Particularly because of the topic of this post, I want to remind our readers that the thoughts we share with you in this and all of our posts are those of a licensed IL managing broker. Accordingly, please do not confuse them with legal advice!
Commercial Real Estate Subleasing
Commercial real estate defines property that is able to be used for a business use. Generally, commercial real estate can also be defined as property that is owned with the purpose of earning money for its owner. Depending on its zoning, a property can be used for commercial purposes, even though it may also be zoned to allow a residential use.
A commercial real estate sublease refers to a situation in which one commercial tenant, we call them the direct tenant, leases its space to a second commercial tenant, which we call the subtenant, instead of the second tenant leasing that space directly from the building owner. Subleasing, also known as subletting, results in the first tenant maintaining its leasehold interest in the Leased Premises, even as it grants to the second tenant, through the sublease, a subleasehold interest in the same Leased Premises. If the first tenant subleases all or part of its space to a second tenant, the first tenant’s name will still be on the lease. In fact, that’s the only tenant named on the lease. And, here is no conceptual reason why there cannot be a succession of subtenants – the direct tenant to the first subtenant, the first subtenant to the second subtenant, and so forth. The lease between the direct tenant and the landlord is usually called the underlying or master lease, in the context of a sublease.
Subleasing or Assignment
Don’t confuse “subleasing” with “assignment”. They are not the same thing. In most office leases, there is a clause or section of the lease that is entitled Subletting and Assignment which defines the respective rights and obligations of the tenant and the landlord that are created by the lease. One important distinction between these two ways of transferring all or part of one’s leasehold interest to a third party is that with a sublease the sublandlord remains contingently liable. We will leave to the attorneys, discussion of assignment.
By entering into a sublease, as the Sublessor, you are transferring to your Sublessee, for a specific period of time and at other terms that are memorialized by the Sublease document, part of your rights and privileges relating to the property. The formal name for those rights, as mentioned above, is “leasehold”. And the rights and privileges enjoyed by the sublessee are its “subleasehold”.
Negotiable Terms of the Commercial Real Estate Sublease
As the saying goes, everything is negotiable. In fact everything is not, but many things are. When considering a sublease of your commercial property, you have multiple options. You might choose to sublet some or all of your space in order to defray the rental expense, especially if you no longer have a need for the space. That might sound pretty familiar since the pandemic! If you choose to sublease only part of the space, you can continue to occupy the remaining area or sublease it to another third party. Whether you sublease all or part of the space, the length of the sublease is negotiable and might be for the entirety of your remaining lease term or for only a part of that period. All terms of a proposed sublease are negotiable by the sublandlord and prospective subtenant. And, generally, all terms of the proposed sublease are subject to approval by the landlord. For that reason, we recommend, when possible, providing the landlord a draft of your proposed sublease, for them to provisionally approve, if they will be so kind as to do so. That arrangement is often possible to negotiate into your lease.
Commercial leases specify multiple conditions according to which the original tenant, also called direct tenant, may and may not put in place a sublease. Those are some of the rights and obligations referred to above.
Limitations and Barriers to Subleasing a Commercial Property
You may sublet your commercial space to another party only if your lease agreement allows for it. Anyone negotiating a lease should know the importance of negotiating its terms, so as to facilitate a possible future sublease and remove multiple obstacles that would otherwise prevent you from entering into a sublease.
A commercial leasehold does not necessarily confer the unfettered ability to sublease your space to any third party. Typically, the landlord will retain the right to approve or disapprove a proposed sublease transaction. Two lease clauses typically bear critically on this dynamic.
The Use Clause in Commercial Real Estate
The Use Clause defines what kind of business activity may be conducted in the office space. For example, if the Use is defined as “public accounting”, then no other type of business activity may be allowed by a proposed subtenant. In such a case, the landlord would be able to decline to approve the proposed sublease, specifically because the proposed use is not public accounting. So, just because you might be a CPA firm and have no interest in conducting any other business activity in your space, you should NOT specify public accounting as the “defined use”.
But, even if the Use clause is favorable because it is not narrowly defined, the building owner has the right to ”reasonably” disapprove a proposed sublease based on other factors of the proposed subtenant, including: its creditworthiness; the amount of visitor traffic that can be expected; even its reputation!
A subtenant is fundamentally reliant upon the good standing of its sublandlord. In other words, the Subleasehold interest exists only through and as long as the direct leasehold interest exists. If the sublandlord defaults on its obligations under the original lease, it loses its leasehold and the subtenant loses its subleasehold. Then the subtenant will need to negotiate a new lease directly with the landlord, if it wants to retain occupancy of the space. Other critical lease language is contained in the aforementioned Subletting and Assignment clause, as well.
How to Sublease Your Commercial Property
Step 1: Look at the Use and the Subletting & Assignment language in your lease agreement.
Because the lease is a binding contract between the landlord and the tenant, no part of the direct lease can be changed simply by agreement between the sublandlord and the subtenant.
Review your lease to check if and under what conditions you are allowed to sublease all or part of your space. It’s nearly certain that, if your lease allows subleasing, you will be required to get the prior written consent of your landlord. If your lease does not allow you to sublease, you can attempt to negotiate with your landlord to allow you to do so. (Obviously, the right time to negotiate the Use and Subleasing clauses is before signing your lease!) The easiest, and likely the most successful, way to negotiate your lease agreement is to utilize the services of a broker who specializes in the representation of commercial tenants. Such professionals are skilled in the process of undertaking and successfully completing exactly this type of transaction.
Step 2: Determine if there is sufficient financial benefit in attempting to sublease some or all of your space
A safe assumption is that it will be costly to effectuate a sublease. Should you bother?
