm Colliers. And tenants favor buildings constructed in the past decade, with vacancy rates at Houston offices built after 2015 at 11.4%, less than half the region’s average, according to Colliers.

Now successful office renovations improve office spaces for employees who may have become used to the comforts of a home office during the pandemic.

“You’re trying to entice people that in some cases, they’ve been working in hybrid or remote for quite some time. And they’re a little reluctant to return to the office, so you’re trying to build a warm and welcoming environment that helps with collaboration, because that’s another big reason to draw people back to the office,” Triolet said.