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The oil and gas downturn

and its impact on


commercial real estate
With the price collapse of oil and
transformation of the industry, how
will commercial real estate markets be
affected?
December 2016

In this paper, we explore the risks the oil and gas (O&G) downturn poses
for the commercial real estate (CRE) sector. The goal of our research is
to identify which US markets and asset classes are at the greatest risk for
value decline. To measure the impact, we first explore why this O&G
downturn is different from past volatility in the O&G markets. We then
identify the real estate markets that are at greatest risk and investigate
the performance of certain asset classes.
A few takeaways from our research:
The duration of the O&G downturn has surprised many and debunked

predictions from top industry analysts. Changes in technology, the


geopolitical landscape and the supply/demand market are creating a
new industry paradigm.

The current supply environment and price collapse


Beginning in 2014, the global consumption of liquid fuels fell below
global production triggering a collapse in the price in oil. Despite rig
count reductions, layoffs and global market uncertainty, world
production of liquid fuels continues to create a surplus environment
today compressing the price of oil. From peak to trough, the price per
barrel of crude oil has declined nearly 70% since June 2014.
Exhibit 1: The following graph illustrates the effect of the hyper
supply environment on the crude oil commodity. Forecasted through
2017, it appears that the minor production slowdowns will have little
effect on the sustaining surplus.
World production vs. consumption of liquid fuels

most dependent on the O&G industry, although some asset classes are
demonstrating resilience more than others.

100
2

The lag effect seen in the market response to the O&G downturn

The oil and gas downturn


Since the oil price collapse began in June 2014, the O&G industry has
entered into a downturn that has endured for more than two years
now. Many experts agree that the drivers of this O&G downturn are
leading to a new normal for industry. Even if the price of oil fully
recovers in the near term, the most recent collapse is going to
change the landscape of the industry indefinitely. Market participants
need to understand how this downturn is different from past crises to
fully understand the long-term implications on CRE.

90

Price per barrel ($)

could indicate that asset performance may worsen as the O&G


downturn progresses.

Although the fundamental issue of supply and demand may be the


core trigger of O&G downturns, the market drivers, operating
environment and technological resources are exceedingly different in
the current environment.

1
2

Adjusted for inflation


Baker Hughes and RigData

Page 2 | The O&G downturn and its impact on commercial real estate

70
0

60

(1)
40

30

2012

2013

2014

Surplus (shortage)

Entering the 1980s, the worlds oil production had grown by 107% in
the prior decade, and the members of the Organization of the
Petroleum Exporting Countries (OPEC) had become sophisticated
producers, providing for 25% of the worlds crude production by
1979.

The events that followed the peak price of oil at $117 1 per barrel in
1980 in the US demonstrate the non-comparable nature of each
crisis. The US average rig count declined by 78% between 1981 and
1988, resulting in significant declines in US production 2 and
impacted US oil production for 28 years. 3 The US average annual rig
count remained stable at an average of 864 active rigs from 1989 to
2003. As a result, US production fell from 8.97 million barrels per
day in 1985 to 5.00 million in 2008, representing a 44% decrease. 4

80

50

The 1980s oil crisis does not provide a road map

In 1981, the growth of the gross domestic product (GDP) of the 30


countries belonging to the Organisation for Economic Co-operation
and Development (OECD) slumped triggering an oil price decline.
Between 1980 and 1983, world average annual consumption
decreased by 3.6 million barrels per day and OPEC countries
decreased production to alleviate pricing pressure. However, in
1985, Saudi Arabia abandoned the price support strategy in favor of
ramping up production to regain lost market share. As a result, the
world was in a 20% hyper supply environment and the price
collapsed.

110

The negative impact on CRE is primarily concentrated in 25 markets

Millions of barrels per day

Introduction

2015

2016

2017

(2)

Crude oil price per barrel

Source: EIA short-term O&G outlook; EIA price history


Forecasted period
A shortage is defined as world consumption being greater than world production of liquid fuels.

