The Memphis office market posted 271,828 square feet of positive absorption in 2022, and that momentum has carried into the first half of 2023. Like most markets, Class A properties accounted for the majority of positive absorption, at 218,851 square feet. This trend has already carried into 2023, as Class A properties lead net absorption totals to begin the year.
As a result of a strong year, the vacancy rate has fallen to 12.4 percent market-wide, an 840-basis-point decrease from the height of the pandemic. Additionally, sublease availabilities are less prevalent in Memphis than other comparable office markets. Currently there is 257,681 square feet of sublease space available in the Memphis market, which has a total net rentable area of 21.7 million square feet. The average among similarly sized Southeast markets is 422,624 square feet. There haven’t been substantial space additions to outweigh the below-average leasing activity thus far in 2023.
The Memphis unemployment rate continues to trend downward to 3.2 percent in April, slightly lower than Tennessee’s 3.3 percent unemployment rate and the national rate of 3.7 percent. The tight labor market has increased demand in East Memphis, as tenants demand high-quality, highly amenitized buildings to attract and retain talent. For example, the East submarket is attractive because of its central location to the Memphis MSA and its high-quality buildings that offer modern infrastructure, onsite security and nearby amenities. The vacancy rate in the East submarket has fallen to pre-pandemic levels at 12.4 percent.
Demand is the leading factor in rent growth; however, operating expenses and construction costs are putting upward pressure on rents. Although maintenance and construction materials are more readily available, their costs remain inflated. This, and increased labor costs are pushing tenant improvement (TI) and operating expenses higher. Build-out costs in the Memphis market have increased by approximately 50 percent from pre-pandemic to the present.
As a result, landlords are requiring longer lease terms to justify a significant contribution to office space build-outs to help amortize the cost of TIs. Increased build-out costs incentivize tenants to remain in place rather than relocating to a new office space.
Due to office tenants’ preference for the East submarket, some building owners are converting outdated buildings to other uses downtown. In 2022, CBRE research estimated roughly 1.1 million square feet of office space downtown was slated to be converted for mixed-use. This trend is positive because it has led to a higher occupancy rate downtown as tenants relocate to other properties in the submarket. However, with waning demand for multifamily product, some of those projects have been halted, leaving the office properties in limbo.
Macroeconomic struggles, post-pandemic office trends and increasing capital markets have all weighed on the construction pipeline. No new office buildings broke ground in 2022, and none are planned through 2024. As inflation slows down, the Federal Reserve could ease monetary policy, providing greater clarity to the real estate sector. This will bring new opportunities for construction projects slated for in-demand areas.
In the East submarket, the Standard Germantown, formerly the Carrefour Center, provided a 2.5-year expected delivery date for the office portion of the mixed-use development, but that project has not broken ground yet.
As the Fed is expected to raise interest rates further, it is unlikely there will be significant office sales in Memphis this year. CBRE economists anticipate the central bank will keep the federal funds rate ranging between 5 percent to 5.25 percent until the end of the year when they begin to cut rates in the fourth quarter. Once rates begin easing, the Memphis office market could experience some key building sales.
Looking ahead, Memphis should continue to experience modest growth as the supply and demand ratio finds balance from the difficulties during the COVID-19 pandemic. Should Memphis follow national trends and see sublease availability in high-demand submarkets like East Memphis, it will create opportunities for tenants searching in a tight submarket, albeit the spaces are still lower than comparable cities’ averages. Due to lingering recessionary concerns, companies have been prompted to evaluate space utilization and cost savings as occupiers consider return-to-office strategies.
According to the CBRE’s Occupancy Benchmark study, 69 percent of respondents reported prioritizing return to office in 2023, and 65 percent are searching for cost reductions. Memphis has already experienced a significant return-to-office wave because of low commute times. Still, it could continue increasing as studies reveal the positive relation between collaboration and in-office work.
Class A properties will likely continue to outperform Class B properties, following the national trend of tenants occupying higher-quality office space with a smaller footprint. Leasing activity will likely remain modest, but the vacancy rate will remain tight in key submarkets due to moveouts remaining low.
— By Josh Seaton, Field Research Analyst, CBRE. This article was originally published in the July 2023 issue of Southeast Real Estate Business.