Low Energy Prices’ Impact on CRE May Be
Negligible
Feb 25, 2015
Brad Doremus and Victor Calanog
In early February, crude oil
prices hit a 52-week low around $44 per barrel, capping off a staggering
decline from a 52-week high of about $100 in mid-2014. While prices had bounced
back somewhat to $50 as of mid-February, the massive decline in oil prices has
already begun to reverberate throughout the economy. The decline will have
different effects for various firms, industries, regions and, in the case of
commercial real estate, property types.
Not
surprisingly, the decline in the price of oil will have a negative impact on
energy-oriented economies around the country. However, this will only 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. 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. As a result of both direct and indirect effects, Reis has revised its
forecasts downward for these energy-oriented metros, though mainly in the
office and industrial sectors.
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. Moreover, the state benefits from very positive demographic
trends. Strong population growth will 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, though 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.
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 in the metros 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.
However, 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.
For most
other metros, a steep decline in oil prices will be a boon for consumers and
businesses alike, effectively acting as a tax break. This will lead 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 is already underway; fourth quarter GDP
figures indicated personal consumption grew at its highest rate in years,
bolstered by the decline in oil prices.
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, gain two-fold from a decline in oil prices. Input costs decrease,
boosting profits, and lower gasoline prices make buying a car more attractive.
However, we
must be careful not to overstate the effect a decline in oil prices may have on
the commercial real estate market. It is not a given that prices will remain
depressed for an extended period. There has already been a bit of a bounce back
in the past couple weeks and even the IEA is expecting prices to rebound as oil
producers cut back on production in response to low prices. Also, as we have
noted, the major energy metro, Houston, has diversified its economic base
significantly over the past couple of decades.
Moreover,
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 feel 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. Note
that 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, changing our current view of
the trajectory of fundamentals in a significant way, is an exaggeration.
Brad Doremus
is senior analyst and Victor Calanog is head of research and economics for New
York-based research firm Reis.