The old school of thought


For the last several decades, O&G professionals, capital markets
experts and commodity analysts have operated on the following set
of fundamental assumptions that may no longer apply to the new
O&G industry paradigm that is taking shape.
1. The global and US O&G production relies on conventional,
vertical drilling rigs, and the US will not be an exporter of
O&G resources.
2. Global consumption for O&G resources will continue to
outmatch growing production.
3. OPEC will continue to be the primary influence on global O&G
supply and production factors.
These assumptions have all proven to be potential fallacies in this
new era of fossil fuel production as evidenced by the emergence of
the US as a leading oil producer (and recently exporters due to
regulatory changes), slowing growth in China and the arrival of
disruptive and innovative technology reaching once-unprocurable
shale reserves that has substantially diminished OPECs influence in
the industry.

3
4

Starting in 1981
US O&G Information Administration (EIA) US production report

Current O&G downturn drivers

The economic consequences

This downturn is unlike previous crises and is driven by a new set of


market-disrupting components:

The O&G downturn has had a noticeable impact on the US economy,


although it has proven more difficult to quantify at the regional or
metropolitan level.

Commodities in crisis: Beginning in mid-2010, the commodities


market began to decline due to decreases in consumption
growth from the traditionally fast growing economies, such as
China, India and other emerging markets. In 2013 alone,
Chinese consumption growth decreased by 54% or 370,000
barrels per day as compared to 2012. Commodity-dependent
countries currently face steep declines in revenues. This will
reduce government spending and result in lower growth in
demand for oil & gas in these countries.

0
2014

2015

Rig count
Oil production
Liquid fuels production

2016

100

2010

2011

2012

2013

2014

100

95

90

85

80

Support activities for mining

Petroleum manufacturing

Petroleum manufacturing

O&G extraction

O&G extraction labor

Petroleum manufacturing labor

Pipeline transportation labor

Support activities for mining labor

GDP: In 2015 and 2016, combined US O&G GDP decreased by


$149 billion, or 26%. This was primarily driven by oilfield
services and O&G extraction capital investment declines or
cancellations. New investment from US mining and exploration
declined by $87.7 billion (or 35%) in 2015 and a total of $222.7
billion from 2013 to 2015. Exploration and production (E&P)
companies have slashed their capital budgets by approximately
30% from 2014 to 2015. Oilfield service companies followed
suit and decreased their budgets by 30%. 7 Since the beginning
of 2015, 195 upstream and oilfield services companies have
filed for bankruptcy. 8

Jobs: Since employment peaked in 2014, conservative


employment projections show a 20% decrease of total labor by
the end of 2016. This does not include additional job loss in
companies that indirectly support the O&G industry. Other
reports from industry insiders and analysts cite industry job loss
figures closer to 250,000 with loss projections at 50% by
2020. 9

Sector: The midstream (pipeline transportation) and


downstream (petroleum manufacturing or refining) companies
have shown resilience in the challenging environment. The
hyper supply phase has created unique storage and logistics
opportunities for traders and companies in the midstream
sector. Downstream companies have benefited from inexpensive
and high-quality US shale crude oil. However, declining prices
will ultimately impact well economics and pipeline throughput,
while oil remains below $60 to $70 a barrel.

Source: EIA; Baker Hughes

Page 3 | The O&G downturn and its impact on commercial real estate

2016*

Production
Consumption
Rig count

EIA
EIA
7 EIA

2015

Additional key aspects of the US O&G economy:

number of active rigs (000's)

10

Millions of barrels per day

Number of active rigs (000's)

200
200

Note - *As of August 2016 Source: U.S. Bureau of Labor Statistics (BLS); U.S. Bureau
of Economic Analysis (BEA)

World liquid fuels and active rigs


15

300

Exhibit 2: The following graphs illustrate the impact of disruptive new


technologies and efficient drilling methods. The most recent oil price
collapse has caused 80% of US rigs to deactivate, but overall liquid
fuels production has increased globally by 3.2% while US oil
production has declined slightly to June 2014 levels. Over the last six
years, drillers have been replacing older rigs with more powerful,
sophisticated rigs with a larger front-end production surplus and a
trailing production decline called the shale tail. In 2009, hydraulic
fracturing accounted for only 7% of US crude oil production; in 2015,
it accounted for 51%. 6

US production and active rigs

300

100

Disruptive technology: Despite massive layoffs, rigs going


offline and increased market volatility, the US has increased
daily crude oil production by 67% from January 2011 to March
2016, although the production is now slightly declining. 5 The
price collapse has forced US O&G companies to innovate rapidly
and strive toward cost optimization by focusing on prolific
unconventional wells that are economical at current prices with
the latest available technology. Resilience shown by the US
shale producers has surprised and reinforced the value of
technological advancements perhaps prolonging the downturn.

