Subleases

Sublease listings remind me of a half yearly sale at Nordstrom. You better get there early in the markdowns to get a deal of selection and price. The longer you wait, the price gets better but the selection wanes until your only choice is an XS purple long sleeve tee. But. The price is unbeatable. If you’re like I am, an XS tee only has once use - that of a dish rag. But I digress. 
 
Much has been ballyhooed about the amount of industrial space coming back to the market - so I did a little research. My trusty spreadsheet is not quite as robust as Jonathan Lansners, but I made it work. 
 
As a quick review, a sublease is a remnant sale of sorts. When an occupant originates a lease agreement, the contracts vary in length. Depending upon the size of the premises, lease terms range from 2-10 years. Many times smaller buildings mean shorter leases. If an occupant can’t - or doesn’t choose to - fulfill the term obligation, they’re faced with three choices. These are a buyout from the owner, a default, or a sublease. A buyout is best for the tenant as they are relieved of the remainder for a fraction of the cost. Since the owner takes the risk and expense of finding a replacement, the situation must be quite compelling. A default is least palatable for both parties - owner and occupant. Subleasing is a nice compromise. The tenant markets the excess space in hopes of locating a surrogate to live out its lease term. 
 
So, on to the numbers. 
 
Presently, in all of Orange County, 92 listings in excess of 50,000 square feet exist. Of these 92, 12 are subleases or 13%. Los Angeles county came in at 497 listings, 73 subleases for 14.6%. Inland markets, spanning that vast swatch of industrial space to our east, clocked in at 245 listings of which 34 were subleases or 13.8%. Most of the give backs appear in square footages above 100,000 square feet. As an example, in the IE the percentage jumps to 16%!
 
Ok, you may be wondering, why does this matter. Allow me to expand on a few reasons. 
 
Market impact. The most valuable subleases in the industrial market closely mimic that of a direct lease. By that I mean the term is long enough for an occupant to spread his moving costs over a period of time. Using our Nordstrom half yearly sale as an example, a beautiful suit in your exact size at a 30% discount is much more appealing that one two sizes too big which will then need expensive alterations. Your savings are eaten up by the expense of making it fit. Plus, in some cases, all sales are final and you can’t take advantage of Nordstrom’s generous return policy. Subleases are similar because all sales are final. Your benefit is in the discounted price - not in other concessions such a tenant improvements. 
 
Additionally, subleases have a downward push on market lease rates. Of the 12 buildings currently available for sublease in Orange County, all will trade at a rate significantly less than that direct listings. With a few of these, the discounts can be explained as anomalies. However, if a large percentage of leasing activity is with these remnants, an adjustment of pricing occurs because the pricing is driving demand. 
 
Occupant considerations. In a sublease arrangement, the tenant becomes the sub-landlord, and the surrogate becomes a sub-tenant. Many occupant/sub landlords price their sublease at a slight discount versus a direct lease with an owner. In my opinion, this is a mistake, because a sub lease really needs to pop and provide a shock and awe price to attract demand. 
 
In order to affect a sublease, you must seek and gain approval from the owner of the property. This approval may not be unreasonably withheld, but it’s a step which must be accomplished. An unauthorized sublease can create a default, which is never advisable.
 
With your surrogate in place, don’t forget you, as the tenant, are still ultimately responsible for the lease obligation. Yes, you’ve located someone to pay the rent in your stead. However, if they fail to pay rent or break another lease covenant, the owner may look to you for a remedy.
 
Owner considerations. If your tenant is financially viable, and has simply outgrown your building thus the need for a sublease, your position is generally pretty solid. If, however, your occupant is struggling for other reasons, such as a downturn in business, or an industry collapse, it’s important to pay close attention to their process of locating a surrogate. Depending upon your tenant’s lease rate compared to the current market rents, it might make business sense to allow your tenant to buy out of their obligation. Under this circumstance, you take the risk of finding a new occupant, but avoid a potential bankruptcy by your tenant which could tie up your real estate for several months. Ultimately, you have the right to approve anyone that wants to sublease your building. As mentioned in the paragraph above, this cannot be unreasonably withheld, but it’s well within your purview to require a use compatible with your building to be sought along with a financially viable group.
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.