SPECIAL REPORT: Lower for longer

It has been a year riddled in macroeconomic volatility, yet it has been global oil prices that have been of most concern in many markets. In the process, a number of US energy-influenced property markets have been taken along for the roller coaster ride.

The West Texas Intermediate (WTI) spot price, a crude oil benchmark, has been zigzagging dramatically for more than a year. After reaching a peak of nearly $108 a barrel in June 2014, prices began to slide precipitously, hitting a low of $43.39 a barrel in March, before climbing back up to $61.05 a barrel in June. Prices then dipped to a low of $38.22 a barrel in late August, but had been holding steady in the mid-to-upper $40s range as of press time, according to the US Energy Information Administration.

The oil price shocks have not been a surprise to Tom Kloza, global head of energy analysis at Oil Price Information Service, a Wall, New Jersey-based oil pricing data provider. “Whenever you have something which is such a lifeblood issue and which has so many different factors that can impact it – geopolitical, currency – volatility is going to be an issue,” he says.

The protracted slump in oil prices arose from a confluence of factors. The US shale oil boom of the past few years helped to bump up crude production in the country by a record 1.2 million barrels a day in 2014, or a 16.2 percent relative gain, the sharpest increase since 1940, according to a research report last month from Los Angeles-based commercial real estate services firm CBRE. But weaker-than-expected global demand for oil, along with the Organization of the Petroleum Exporting Countries (OPEC) continuing to maintain its oil production volumes in order to hold market share, created an oversupply that has driven down prices far more dramatically than anticipated.

Hardest hit

But not everyone had anticipated oil price volatility – among them the firms that invested in the US shale oil markets, which have been the hardest-hit of the country’s energy markets, says Kloza. “Certainly, the companies in shale, they’re not making the profits they thought they would make.”

Before oil prices began to plummet during the latter half of 2014, private equity real estate investors such as the property division of Kohlberg Kravis Roberts (KKR) and Related Companies, both from New York, were making significant real estate plays in the largest US oil shale markets, namely the Permian Basin and Eagle Ford Shale in Texas and Bakken Shale in North Dakota. In such markets, energy exploration and production activity had been responsible for record levels of job, income and population growth, which had sent residential real estate demand skyrocketing.

For example, in 2012, KKR partnered with Pfeffer Capital and CP Realty in 2012 to buy land to develop The Ridge at Harvest Hills, a 163-acre master-planned residential community in Williston, North Dakota. Meanwhile, in March 2014, Related acquired a portfolio of 21 multifamily apartment properties encompassing approximately 3,000 apartment units in Midland and Odessa, Texas.

In fact, Related launched a dedicated fund, Related Energy Related Real Estate Fund, last year for real estate opportunities in the US shale oil markets. Through the vehicle, which had a $300 million equity target, the firm intended to buy and build up to 6,000 multifamily properties in the US shale oil markets.

Investors that have made big real estate bets in oil-dependent property markets in the past few years “have got to be hurting,” says one fund manager. “Those markets are getting pummeled. The low oil prices are very detrimental to the economics they made a few years ago.”

Neither Related not KKR would comment.

However, in an interview with PERE in February, Justin Metz, managing principal of Related Fund Management, acknowledged that the precipitous drop in oil prices was a potential concern for the firm’s energy-related strategy. “I think there will be some negative effects in the energy markets,” he said. However, the price decline had yet to have an impact on property fundamentals, since real estate demand typically lags any changes in the economy.

Metz also had noted that the firm had only invested a small amount of capital in energy-related real estate at the time. “We haven’t been investing capital, because we’re not really sure where the bottom is,” he said. “There’s a huge correlation between the price of the commodity and the success of the real estate strategy. They’re very coupled together, and so until we feel comfortable with the pricing of that commodity and the stabilization of that price and maybe even the upward trend of that price, we’re just going to watch and monitor.”

Houston, do we have a problem?