400

400

OPEC continues production: In November of 2014, OPEC


couldnt agree to artificially decrease supply by restricting
member states production. As a result, the hyper supply
environment has intensified as countries and companies now
compete for market share by increasing production of costeffective wells. OPEC has only recently begun discussion of
production caps to alleviate the hyper supply environment.

500

500

Global political and economic uncertainty: The Brexit


announcement, continued geopolitical conflict in Africa and the
Middle East, the US presidential election and the consistent
global economic growth slowdown have increased investor
uncertainty and slowed capital investment.

US oil and gas GDP and employment

600

GDP in billions

Exhibit 3: The graph below summarizes the key sector components


and their contributions to US GDP and employment in the O&G
industry. We recognized a sharp decline in GDP and employment
within the sector between 2014 and 2016.

Total employment in thousands

Haynesboone O&G Bankruptcy Reports and Surveys


Bloomberg and OilPro

Identifying the US CRE markets at risk


Although the US economy is well diversified, certain states and metropolitan areas have a greater dependency on the O&G industry than others.
Some markets have nearly one-third of their total economy generated from the sector. We have identified these markets as facing the greatest
real estate risk from the O&G downturn and it may just be the beginning.

O&G markets heat map

Heat map areas: O&G operating areas based on


basin activity

High risk: Metropolitan economic metrics reflect a high dependency on


O&G and are likely experiencing negative CRE metrics
Medium risk: Metropolitan economic metrics reflect a medium dependency
on O&G. CRE key performance metrics may or may not be influenced
Low risk: Metropolitan economic metrics reflect potential signs of O&G
dependency, but economic and CRE metrics demonstrating resilience

States most dependent on the O&G industry


Historically, 17 states have driven the O&G economy in the US, with
contributions to the overall state GDP ranging from 1.7% (California)
to 30.8% (Alaska) based on 2014 data. Similar to Alaska, six other
states claimed double-digit contributions to overall GDP in 2014 from
the O&G industry.
Exhibit 4: The adjacent table highlights the seven high-risk states
that are susceptible to CRE market volatility due to the oil price
collapse. Prior to the collapse, these at-risk states added nearly
327,000 jobs from 2010 to 2014. Following the collapse, these
seven states lost 75% of their active rigs by July 2016, which
translated to a substantial loss of jobs in certain markets. These
states combined now claim approximately 84% of the active rigs left
in the US.

Source: EIA; Drilling Maps activity report 2014

% of State GDP
State
2014
State
2014 2015*
2015*
Alaska
30.8
17.8
Oklahoma
19.7
11.1
Wyoming
19.2
22.6
Texas
16.3
8.5
Louisiana
17.3
4.6
North Dakota 17.4
12.5
New Mexico
11.9
9.2
Montana
6.6
5.0
West Virginia
7.3
13.1
Colorado
6.1
3.8
Kansas
4.3
1.1
Utah
3.2
2.2
Arkansas
3.8
1.9
Mississippi
3.0
0.9
Ohio
3.3
1.0
Pennsylvania
3.3
2.2
California
1.7
0.4
Selected Total
US Total

