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VOL. 127 | NO. 129 | Tuesday, July 3, 2012

‘Perfect Storm’

Subleasing hits record high amid continuing economic uncertainty

By Sarah Baker

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Office sublease space reached a record high in the first quarter, and local experts are forecasting even more leases from one lessee to another to hit the market prior to year-end.

Toyota Center, left, is seeing a significant amount of sublease activity from one tenant. Extra Space Storage is subleasing the majority of the property until 2015.  

(Photo: Lance Murphey)

Office subleasing totaled 600,664 square feet during the first three months of the year, according to Cushman & Wakefield/Commercial Advisors LLC’s Q1 office market report. That’s nearly 14 percent of total available space.

The stage was set for a rise in subleasing three years ago, said Larry Jensen, president and CEO of Commercial Advisors.

“Essentially what we did in 2009 and 2010 as real estate practitioners was … a downsizing, rightsizing; lend and extend,” Jensen said. “There were very few forward-looking deals. They (said), ‘Give me a six-month extension,’ ‘I want a one-year extension,’ ‘I need to get out of 10,000 square feet.’ We spent two years cleaning up corporate real estate to get it right-sized.”

The drive for efficiency has created the downsizing, which is especially reflected in the larger spaces.

“You’re seeing a macro shift in the utilization of office space in particular to shared spaces,” Jensen said. “We’ve seen national discussions about space that were once 60 square feet per person; the average probably now is about 200.”

The largest office sublease is in Harrah’s Center, 1023 Cherry Road, whose two buildings total 131,000 square feet. However, Jensen said that campus is problematic because it’s considered multi-tenant but would require loads of capital to truly be defined as such.

“There’s not very many 100,000-plus square foot tenants floating around in Memphis,” Jensen said. “Harrah’s is a great building, but when we looked at it to bring it into multi-tenant, it’s pretty challenging.”

Ron Riley, who recently joined Colliers International Management Services as senior vice president of its office division, expects another 150,000 square feet to enter the market by the close of 2012.

He said the amount of sublease space the Memphis office market currently has available represents 124 percent more than the city’s historic yearly average since 2000. What’s more, local direct office vacancy square footage represents 32.9 percent more than its historic yearly average since 2000.

“When you combine both of these elements … you get a tremendously soft and volatile market,” Riley said. “ … We are likely going to see quite a bit more sublease space hit the market. When you factor in Morgan Keegan and the vacant floors they currently have Downtown and Pinnacle Airlines and its uncertainty, it is possibly lining up for the perfect storm.”

But to accurately analyze sublease space and its effect, Riley said it’s necessary to dig into the specific tenants and the motivation for them to sublease.

“Oftentimes, a company will sublease when they need to expand and move to another building, but they do so with some certainty that they can mitigate their monetary exposure,” he said. “However in today’s environment, that would be the exception and not the norm.”

Take for instance First Tennessee Bank and its desire to sublease at Lynnfield Office Park, Building C & D, in East Memphis. The bank is trying to shed 105,000 square feet because it’s scaling its operation and has available space elsewhere, including its Downtown headquarters at 165 Madison Ave.

The majority of the market’s sublease space – 59 percent – is in the East office submarket. While rental rates remained flat in Q1, East Class A rates rose for the first time since hitting a record high in 2008 of $26.77.

Riley said First Tennessee’s situation is troublesome, as it not only creates a tremendous hole in that property, but the overall Class B market.

“With a sublease like this one and many others, the tenant has significant term remaining thus making it more attractive for an end user,” Riley said. “Those subleases with less than 24 months of term become more cumbersome and complex for an end user to try and negotiate.”

Jensen said while the market’s overall 600,664 square feet of sublease space can seem daunting at first glance, several of the market’s subleases have expirations in the next 12 months, which totals about 85,000 square feet.

One of those is a 125,000-square-foot lease BellSouth Mobility Building at 700 Goodlett Farms Parkway expiring Dec. 31, which will in turn terminate a 50,000-square-foot sublease.

“It is not likely a sublease will occur with less than 12 months remaining simply because the costs are too high unless there is a valid ‘plug and play’ requirement for a short-term tenancy,” Jensen said.

In addition, two subleases in East Memphis are technically office subleases, but are really office suites offered to individuals – 24,000 square feet at the Colonnade Center at 1661 International and 15,000 square feet at 6000 Poplar.

Yet another significant sublease in the market is Extra Space Storage (formerly Storage USA Inc.), which is subleasing the majority of the Toyota Center Downtown until 2015. Riley said Toyota Center is a good microcosm of today’s office real estate market, given all of the activity that building has seen as of late.

“You have Extra Space Storage that needs to sublease space, LRK (Inc.) consolidating its operation to get efficient, new sublease tenants coming in and capitalizing on reduced rates and a buyer purchasing the asset,” Riley said. “While this building was purchased (by Hertz Investment Group LLC) in a portfolio, buyers have a historic opportunity to place funds in assets that have the potential to generate tremendous upside. We are starting to see loan servicers and regional banks adjust expectations on exit prices and willing to transact to clear the books.”

RECORD TOTALS DAY WEEK YEAR
PROPERTY SALES 51 223 1,152
MORTGAGES 55 189 861
FORECLOSURE NOTICES 25 45 144
BUILDING PERMITS 149 541 2,593
BANKRUPTCIES 24 120 581
BUSINESS LICENSES 14 65 264
UTILITY CONNECTIONS 0 0 0
MARRIAGE LICENSES 0 0 0