The Potential Impact of Sector Concentration on Office Vacancy Rates
While the concept of diversification is almost universally accepted within risk management circles, many large American cities did not get the memo - at least when it comes to industry diversification. In many American cities, one or two major industries are responsible for much of a city’s fortune or distress. This is nothing new, and it can have a multiplying effect when a city does not have broad tenant diversification. Challenges arise when at least one of these industries falters. The result is not only added pressure for the companies in those industries, but also for the firms that emerged to support the industry.
Houston is a great case study to understand how the contagion can spread across a city and its commercial real estate. Houston, Texas is a great example of a major U.S. city recently hit with economic challenges due to its exposure to the oil and gas industries. In 2015, a combination of factors led to a dramatic drop in crude prices and related commodities (more on this below). The contraction in prices was magnified by the fact that many oil and gas companies, be they up stream energy companies, exploration and production, or oilfield services companies, are often burdened with significant leverage. The drop in prices had a direct impact on an energy company’s top line and, subsequently, its debt service capacity.
In order to stay afloat, many companies in the space had to reduce operating expenses to avoid defaulting on interest payments and to maintain compliance with loan covenants. After a few months, the cuts began to spread to related industries that supported these energy companies, and service firms began to feel the pinch. Everything from accounting and law firms to consulting firms and caterers began seeing reduced demand in their Houston offices. After a few more months passed, the energy companies began making headcount reductions, impacting restaurants and bars. Within one year of the collapse in crude prices, headcount at energy company vendors was scaled back.
The result for Houston was reduced tenant utilization of space. Some tenants retained their full space, some began subleasing unused office space, and others sought rent relief from landlords. Up until August 2015, many companies failed to see the exposure many of these firms had to commodity prices. That lesson has been sorely learned by a city and its landlords that continue to recover today.
TRA’s Review Process Looks for External Vulnerabilities
Knowing the drivers that could lead to a sector-wide downturn is a critical component of TRA’s diligence. When we look at a company, not only do we assess how vulnerable a company’s balance sheet is to market forces, and we evaluate where potential external shocks could come from. This is inherently more important when clients have a large concentration within one or two industries. While energy companies can be overly exposed to oil and gas prices, startups and the venture capital space are more influenced by movements in interest rates. There is no one size fits all approach, but TRA is well positioned to advise on these external market factors. Reach out to us for advice and guidance on how to monitor your rent roll against these and other risks.