% of US

State O&G

% of

O&G

labor growth

State

labor
(000's)
labor
State rig counts
2014
10-14
%
2014 Jun-14
Jun-14 Aug-16
Aug-16 Change
Change
2014 10-14
%
2014
3.1
2
16.2
3.5
10
4
(6)
6.6
42
39.2
6.5
208
62
(146)
1.4
5
20.3
6.8
51
8
(43)
46.1
176
41.7
3.7
889
238
(651)
7.5
11
13.1
3.7
107
43
(64)
1.8
21 174.8
5.5
171
27
(144)
2.0
12
49.2
3.2
90
30
(60)
0.5
3
38.6
1.6
7
0
(7)
1.0
6
26.2
3.0
25
8
(17)
3.3
19
43.1
1.8
69
21
(48)
1.1
13
35.8
2.7
30
0
(30)
0.8
3
31.4
0.8
27
3
(24)
0.8
2
10.4
1.1
11
0
(11)
0.5
4
23.5
1.3
14
3
(11)
10
34.1
0.6
41
14
(27)
3.4
3.9
16
46.9
0.7
59
17
(42)
7.1
9
12.6
0.4
48
5
(43)
354
1,857
483 (1,374)
400
1,873
491 (1,382)

*2015 GDP contribution numbers are generated from the North American Industry Classification
System (NAICS) code for mining, do not include pipeline transportation and may include sectors
non-specific to O&G.
Source: BLS; BEA; Baker Hughes and RigData

Page 4 | The O&G downturn and its impact on commercial real estate

What is the impact on real estate?

In examining specific markets, you first must distinguish between the


larger, primary markets that may mitigate some of the pressures on
the CRE markets through diversified economies versus the smaller,
less diversified secondary markets. As seen below, we identified 25
markets directly influenced by the O&G industry.
Exhibit 5: Using a GDP and employment analysis of the peak period in
201314, we identified primary markets with populations of
500,000+ and secondary markets with potential real estate exposure
risk given their dependency on the O&G industry. The letter key
correlates to the map.
Actual total non-farm

Est. O&G as %
of GDP

Primary markets

Est. O&G labor (000's)

labor (000's)

Key Metropolitan
2014 2015*
2015* Jun-14
Jun-14 Jun-16
Jun-16 %
Change Jun-14
Jun-14 Jun-16
Key
Metropolitan State
State 2014
% Change
Jun-16 %% Change
Change

A
B
C
D
E
F
G
H

Houston

TX

24.2

20.0

109.3

86.7

San Antonio

TX

7.0

Pittsburgh

PA

9.9

Oklahoma City OK
New Orleans

6.0

8.7

6.0

11.9

20.8

15.0

20.6

15.2

(26.2)

618

635

2.8

LA

21.0

17.0

8.1

6.3

(22.2)

568

577

1.6

Tulsa

OK

18.7

15.0

7.7

6.2

(19.5)

440

446

1.2

Bakersfield

CA

19.4

14.0

12.4

8.8

(29.0)

256

263

2.7

Baton Rouge

LA

12.8

11.0

1.2

0.9

(25.0)

394

415

5.3

180

140

(22.0) 7,336

7,522

2.5

Selected total

(20.7) 2,932

2,999

2.3

6.8

(21.8)

955

1,009

5.6

9.5

(20.2) 1,173

1,180

0.5

Secondary markets

Key Metropolitan
2014 2015*
2015* Jun-14
Jun-14 Jun-16
Jun-16 %
Change Jun-14
Jun-14 Jun-16
Key
Metropolitan State
State 2014
% Change
Jun-16 %% Change
Change

I
J
K
L
MV
N
O
P
Q
R
S
T
U
MV
W
X
Y

Lafayette

LA

21.9

16.0

23.4

15.8

Corpus Christi TX

(32.5)

222

208

(6.5)

*17.0

14.0

24.4

23.1

(5.3)

193

198

2.4

Shreveport

LA

14.3

9.0

5.3

3.7

(30.2)

185

183

(1.0)

Anchorage

AK

19.6

12.0

3.8

3.1

(18.4)

185

188

Odessa

TX

26.6

20.0

19.2

15.8

(17.7)

78

73

Greeley

CO

14.9

12.0

18.6

17.0

(8.6)

97

102

4.8

Fort Smith

AR

7.6

5.0

6.6

5.8

(12.1)

113

114

1.2

Laredo

TX

12.3

7.0

4.8

4.2

(12.5)

98

104

5.6

Tyler

TX

24.0

14.0

6.6

6.3

(4.5)

