The sublease market has been one of the few "growth" opportunities in the office sector during the past few years. Fueled by massive corporate restructuring and downsizing, companies have placed tens of millions of square feet of office space on the market during recent years. It is important to know how valuation and marketing of sublease space can differ significantly from direct lease space. Being aware of the similarities and diversities can mean the difference between a company signing a subtenant or continuing to pay rent through the remaining leasehold term.
In most cases, the reason sublease office space becomes available has nothing to do with the real estate market. Most likely, a company has decided to downsize, change geographic locations, sell off divisions or subsidiaries, or otherwise restructure company operations. As the office market has begun to strengthen around the country, companies are paying closer attention to how much leasehold obligation can be salvaged through subletting, or similarly, positioning the space so that a lease termination fee less than the actual leasehold value can be accomplished. In many cases, the company automatically writes off the remaining cost of the leasehold interest, and has no thoughts of salvaging the value of the leasehold through subleasing the vacant space.
But by subletting available space, a company can reverse some of that lost rent. Instead of paying rent on unused space, a sub lessee may take over the terms of the lease, turning a negative cash flow into income.
In a tight office market it may be possible to actually profit through a sublease. However, this is the exception and not the rule. Many leases contain either a recapture clause, or a shared sublease profit clause. In the recapture clause situation, the tenant must undertake locating a suitable, credit worthy replacement tenant and the landlord then has the option to terminate the lease and sign a new lease, usually at the higher market rate. In some instances the former tenant may even be required to pay for the replacement tenants improvements, and in almost all cases the financial upside goes 100% to the landlord. With a shared sublease profit clause, a predetermined formula is set forth in the lease, with or without the cost of leasing commissions, tenant improvements or other expenses taken off the top before net savings are shared.
Companies may still need to look at any sublease revenue as bonus income, but also must face the subleasing challenge realistically. Even in a tight market some available sublease spaces are never sublet, and the tenant company pays rent throughout the term even though the space is marketed. This is a factor of the marketplace, and a broker who is overly optimistic about getting a subtenant in spite of all the pitfalls is doing his or her client a disservice.
Reviewing the Options
Sublease situations can be handled in four ways: the buyout, the sublet, the recapture and the write-off. The first and "cleanest" from the tenant standpoint is the buyout, in which the tenant negotiates with the landlord for a cash settlement that releases the tenant from all remaining leasehold obligations. Many owners in today’s difficult office market are unwilling to release a tenant without having a replacement tenant lined up, unless the buyout price is large enough to outweigh the risks and expenses of finding a new tenant. The greater the credit of the existing tenant the more reluctant most landlords are to take back the space. In some cases, landlords will ask for the entire remaining term to be paid upfront. For some corporate tenants, getting the lease off the books is worth this immediate write down and cash payment.
To increase the tenant’s bargaining position, the second approach, subleasing, is used. Once a sub lessee prospect is located, the tenant approaches the landlord. Depending upon the credit of the prospect and scope of tenant improvements needed, a buyout may be more easily achievable because the landlord doesn’t have the retenanting risk. It’s important that the tenant verify the credit for any potential sub lessee because in most cases if the subtenant defaults, the primary tenant remains liable for the leasehold obligation.
In the recapture situation the space is aggressively marketed with the objective of locating a longer-term tenant willing to pay market rent. This potential tenant is brought to the landlord who then recaptures the space, signs a lease directly with the prospect, and terminates the existing leasehold.
The fourth approach for a tenant is to simply write off the remaining term, pay the rent on the vacant space, and not attempt to sublet the space.
Negotiating a Three-Way Deal
Subleasing is more complicated than direct leasing. For one thing, when subleasing, additional parties are involved in the negotiation process. Rather than a two-party, landlord-tenant negotiation, negotiations tend to be triangular: owner-tenant-sub lessee. The landlord’s consent is required for most subleases, especially if the original lease must be changed, if the lease needs to be extended, or if the sub lessee requires tenant improvements. The tenant and sub lessee may agree completely and only the dissenting landlord prevents a successful sublease. It’s important to get the landlord’s cooperation from start of negotiations. If you have identified the landlord’s goals and reservations in the initial stages, the entire sublease process will be less painful.
An additional difference is the lease document. In a sublease, the sub lessee agrees to the terms and conditions in the primary lease. Negotiating changes with the landlord adds to the transaction’s complexity, as the landlord may not make the same lease concessions for a sub lessee as he or she did when dealing with a new prospect for a direct lease. A landlord may have granted "personal rights" to the original tenant that are not transferable to a sub lessee. This commonly happens with amenities such as parking rights and expansion and renewal options. The landlord may have valid reasons for initially making these rights "personal," such as the specific credit of the tenant or the size of space initially leased. These items should be identified at the beginning of the sublease assignment and, if they are critical to the leasehold, the sub lessee should attempt to find out from the landlord under what conditions these rights would be transferable.
