Memphis Office Market’s Pecking Order is Easily Visible During the Current Upturn

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When it comes to grading commercial office space, there is no doubt that location is still king — and other factors such as price, architecture, functionality and amenities all take a back seat to the property’s location. Since we assign buildings letter grades (A and B), let’s take a look at what these letter combinations mean and the relationship of quality to location. In these scenarios, the first letter describes the building’s class (A or B) and the second letter represents the desirability of its location (A or B).

The A/A designation refers to Class A buildings in Class A locations. It’s no surprise that this is the first category of office space absorbed when a market heats up and leasing volume intensifies. During this stage of the cycle, rental rates to inch upward, and more importantly, lease renewal terms tighten as landlords sense a shift toward the middle. For Memphis, Tenn., the total vacancy for Class A space in the East Memphis submarket decreased from 2.9 percent during third quarter 2014 to 2 percent in fourth quarter 2014. Almost 24,000 square feet of Class A office space in the East submarket was leased during fourth quarter 2014, and this leaves a meager 53,331 square feet of Class A space available for the entire submarket.

Once the A/A tier becomes scarce, occupiers gravitate to existing Class B buildings in Class A locations. For many of these properties, there is opportunity for a “second life” as property owners rush to improve cosmetics of the building to bring it back as a viable Class A alternative. This exact trend already occurred early 2014 in much of the Southeast, and many markets in the U.S. are squarely positioned in this phase.

For Memphis, we are in this point of the cycle as Memphis’ overall office market closed 2014 with a cumulative 129,493 square feet of positive net absorption, the largest annual total since 2011, with much of this absorption resulting from the remaining A/A tier’s vacancy being consumed and the beginning of the B/A tier seeing a solid increase in leasing activity. Availability of Class A space in the Memphis MSA also lessened to 10.7 percent in fourth quarter 2014, down from 11.5 percent in third quarter 2014, with the East and Midtown submarkets having the lowest availability rates of Memphis’ seven submarkets.

Not until the majority of a market’s vacancy is absorbed do we expect to see new construction. For most of the U.S., new construction has been at a minimum due to the high costs of building materials and land. For the tenant, one of the main issues of choosing new construction versus existing space is cost. The cost of new construction demands higher rental rates from the lead tenant, in order to minimize the developer’s risk. However, once the building is delivered, others may be able to backfill the remaining vacancy at lower rates.

International Paper will occupy a new fourth tower at the company’s headquarters campus, which is an example of the aforementioned new construction satisfying the need where existing vacancy cannot. The 241,000-square-foot, nine-story Class A office building will hit the market as a 100 percent leased space. If absorption continues to trend upward, even more construction announcements from larger tenants should occur in the coming year.

Only after the A/A and A/B tiers of office space are substantially absorbed and construction is at a standstill should we see occupiers considering office properties in B locations. This phenomenon supports that price is not always what drives the real estate decision; rather, location really counts when companies decide to move.

For Memphis, we are just beginning to see attention paid to secondary and tertiary locations’ Class A properties. Total vacancy for Class A space in the Memphis 385 Corridor was 12.6 percent in fourth quarter 2014, amounting to 345,094 square feet of available space.

For Memphis and most cities in the Southeast, the B/B tier of office space represents more than half of existing vacancy. Nevertheless, hope remains for this sector as some tenants still seek large blocks of inexpensive space with little aesthetics. The only drawback of a rebounding market is that it usually sees better capitalized tenants that regard price as being less important than image when it comes to their office space needs.

— By Ron Kastner, Senior Vice President of CBRE|Memphis. This article originally appeared in the March 2015 issue of Southeast Real Estate Business.