99

104

5.2

Charleston

WV

7.6

6.0

9.9

7.9

(20.2)

127

124

(2.3)

Longview

TX

23.3

17.0

18.5

15.5

(16.2)

104

100

(3.0)

Lake Charles

LA

32.1

30.0

0.8

0.4

(50.0)

98

105

8.0

Billings

MT

17.1

15.0

5.3

3.7

(30.2)

83

87

4.3

Midland

TX

67.0

60.0

28.5

24.3

(14.7)

95

91

(4.1)

Bismarck

ND

NA

NA

6.4

5.9

(7.8)

75

76

1.2

Farmington

NM

46.6

34.0

NA

NA

NA

51

51

0.0

Casper

WY

28.7

20.0

4.3

2.6

43

40

(7.6)

186.4

155.1

(16.8) 1,945

1,946

Selected total

(39.5)

1.6
(7.0)

0.1

Source: US Census Bureau; BLS; BEA


Metro GDP 2014 is generated from the NAICS code for mining, does not include pipeline
transportation and may include sectors non-specific to O&G.

Certain CRE asset classes and markets have recently begun to exhibit
signs of stress due to the O&G downturn. The cancellation of large
projects, increased bankruptcies and continued layoffs will impact the
demand for existing and newly constructed space. The impact on real
estate has had a lagging response to the O&G downturn as CRE key
performance metrics have just recently started to show signs of
distress. This indicates we may only be at the beginning of a
flattening or declining cycle. To navigate the minefield of hidden
risks, we have identified key trends resulting from the current and
future O&G climate.

Contrasting effects on economic markets


The size and diversity of the subject metropolitan statistical areas
(MSAs) economies matter greatly when evaluating the impact of the
current O&G downturn. A high reliance on O&G GDP is an initial
warning sign, but certain primary markets have mitigated job losses
in the O&G industry with positive job growth from other industries.
An example of a well-diversified economy that demonstrated net job
growth over the past year and increasing CRE values is Dallas, Texas.
However, layoffs and bankruptcies are impacting performance at
particular office and multifamily properties in the corporate hubs of
the O&G industry. While some are better protected, primary markets
still bear risk within certain real estate submarkets.
Secondary markets (oil boom towns) will face the greatest headwinds
due to the spike in population and employment growth attributed to
the O&G industry from 2010 to 2014. As a result of the downturn,
projects are being canceled and migrant workers are leaving the
region. Markets with a heavy reliance on extraction and oilfield
services-based businesses are the most at risk, because they lack the
economic and labor diversity necessary to absorb the shock.

Rig counts and employment in secondary markets


Employment is one of the primary drivers of economic activity and
performance of CRE assets. However, changes in rig counts will likely
provide better insight into the depth and duration of the poor
performance in these O&G-driven economies. Historically, each
active drilling rig creates 135 jobs directly and indirectly. Other
experts anticipate this number could range up to 350 and beyond. 10
With many analysts projecting continued market consolidation and
layoffs, real estate assets that support rig activity in secondary
markets are expected to face significant challenges.
Exhibit 6: To better understand the impact the large-scale decrease
of US rigs (80%) has had on real estate, we analyzed price trends on
five asset types in every county with available data that had more
than eight active rigs since 2010. A large percentage of this data
came from counties related to our identified secondary markets.

*The metropolitan 2015 GDP and Corpus Christi 2014 GDP are estimated from the NAICS mining
code or trends from prior years.

Labor employment is an estimated number based on BLS-provided data and does not include
manufacturing or pipeline transportation. Some fields include NAICS code for mining, logging and
construction or the code for mining and logging.

Price trends per asset class in high rig count counties


100,000
Multifamily price per unit

Identified at-risk profiles were a result of considering broad economic trends and factors and are
not exclusive nor inclusive of every possible variable affecting the identified markets.

