The Yin and Yang of Commercial Real Estate Subleases

Subleases. I avoid them at all costs. Why? Because subleases are generally unfavorable to the original tenant (sub-landlord) and landlord (master landlord), risky, and complicated. Sometimes, however, a sublease cannot be avoided and in isolated cases some benefits inure to the parties. What follows is a review of the ups and downs of a commercial real estate sublease.

What is a Sublease? When a tenant must relieve himself of a lease obligation prior to the expiration of the lease, the need to sublease occurs. The lease of commercial real estate has a landlord and a tenant. The two parties agree to a term (commencement and expiration), an amount of rent to be paid monthly, any annual increases in the amount of monthly rent over the term, and any concessions - abated rent, building improvements, and pre-possession clean up. The points are memorialized into a lease agreement and both parties sign. Every effort is made by the tenant to live up to the terms of the lease. Occasionally, the tenant finds himself unable to fulfill the lease obligation - outgrows the building and must move, is acquired by a competitor and finds the space is redundant, or the sales of the business no longer support the rent payments - just to name a few examples. In a sublease arrangement, the landlord becomes the master landlord and the tenant becomes the sub-landlord. The new occupant is referred to as a sub-tenant. Confusing, huh?

A sublease is unfavorable to the tenant. The tenant is committed to the landlord for an amount of rent over a period of time and very few landlords would let the tenant walk without a hefty penalty. A sublease is akin to a "fire sale" - the lease is no longer needed or wanted - and thus must be liquidated. The tenant (now the sub-landlord) is desperate to get rid of the excess space but has very little leverage with which to negotiate. Additionally, if a sub-tenant is located, and a deal struck, the original tenant is still on the hook if the sub-tenant does not play nicely - fails to pay rent. Another unfavorable factor is the term remaining on the lease. Most prospective tenants seek a three to seven year lease term. If the term of the sublease has fewer than three years remaining, the sublease has less appeal to prospective tenants in the market. Occasionally, a landlord will capitalize on the shortened term, realize the term is less marketable, and use the tenant's desire to liquidate as a means to secure a new tenant.

A sublease is unfavorable to the landlord. A layer of risk and complexity is added with a sub-tenant. The tenant with whom you negotiated and transacted is now vacating your building. Although the tenant is still obligated for the performance of the lease, another party (sub-tenant) is now your occupant. To a certain extent, your original tenant's faithful rent performance is dependent upon the sub-tenant - sub-tenant pays the tenant and the tenant pays you. Frequently, if the remaining lease term is fewer than three years, a prospective sub-tenant may want a longer term. You now must commence negotiations several years sooner than you anticipated. You must now decide - well before the old lease expires - what your attitude is on a longer term.

A sublease is risky for the sub-tenant. Subleases are generally taken "as is - where is". Remember, the sub-landlord (tenant) is out and consequently doesn't want to spend any money refurbishing the space. The normal concession package of abated rent, building improvements and clean up are rare with a sublease. You may be asked to vacate at the end of the sublease term because you will not have any options to extend or any renewal rights. What happens if the sub-landlord (tenant) fails to pay rent? Your position is compromised - or worse - you get evicted!

Sometimes benefits occur. Subleases appeal to new companies with little or no credit history. A sub-landlord (tenant) is less concerned with credit - after all the sub-landlord (tenant) is still obligated. Subleases are advantageous for fast growing companies. Because a shorter term remains with a sublease, a fast growing company has the flexibility afforded with a shorter term - they are not committing to a long term obligation. As revenue and employee growth are uncertain for these companies, the shorter term works. Sometimes, the market rate for new leases is greater than the rate for a sublease - a sub-tenant can save money. On the flip side, a sub-landlord (tenant) can make money. Just make sure your agreement allows you to reap any profits taken from a sublease.

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Are You PREPARED to Make a Commercial Real Estate Deal?

You've decided that now is the time to sell your commercial real estate. Many factors have brought you to this place. We won't discuss those reasons today. Or, selling is not your thing and you believe it's best to find a tenant for your vacant building and commit to a long term lease. On the flip side, you are an occupant whose business need has propelled you into the market to find a suitable location to house your business. You may choose to buy or lease a location. 

Regardless which side of the transaction your interest lies - owner or occupant - are you prepared to make a deal? Let's quarter this question and analyze all four positions - owner selling, owner leasing, occupant buying, occupant leasing. 

Owner selling. A funny thing happens when you market your commercial real estate for sale - folks want to tour, questions arise, issues surface - you get offers! Now what? Well, you respond to the buyers and negotiate the transaction, right? Sometimes, not that easy. Occasionally, owners are un-prepared for the inevitable - actually making a deal. Make sure you've engaged good tax, legal, and commercial real estate brokerage assistance - before you take your property to market. Know the tax impact to you of the sale and create a strategy for the proceeds. - will you pay the tax or exchange the gain into another building? What contract form will you use to execute the sale? There are some good standard documents such as the AIR Purchase and Sale Agreement, but will this contract provide adequate protection for you as the seller and enough representations and warranties for the buyer? Your commercial real estate broker should provide a complete review of the market, financing scenarios for potential buyers, and a means to vet prospective purchasers and their ability to close. Often the best buyer is not the buyer who offers the most. Finally, you should consider completing some pre sale inspections of the roof and air conditioning and adjust your asking price accordingly. You're ready. Bring on those buyers! 

Owner leasing.  Equally important in leasing your commercial real estate, is assembling your tax, legal, and brokerage team. The primary differences in a sale and lease are the tax impact to you and the nature of the relationship with the occupant - you are not generating a pile of cash that is subject to taxes and you are creating a three to five year "marriage" with the occupant. Things such as the occupant's use of the building, the occupant's credit worthiness, your means and desire to fund tenant improvement costs and brokerage fees must be carefully planned. Remember, you're not closing a sale and receiving any cash. How will you fund the costs of the transaction? You're making a credit call. What will you require from the prospective occupant to insure you receive all your rent in a timely manner?

Occupant buying. Before you jump in the car to look at the new building that popped up down the street, get yourself pre qualified for financing. Period! Will your use of a building require any special permits? If so, have knowledge of the time necessary to perfect these permits. Have a handle on your cost to move. I've seen this derail many deals when occupants underestimate this cost. Finally, create your buying entity - LLC, etc. and sit with your tax professional to understand the tax impact of owning vs. leasing commercial real estate. Ok, let's see what's down the street. 

Occupant leasing. Similar to buying in your preparation, but different in the financing. You are not seeking bank financing for a purchase. You are, however, persuading an owner to "loan" you the use of his building for three to five years in return for paying him rent. Make sure your tax returns (personal and corporate) as well as financials (personal and corporate) are complete, up to date, readily accessible and easy to forward. All owners will require a review of your credit worthiness. Submit your financials with your offer to lease. You'll save tons of time and get a speedier response. 

#CRE Professional Designations...worth it? TUESDAY Traffic Tips.

#CRE Professional Designations...worth it? Congratulations to our colleague Andrew Cheney for achieving the CRE, Counselor of Real Estate...only one of forty five in the WORLD with the CCIM, SIOR, and CRE designations. So, are these designations important? Or just a string of letters next to your name? I discuss this and much more on this week's VIDEO TIP.