A critical distinction between subleasing and direct leasing is the length of the remaining lease term. In direct leasing, the landlord can offer three-, five-, or even ten-year lease terms, with the possibility of lease extension options. But because the sublease term is limited by the remainder of the primary term, the value of the leasehold may be greatly reduced if the remaining term is less than five years. Many companies do not wish to move into an office suite for only a one- or two-year period and then have to relocate. This problem may be alleviated if the landlord is willing to either sign an additional new lease directly with the sublet prospect or to sign a new lease beginning at the expiration of the original lease.
One last difference between sublease and direct lease space is the potential for some tenants to offer furniture and telephone systems as part of the sublease package. This may represent substantial savings to the prospect, and may outweigh the salvage value to the tenant if these systems were removed from the space and sold separately.
Keeping a Competitive Edge
Available sublease space competes not only with direct-lease office space in the marketplace, but also with other sublease space that is offered at greatly reduced rental rates. It might also be directly competing with the landlord’s space within the same building. In some markets, large blocks of available office space or premier spaces are scarce. When such a space is available through a sublease, its competitiveness and leaseability increase.
In general, benchmarks of a competitive sublease office space include:
A remaining lease term in excess of three years
An open layout or generic office buildout
A flexible and cooperative landlord
A highly motivated sublessor
A short-term lease can be a major stumbling block not only in allowing the space to be competitive, but also in dealing with tenant improvements. The economics of amortizing even a small amount of improvements over a short term may be unworkable. For example, using a 12% interest rate for tenant improvements that cost $10 per square foot, the cost to amortize the improvements over a five-year term is $0.22 per square foot per month. This same $10 per square foot over a 20-month sublease term is $0.55 per square foot per month. Tenant reconstruction might additionally involve substantial costs in retrofitting the building due to changes in the fire, life-safety, and disability code or requirements. The landlord might view this as an investment building, but to the tenant who is trying to cut losses, building rest rooms for the disabled or fire-rated corridors takes on a different meaning. These issues must be carefully analyzed in the initial stages when a tenant is deciding whether to sublease their office space.
The tenant may prefer to offer free rent or rent credit toward the subtenant’s tenant improvements rather than do the renovations for the sub lessee. When a space exceeds 3,000 square feet, rarely will an office tenant move into it without any alterations, even if they include only minor repainting, new carpeting, or minimum wall changes. In a number of instances the potential sub lessee may not be prepared to undertake tenant improvement construction, and the sublease opportunity may be lost if the space is not renovated for the subtenant. Many Fortune 500 corporations are not structured to undertake their own interior construction, including even minor changes, and will instead prefer to relocate using a direct lease with which the corporation is more familiar. If the sublessor can offer tenant improvements, the sublease space may be better able to stay competitive.
Another option is to divide the space into smaller sub-leasable areas. A qualified architect, tenant improvement contractor, and subleasing contractor, and subleasing specialist should be brought on board in the very beginning to help identify costs. Their input may determine whether the space can be subdivided, and if so, how to best do it. Having the space planner and contractor on board in the initial stages helps to lay out the space and identify potential subdivision strategies. The tenant may decide that an "as-is," all-or-nothing sublet will recapture more rent at greatly reduced rental rates than dividing the space with a tenant improvement allowance and offering the space at dramatically higher sublease rents. On the other hand, a tenant vacating a portion of their space might also consider the overall economic impact of vacating the entire space, if this greatly increases the chance that the space will be sublet.
Putting a Price Tag on Space
Factors that help determine the price of the sublease space include the existing layout, the condition of the local office market, the length remaining on the primary lease, and the overall contract rent as compared with market rents. In some instances the space might be priced at or above contract rate and still be competitive. This might occur if the original lease rate was below market, if transferable landlord concessions were substantial, or if the office space was in a particularly well-located and desirable building. But in most cases a discount is involved, and this can range from 20% to 75% of the current lease rate. The leasing agent will be able to provide market survey information that will enable the tenant to price the sublease space appropriately. Because a sublease is time-sensitive, it might be prudent to aggressively market the space with the price substantially discounted from the onset of the sublet. An alternate strategy would be to market the space at a slight discount if the space still remains available after 90 days.
A tenant may offer different prices for subdivided space that has different floors or different views. For example, large blocks for space might be offered at a lower rental rate than smaller areas. Careful initial planning is important-if the premium space is leased first, the remaining space may be rendered almost unleaseable.
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