Friday, June 17, 2016

The Yin and Yang of Commercial Real Estate Subleases

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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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