350
300

80,000

250

60,000

200

40,000

150
100

20,000

50
0

Multifamily

Industrial

Source: Apartments.com; CoStar, Inc.; CBRE-EA,

10

Canadian rig count survey

Page 5 | The O&G downturn and its impact on commercial real estate

Office

Retail

Price per square foot

Top 25 markets dependent on the O&G industry

The lag effect

Capitalization rate trends

Our analysis has led us to believe there is a notable and consistent


progression on how markets are being affected. The first indicator of
poor CRE market performance begins with vacancy rates and rental
rates and then proceeds to declining transaction volumes. Ultimately,
price trends and cap rates will be impacted as transactions react to
the negative key performance indicators. Illustrated in exhibit 6 is the
price trend reaction per asset class. In 4Q2015, asset classes on
average began to decline or flatten in price per unit and price per
square foot. This is at least one year into the crisis, which also
illustrates the lag effect. Furthermore, transaction activity has
slowed in these markets beginning in 2015.

In addition to vacancy rate increases, we have noted a flattening or


an increase to cap rates within certain primary markets, but it varies
by asset class. For instance, Houston has experienced increasing cap
rates in office and multifamily, but retail cap rates have continued to
decrease. The variances indicate that the negative impact to real
estate is unique to each market, but unfavorable trends do exist.
Exhibit 8: After identifying potential at-risk markets, we examined
summary level data from all of our primary and secondary markets to
trend cap rates for the four major asset classes. We note an uptick in
cap rates across several asset classes in the primary markets starting
in 4Q2015.

The secondary and rural markets appear to be at the greatest risk


with significant supply recently delivered in the multifamily,
hospitality and office assets. Unfortunately, relevant data is sparse
and difficult to obtain in the markets due to lack of transaction
volume. This only increases the need for cautious and meticulous
research in these identified areas to uncover true asset market value.

Cap rate trends from 2014 to 2016

Which asset class could be the biggest risk in your


portfolio?

Exhibit 7: The following tables demonstrate key trends observed in


vacancy and rent growth in the primary and secondary markets at
risk. It is important to note some markets are reacting slower than
others. New Orleans and Oklahoma City didnt experience decreasing
vacancy rates until the end of 2015, while Houston and Bakersfield
reacted faster to the new, hostile environment.

5.4 11,815

5.6

5,107

6.5

831

(6,708)

San Antonio

6.5

4,442

6.0

6,512

6.7

600

2,070

Tulsa

6.6

1,860

6.1

404

7.3

(297)

(1,456)

Oklahoma City

6.3

1,119

7.2

263

8.1

(74)

(856)

Metropolitan
Metropolitan

Class A office
7.6

8.1

12.3

4.2

6.6

6.8

6.3

13.2

16.1

2.9

10.8

12.7

14.1

8.1

4.1

6.4

2.3

8.1

7.4

8.0

14.8

14.3

15.8

1.5

10.9

10.6

10.1

Oklahoma City
San Antonio

Total office market

10.1

(0.5)
1.4
0.6
(0.5)

New Orleans

8.1

7.9

8.9

1.0

10.1

9.4

8.6

(0.8)

Pittsburgh

7.8

7.7

8.7

1.0

8.0

8.2

7.7

(0.5)

13.5

9.8

10.7

0.9

10.8

10.9

11.4

0.5

8.2
8.6
0.4
Tulsa
8.3
* As of 2Q2016
Multifamily rental rates % change
Primary
M-to-M
YOY Secondary
Secondary
M-to-M
Primary
M-to-M YOY
M-to-M

11.2

10.8

10.2

(0.6)

Nationally
Houston
San Antonio

0.1
(0.2)
0.1

2.3 Lafayette
(1.3) Corpus Christi

(3.6)

0.0

1.9

2.3 Shreveport

(0.4)

(1.1)

(0.5) Anchorage

(1.3)

(6.9)

Pittsburgh

(0.7)

Oklahoma City

(0.1)

1.8 Odessa

0.0

(0.7) Greeley

New Orleans

YOY
YOY

(1.0)

4.4

Tulsa

(0.9)

(1.5) Fort Smith

0.5

(0.9)

