Subleasing — What Makes It So Hard?

The COVID-19 pandemic and its aftermath caused a lot of office space users to reevaluate their space needs.  While the jury is still out on the permanence or temporary nature of the work from home trend, at a minimum many large occupiers have determined that their office footprint can be reduced or in some cases eliminated.  The result has been record amounts of sublease space coming on the market, which has had a significant impact on both sublessors and sublessees.

The sublease market can create opportunity for both sides, but it also comes with a host of issues that make accomplishing a mutually beneficial sublease transaction difficult.  While these are not unique to the pandemic or post-pandemic eras, in many ways they have been amplified by the sheer volume of leased but unoccupied or underoccupied space.  This article will address some of these issues, perhaps explaining why so many sublease spaces remain available after a substantial period of marketing.

SUBLESSOR PERSPECTIVE

COMPETING WITH DIRECT SPACE

A tenant wishing to mitigate its costs from excess space competes not only with other subleases, but with space being leased from a building owner as well (direct space).  When the tenant originally entered into a lease for the space, they most likely received a generous tenant improvement allowance to build the space to their liking, as well as other concessions such as free rent for a period of time.  In return they made a firm commitment to lease and pay for the space for a set period.  Building owners can offer such incentives because they are often well capitalized and they are in the business of leasing space.  Additionally, building owners can offer different space sizes, configurations, lease term length and growth options.

A sublandlord typically has few if any of these to offer.  The sublandlord is effectively stuck with an obligation for a lease term that is set in stone, and the only way to compete with the direct space market is on the basis of price.  Sublandlords are generally averse to advancing significant capital to alter the space, and the key objective is usually to get some level of monetary recovery against their commitment.  This is why sublease asking rates are often significantly discounted off of both the rental rates quoted by the landlord and the rate actually being paid by the sublandlord.

SUBLEASE PROVISIONS IN THE LEASE

Building owners dislike competing with their own tenants in their efforts to lease space.  As a result, many if not most office leases contain restrictions on subleasing.  Among these are:

• Requirements for landlord consent and approval of the subtenant and the sublease terms.  At a minimum, the landlord should be required to be reasonable and timely with its approvals, but often a building’s form lease will provide that a landlord can withhold its consent “in its sole discretion”.

• Restrictions that the subtenant cannot be a governmental agency, a medical user, or a tenant whose employee density is going to be greater than the sublandlord’s.

• Restrictions that the subtenant cannot be an existing tenant in the building.

• Restrictions that the subtenant cannot be an active or recent direct leasing prospect in the building or in other buildings owned by the same landlord.

• Recapture provisions, whereby the tenant has marketed the space for sublease and found a prospective subtenant after much time and effort, but the landlord has the option to terminate the lease and “recapture” the space in lieu of approving the sublease.

FINANCIAL STRENGTH OF THE SUBTENANT

Building owners are used to evaluating the financial strength of a tenant in the normal course of their due diligence before a lease is signed.  In a sublease situation the sublandlord needs to take this on.  If the subtenant is somewhat shaky financially, the risk is not only that the subtenant will not live up to their obligations.  An additional risk is the potential for extensive time and expense of eviction and remarketing the space.  Therefore, it’s important to carefully consider the financial strength and credit history of the subtenant before making a firm commitment to enter into a sublease.

Another distinction from home mortgage debt is the shorter duration of commercial mortgage debt.  Commercial mortgages, while structured to amortize over a 20 to 30 year term, will frequently mature (i.e., balloon) after five to ten years.  This forces a borrower to sell or refinance the property at a point in time where conditions may not be favorable.  Interest rates may have risen from the date the property was originally financed or lender underwriting standards may have tightened.  If the leasing market has deteriorated or the property itself has experienced a decline in cash flow due to a loss of tenants, refinancing will be much more difficult.

A good understanding of the debt structure and maturity of the debt is meaningful both to evaluate risk and to identify possible opportunity.  If debt is maturing soon, an owner’s motivation to stabilize the cash flow being generated can enhance the negotiating leverage for an existing or potential new tenant.

SUBLESSEE PERSPECTIVE

FINDING A BARGAIN

As noted above, the primary benefit a sublandlord can offer a prospective lessee is a reduced price (i.e., rental rate).  Consequently, subleases are often priced at a significant discount from the rate offered on direct space from a building owner.  This is especially true for an existing lease with a short duration .  As a general rule, the longer the remaining lease term the closer to the building’s direct asking rate a sublease rent will be.  Nonetheless, a sublease will most always have some amount of discount off of a building’s direct asking rent.

SPACE HAS TO FIT

It is rare that an office space is a perfect fit for more than one tenant.  As a result, a subtenant will often have to compromise on some of the factors they might otherwise consider important.  A building owner could offer significant tenant buildout dollars to modify the space, but a sublandlord is usually not prepared to do so.  The tradeoff is price.  The subtenant gets somewhat of a bargain rental, likely with deeply discounted rates and rental abatement, but if there are any modifications to be made to the space subtenants must fund those themselves.

SET TERM - OFTEN RELATIVELY SHORT

A typical office lease will run for a lease term ranging from 5 to 15 years or so.  In the case of a sublease, much of that lease term has often already run.  A two year sublease may be a bargain at half price or better, but the subtenant will have to go through the leasing process again in two years.  This can be an advantage for entities uncertain about their space requirements in the future, as they can maintain flexibility for growth or unforeseen changes in business.  On the other hand, for a tenant with a more predictable future the process of searching for space and relocating after a short sublease term can be time consuming and counterproductive.

BIG INCREASE IN COST WHEN SUBLEASE TERM ENDS

Even if a sublease space is close to a perfect fit, the negotiated bargain will only last as long as the sublease term.  After that if the subtenant wants to remain in the space and negotiate a direct lease with ownership, the financial terms will be significantly higher than those under the sublease.

FINANCIAL STRENGTH OF LANDLORD

An often overlooked aspect of subleasing is the financial health of the sublessor.  This is important for the subtenant, because if the sublessor defaults on its lease (note that a bankruptcy filing in itself is often an event of default), the subtenant will have no legal right to occupy the space.  This is true even though the landlord has consented to the sublease.

To be sure, subleases can provide benefits for both parties, enabling a sublessor to mitigate its commitment for space it no longer wants or needs, while at the same time providing a relative financial bargain for the sublessee.  It’s not particularly easy, however, and sublessors and sublessees should set their expectations accordingly.