Not all US energy markets are the same, however. Clearly, the markets that are heavily dependent on the industry have been the hardest hit. Aside from the shale oil areas, one market that has suffered considerably from the oil-price slump has been Houston, currently the sixth-largest office market in the country.

“Houston clearly has been slammed by the drop in oil prices,” which has created negative absorption of space in that market, says Doug Herzbrun, global head of research at CBRE Global Investors (GI). “Unfortunately, this is happening exactly as a lot of buildings are being completed, so it’s a very dire outlook in general in the near-term for the Houston office market.” Indeed, Houston has been the only US energy market to not see its office vacancy rate decline in the past four quarters, according to the CBRE report.

However, Herzbrun points out that the impact of low oil prices on Houston’s real estate market varies depending on the sector and submarket. Within multifamily, the property sector where CBRE GI has the greatest amount of exposure in Houston, the firm has apartment communities that have waiting lists for tenants, while other multifamily assets, located near the city’s Energy Corridor, have been more challenged. Meanwhile, Houston’s industrial property sector has remained robust because of demand from oil refineries, which, unlike oil exploration and production companies, have benefited from lower energy costs. Houston also was the top market for retail absorption in the US over the past year, according to the CBRE report.

Similarly, other property markets within Texas have fared differently than Houston. “There was an initial knee-jerk reaction that this really was going to drag down Texas as a whole, but we’ve definitely seen dramatic variation in how the economies of the various Texas metro areas have responded to this,” says Herzbrun. “Dallas just continues to be one of the strongest regional economies in the US. It’s far more diversified than Houston and other Texas metro areas.”

Real estate managers such as CBRE GI see current pricing conditions as an opportune time to invest in the US energy markets. “Underwritten correctly, we would look at something in Houston today,” Herzbrun says. Although the firm would stay away from ground-up office development, CBRE GI would consider select infill apartment construction opportunities in the market. It also would seek to buy quality assets that are being sold under distressed conditions, although there currently aren’t many such properties available, he says.

Ronald Dickerman, president and founder of Madison International Realty, also says his firm would be open to acquiring prime properties at discounts in markets such as Houston. “It is a countercyclical investment right now,” he says.

Madison currently has exposure to the US oil markets through its ownership interest in Orlando, Florida-based office real estate investment trust Parkway Properties, which derives about 22 percent of its net operating income from its property holdings in Houston. However, Dickerman points out that Parkway’s current risk exposure to oil price markets is relatively low, given the extremely limited lease expirations in Houston for the next 24 months to 36 months.

Near-death experience

At current oil price levels, Kloza says that many energy companies have been able to survive by cutting costs and using their most productive oil fields. However, such firms had a “near-death experience” for a couple of weeks in August, when oil prices dipped below $40 a barrel – the level where most energy firms are no longer able to sustain their operations.

“I wouldn’t be surprised to see a few more near death experiences for the rest of this year, and maybe at one point in the first part of 2016,” says Kloza. “I certainly would be nervous.”

Kloza says that oil prices currently are in a “slog,” and predicts that WTI spot prices are likely to remain between $38 and $50 through the spring of next year. CBRE predicts pricing will reach $50 a barrel to $70 a barrel over the next year.

Although he expects that the oil prices will stabilize sometime early next year, Kloza believes that the pricing is unlikely to return to its previous peak levels. “From 2011 to 2014 first half, we would get up to $110, $115, and the lows tended to be $75 or $80,” he says. “I think those lows become the ceilings.”

Herzbrun agrees. “I don’t know that the $100 a barrel is returning anytime soon, given that a lot of supply is opening potentially around the world,” he says. It would be more realistic for oil prices to stabilize and return to the $60 a barrel range, where it generally is considered profitable to produce oil in the US.

“I do believe the mantra that is mentioned is lower for longer,” says Kloza. “Lower for longer could mean that you really develop a fitness and a discipline that serves you better when prices ultimately do rebound. But boy, you could go into a state of shock before that.”