Bakersfield
Baton Rouge
State
State

(0.1)
0.2

(1.5) Laredo
1.7 Tyler
Charleston

0.7
0.0

1.1
(0.4)
-

Alaska
(0.4) (4.2) Longview
0.1
1.2
Oklahoma
0.0
0.6 Lake Charles
(0.3) (1.1)
Wyoming
(0.9) (3.0) Billings
North Dakota
0.4
(5.4) Midland
(0.2) (19.4)
Louisiana
(0.2) (0.1) Bismarck
(0.1) (1.4)
Texas
0.0
2.4 Farmington
New Mexico
0.1
1.8 Casper
* As of August 2016
"-" signifies data was unavailable. Colored "gray" markets are
negative in both month-to-month (M-to-M) and YOY periods
Absorption data is net absorption square footage per year
11

STR and Hotelnewsnow

Page 6 | The O&G downturn and its impact on commercial real estate

Flattening/Volatility

San Antonio

TX

Increasing

Pittsburgh

PA

N/A

New Orleans

LA

Tulsa

OK

Bakersfield

CA

Baton Rouge

LA

As the shale boom took hold in 2009 and O&G production expanded
in the US, new room supply quickly followed the growth in the related
O&G markets. Since 2010, the O&G regions accounted for 20% of the
total of new hotel rooms developed in the US with approximately
7,500 rooms being delivered annually, according to Smith Travel
Research (STR). However, the O&G downturn is now having a direct
impact on hotel demand.
The reported revenue per available room (RevPAR) for the heavily
concentrated O&G markets declined 18.4% in the first quarter of
2016 and 14.2% over the trailing 12-month period, according to
STR. 11 The poor performance is expected to continue as new supply
previously committed to is delivered in 2016. While developers are
no longer committing to new projects, the market will require
significant time to absorb all of the recently delivered space and for
jobs to return in a meaningful way.

Exhibit 9: The following demonstrates the erosion in the hospitality


market based on the sustained negative growth of RevPAR.
20

RevPAR % change vs. crude oil price

120

15

(1.7) (21.1)
(0.2)

TX

Percent change (%)

Baton Rouge

Houston

Key

The risk in hospitality

2Q2014
2Q2014 2Q2015
2Q2015 2Q2016
2Q2016 2015-16
2Q2014 2Q2015
2Q2015 2Q2016
2Q2016 2015-16 2Q2014

Bakersfield
Houston

Decreasing

100

10

80

60

0
-5

40

-10

20

-15
-20
2011

2012

2013

2014

Running 12-month RevPar change


Source: Costar;
Apartment Lists Rent
Report; CBRE-EA

As of 1Q2016
Source: EIA; Hotelnewsnow; STR

2015

2016

WTI Spot Price

Price per barrel ($)

* As of 2Q2016
Vacancy rates (%)

US

As of 2Q2016
Source: REIS; RCA

Net Absorp.
2014
2015
2016*
% Absorp.
Vac.%
% Absorp.
Vac.
Absorp. Vac.
Vac. %%Absorp.
Absorp. Vac.
Vac.%
Absorp. 2014-15

Houston

St. Office
Multifamily Industrial
Industrial Retail
Retail
St.
Office Multifamily

National

Oklahoma City OK

We believe that office properties more specifically, Class A office


properties and multifamily properties bear the highest risks due to
observed increases in vacancy rates.

Multifamily (000's)
Metropolitan
Metropolitan

Metropolitan
Metropolitan

The resilient markets and assets


Despite a high reliance of GDP and labor on the O&G industry, certain
markets and asset classes have demonstrated either a sluggish
response or significant resilience to the O&G headwinds.
Of the impacted markets analyzed, primary markets have a natural
hedge against the O&G downturn through economic diversity. In
addition, the industrial and retail asset classes appear to be steady or
improving, with decreasing vacancy rates, increasing rental rates and
stable to decreasing cap rates with exceptions in certain areas.
There are several factors that could be contributing to this:

Industrial assets, such as warehouses and flex building types,


are being purchased by O&G companies for the storage of
inventory during the current downturn. Furthermore,
e-commerce has driven industrial asset class demand in some
markets.

Retail assets are experiencing rising rental and decreasing


vacancy rates due to the improving economy, an increase in
disposable income and strong US employment, as well as
Americans increased willingness to take on credit card debt at
levels last seen in 2007. 12 The cheap price Americans are
paying at the pump will continue to drive increases in disposable
income.

