Subleasing is a common method of occupying commercial property as opposed to executing a conventional lease directly with a landlord. The most common reason a tenant (sublessee) subleases space is to save money and time. Subleases are almost always priced well below the fair market rates for comparable properties, already built-out and often include furniture fixtures and equipment at no additional cost.
“Subleases are often a situation where ‘one company’s rain is another’s blue sky,’” says Robert Chavez, founder and CEO of Guardian Commercial Realty. “One company no longer has the need for a particular leased space but still has term remaining on its lease. Rather than pay an exorbitant buy-out fee or let the space lie vacant, the intelligent play is to market the space for sublease to a third party and offset some of the costs.”
Smart Business spoke to Chavez for more about what to consider before signing on for a sublease.
In what situations does a sublease make sense?
Most subleases are small to medium sized premises. Landlords are able to offer myriad space configurations and construction allowances to suit a tenant’s particular needs. However, tenants subleasing space (sublessors) are much more limited. While there may be a few exceptions, sublessors are only able to offer their space in its existing configuration because the cost to reconfigure or divide the sublet premises is prohibitively expensive. Any material changes to the space would defeat the purpose of subleasing it. Moreover, the sublessor is hemorrhaging money every month that its sublease remains vacant. Accordingly, they are motivated to price the space aggressively, sublease it quickly and cut their losses.
What risks exist for sublessees, and how can they be addressed?
While subleasing space may sound like a simple and mutually beneficial option, and it oftentimes is, companies are well advised to exercise caution and diligence in several key areas.
First, always ask to see the sublessor’s audited financial statements. Imagine spending the time and money to move into a new sublease space only to have the sublessor default on its master lease during the term. The underlying landlord may have the option to either terminate or materially alter terms of the sublease. The sublessee is then forced to vacate or renegotiate at less favorable terms. This is obviously not what the sublessee bargained for and could have very damaging economic and logistic consequences. While reviewing financial statements is not a guarantee that a sublessor will never default, it is nonetheless a prudent exercise that provides the sublessee sufficient information to make an informed decision. If the sublessor refuses to provide the information, that is likely a warning sign of bad things to come.
Next, make certain that you can pay rent to the landlord directly in the event of a default by the sublessor. This is often referred to as a Right-to-Cure Provision. Negotiating such provisions can be more complicated than they first appear. The landlord often wants the full rent as set forth in the lease as opposed to the discounted sublease rent. It is important to have a qualified professional negotiate this clause for you as the rationale and leverage points may not be obvious.
Be sure to request and review a copy of the underlying lease and any related addenda. Understand the obligations of each party, how they interrelate and how you can be adversely affected. The boring-but-important clauses like indemnification and operating expense escalations can be very significant.
Subleases also require more documentation than conventional leases. There is the sublease itself, the landlord’s consent agreement and the underlying lease, including any addenda. This will require extra time to negotiate and will involve multiple parties, as opposed to just two. The landlord’s consent alone can add up to a month of extra time waiting for the landlord to officially respond, so be sure to plan for it.
Last, it is a very good idea to request a copy of the sublease provisions from the master lease before commencing detailed business point negotiations. The sublessor will not likely provide the entire lease until a letter of intent (LOI) is agreed upon, but that may be too late. I have seen leases with subleasing restrictions so egregious that the sublease could not be consummated and months of previous negotiations were wasted. For example, some leases contain provisions prohibiting subleasing to existing tenants in the building, or to potential tenants that have recently submitted proposals to the landlord for direct space. It would certainly be nice to know what sublease restrictions exist before getting started.
Do you advise tenants to enter into a sublease?
Subleases can be a terrific value under the right appropriate circumstances and if properly negotiated. Just be sure to do your homework and consult with a professional so you get the full benefit of your bargain absent any surprises.
More next month on what you should be aware of if you are a tenant who needs to sublease its space.
Robert Chavez is the founder and CEO of Guardian Commercial Realty. Reach him at Robert.Chavez@GuardianUSA.net or (310) 882-2060.