Review the economics of your lease to identify your “current escalated gross rental rate”. Then compare that to the market for equivalent spaces, against which you will be in competition for a subtenant. Those other spaces can be both direct-lease and sublease opportunities.
The likely costs to you will include these line-items:
- A commission payable to the broker representing the subtenant;
- And a commission payable to the broker that represents you;
- At least minor redecorating – for example new carpet and paint;
- If the sublease is for part of your space and you don’t want to have a space-sharing arrangement with your subtenant, you will need to divide the two spaces with a “demising partition” and if you and your subtenant want to have separate electrical and HVAC systems, they will have to be made separate;
- Unless your lease is “below market”, you will have to consider discounting the rent that your subtenant pays you, compared to the rent that your lease obligates you to pay;
- Legal Fees for your attorney; and
- Legal Fees for your landlord’s attorney’s review of the proposed sublease.
Step 3: Give notice
Before taking further steps to accomplish a sublease, seek the tentative approval of your landlord to the proposed sublease. They might just give it!
Step 4: Find a proposed subtenant
Using the services of an office tenant representative should also provide powerful marketing reach. That’s because most such brokers can publish the sublease opportunity in the state-of-the-art resource called CoStar, which makes information about your available sublease widely known, especially to the tenant-rep community. They know most of the tenants that are in the market. Members of the tenant-rep community who are looking for space in your market can then bring your sublease opportunity to the attention of their respective clients.
Step 4: Draft and sign a commercial sublease agreement
Once you find a creditworthy prospective subtenant, you need to draft a commercial sublease agreement to define the terms of their subtenancy. Generally, a direct lease can be around forty pages long, without exhibits, while a sublease can be as short as three pages or so. As stated earlier, your direct lease with your landlord remains binding on you. The proposed sublease agreement will not and can not change anything at all about your lease. This means that if your subtenant defaults on its sublease obligations, you remain liable for paying your full rent to the landlord. That is the chief significance of contingent liability. You are also liable for any infringement of the Rules & Regulations of your lease that is committed by your subtenant.
Pros and Cons of Subleasing Office Space
There are positive aspects for both parties to a sublease. But subleasing also involves complicating factors, which may or may not make it a desirable solution. Generally, the credit worthiness of both subtenant and sublandlord are at the heart of the matter. As you can appreciate, some of these are reasons for which subleases are generally discounted to market.
- From the subtenant’s perspective, subleasing office space is expected to save money, because subleases generally are significantly discounted, compared to leasing the same space directly from the building owner. However, as stated above, the subtenant’s rights to the space are secondary, because they are dependent on the original tenant remaining current with the rent. If your subandlord defaults, then your right to occupy the space under the discounted terms of the sublease are automatically ended.
- And rarely does the building owner make any contribution to pay for modifications to the sublease space. That expense is borne by the sublandlord and/or the subtenant, if the building owner agrees to allow any changes to be made.
- Subleases are generally for relatively short periods of time, compared to direct leases.
- Once the sublease expires, if the layout remains useful for the ongoing purposes of the sublessee, it may be able to remain in the space as a direct tenant with a rental rate that is still discounted to market. But that’s only because the building owner does not have to invest the typically expected amount to rebuild the space.
- Often, if it’s desirable to the prospective subtenant to secure a lease term that is longer than the length of the remainder of the direct lease, it can negotiate the sublease terms with the direct tenant, the sublandlord-to-be, and separately negotiate an extension, which is sometimes called a wrap-around lease, directly with the building owner. For example, the sublease term might be 19 months and the wrap-around lease might be for an additional 41 months, for a total of 60 months.
- From the sublandlord’s perspective, subleasing is a way to defray the cost of space that is no longer needed for its own business operations, whether for the full remainder of its lease term or for only part of that time period.
- Occasionally, as the years elapse, the economics of a commercial lease come to be below market. Sometimes they are sufficiently lower than market to present an arbitrage opportunity for the benefit of the sublandlord. A typical part of the Subletting and Assignment clause is the requirement to share with the building owner any profit that might result from a sublease. Sometimes, in spite of that, it’s possible to actually make a profit by being the sublandlord. Sometimes! When negotiating your direct lease, take care to negotiate that any profit from a future sublease of your space will be calculated after netting out your expenses to effectuate the sublease.
Sublease Office Space
In our experience as office tenant representatives, we have found that the best approach for the prospective office tenant is to investigate both direct-lease and sublease opportunities. And, unless the prospective tenant specifically desires an unusually short lease term, a direct lease offers more flexibility with regard to both length of lease and layout of the office interior. At MAP Real Estate, we generally first identify direct lease opportunities for our clients and then compare the best of them to what we can accomplish in the sublease market.
MAP Real Estate, Inc. will assist you in all of your commercial real estate needs.
A Closing Thought
During the last 35 years, I recall a single period during which subleases became more expensive (aka valuable) than direct lease space, equalizing for class of building. In other words, the normal correlation between shortness of remaining lease term with deepness of discount became inverted. The shorter the lease term, the more valuable was the space. It was during the dotcom boom. The apparent explanation was fierce competition among start-ups on meteoric growth trajectories. That made sublease spaces that were in move-in condition with very little remaining lease term more valuable. Ordinarily, the shorter the remaining term, the deeper the discount to market. Conversely, the longer the remaining lease term available for the subtenant, the lower the discount of the sublease rent to the market rent for the same space, if it were leased directly from the building owner.
Now we are in this pandemic and there is a lot of space being offered on the sublease market. That makes it very competitive.
The information presented in this article is not legal advice, is not to be acted on as such, may not be current and is subject to change without notice.