The bottom line

Ernst & Young LLP Transaction Advisory Services


Transaction Real Estate Group

Steve Rado
Principal
+1 214 754 3443
steve.rado@ey.com

Cally Miltenberger
Senior Manager
+1 214 754 3443
cally.miltenberger@ey.com

Krista Reed

Manager
+1 713 750 1468
krista.reed@ey.com

David Trigg

Analyst
+1 214 665 5712
david.trigg@ey.com

As of October 2016, the price per barrel is now hovering around


$49. Investors and analysts alike are beginning to hope this is the
beginning of a long road back to economical production. Perhaps the
analysts are correct, and oil will hover between $40 and $60 per
barrel throughout the rest of 2016 and then in 2017 bounce back to
life, potentially reaching a more operative price point mark.
Unfortunately, a recovery in oil prices may not help the real estate
sector recover in certain markets or assets. This is because of the
new normal of the O&G industry fewer people, more production.
Labor will recover at a much slower pace, while companies attempt
to improve their balance sheets. People drive the need for space.
O&G labor declines are forecasted to continue into 2017. In the
1980s, Texas alone lost 250,000 jobs. If this crisis continues,
properties built specifically to support the growing demand of this
industry will become more distressed.
The dangers in the oil boom town secondary markets are great and
will only escalate over time as loans reach maturity and O&G
companies continue project cancellations. The multifamily, office and
hospitality complexes recently constructed in Bakersfield, California,
and Midland, Texas, will likely never hit the metrics the developers
originally sought, crippling expected cash flow generation.
The primary markets, although more diversified today, face risks in
certain submarkets. Select O&G corridors and new housing built
specifically for the once-growing O&G companies will face challenging
market conditions as the downturn continues. The amount of
sublease space coming online is starting to negatively impact market
rents already.
Given the lag effect, we suspect this may be just the beginning of a
period of poor performance for our identified at-risk markets and
asset classes. Asset managers, investors, professionals and both
equity and debt investors in the real estate sector need to be on alert
until we come out of this period of uncertainty.

12

The Wall Street Journal

Page 7 | The O&G downturn and its impact on commercial real estate

Data and sources: USA, state and metropolitan area statistical data was
sourced from the Bureau of Labor Statistics (BLS) and the Bureau of
Economic Analysis (BEA), the NAICS coding index for sector determination.
State and metropolitan data considered was dependent on the availability
of NAICS index coding data. All data should be treated as best estimates
for each region due to the included or excluded economic components as
a result of available NAICS coding.
Identified at-risk markets were a result of data availability, market activity
and corresponding O&G market performance indicators. Some areas were
excluded due to data availability. This is not a comprehensive nor an allinclusive list but a hypothesis on the potential affect the O&G economy
can have on real estate assets.
Real estate metrics and analytics are aggregates of available data. For the
secondary markets and low population counties, transaction metrics were
often sparse and difficult to obtain. Data provided is our best result from
using a variety of sources to create an illustrative image of what could or is
happening in the market.

EY | Assurance | Tax | Transactions | Advisory


About EY
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Limited, a UK company limited by guarantee, does not provide
services to clients. For more information about our
organization, please visit ey.com.
Ernst & Young LLP is a client-serving member firm of Ernst &
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About EYs Global Real Estate, Hospitality & Construction Sector
Todays real estate sector must adopt new approaches to address
regulatory requirements and financial risks, while meeting the
challenges of expanding globally and achieving sustainable growth.
EYs Global Real Estate, Hospitality & Construction (RHC) Sector
brings together a worldwide team of professionals to help you
succeed a team with deep technical experience in providing
assurance, tax, transaction and advisory services. The Sector
works to anticipate market trends, identify the implications and
develop points of view on relevant sector issues. Ultimately it
enables us to help you meet your goals and compete more
effectively.
2016 Ernst & Young LLP.
All Rights Reserved.
SCORE No. 04196-161US
1609-2055121
ED None
This material has been prepared for general informational
purposes only and is not intended to be relied upon as
accounting, tax or other professional advice. Please refer to
your advisors for specific advice.
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