Looking for a great deal on office space? A sublease may be the answer. Subleases are often attractive to businesses as they offer a low cost, flexible, turnkey solution. Start-up companies and established companies can find subleases to be a great opportunity. They are, however, not without challenges and risks. In this post, I discuss the advantages and disadvantages of subleasing and how businesses can navigate the sublease process to get a great office space that will help propel their business.
Sublease Advantages As most tenants who are looking to sublease their space are doing so as a matter of cost reduction and not profit, subleases offer the following:
- Low Cost Rents are typically discounted as the term length tends to be shorter than a direct lease and as a way to entice a subtenant to take the space “as is” without having to contribute any further money to renovate the space (unlike a direct lease where the landlord is offering large cash allowances for improvements). In keeping with that thinking, where improvements are needed, a tenant/sublandlord will typically offer a period of free rent to allow the subtenant to offset their cost for improvements.
- Flexibility As most subleases are for a shorter-term, they offer flexibility without the long-term commitment of a direct lease.
- Minimal Capital Investment: Turnkey As most subleases come fully furnished and constructed, the space may be “turnkey” ready; thus, subtenant’s investment is minimal, i.e., telecommunications cabling, etc.
- Speed Unlike a direct lease that may require several weeks for construction, the space is likely ready for immediate occupancy.
- Minimal Security Deposit As tenants/sublandlords are looking to “stop the bleeding” and their transaction costs are less (brokerage, attorney and landlord review fees) than a direct lease that typically includes large construction costs, a tenant/sublandlord’s requirements for lease securitization from the subtenant are typically less.
Sublease Disadvantages In a traditional lease, there are two parties: landlord and tenant. In a sublease, there are three parties: landlord (Master Landlord), tenant (Sublandlord) and Subtenant. While the master landlord owns the building, the subtenant has no legal relationship with the master landlord. Instead, the master landlord’s relationship is only with the tenant/sublandlord and the subtenant’s relationship is only with the tenant/sublandlord. It is this disjointed 3-party relationship that is the root of the challenges of subleases. A major misconception is that a sublease is simple to document by incorporating by reference the terms of the master lease; however, there are many issues that need to be addressed in the sublease to avoid any unintended consequences. In addition to the sublease document to negotiate between sublandlord and subtenant, there is a Consent agreement which is then negotiated among all three parties.
- Uncertainty Being subordinate to the tenant/sublandlord and not having any legal standing with the master landlord, the sublease space is dependent upon the tenant/sublandlord being in good standing under the master lease. If the lease is terminated (whether through tenant’s default or otherwise), then the sublease is also terminated, and the subtenant is left in a very vulnerable position.
- Enforcing Landlord’s Obligations By not having a legal relationship with the master landlord, the subtenant is handicapped when seeking to have the landlord perform its obligations (i.e., services) and instead must rely upon the sublandlord/tenant to enforce the lease against the master landlord. Similarly, the subtenant cannot challenge charges it receives from the master landlord, i.e., disputing operating expense charges where they are passed-through as part of the sublease.
- Inheriting Master Lease If the sublandlord/tenant did a poor job negotiating the lease, the subtenant inherits those issues. Conversely, of course, they can be the beneficiary of a well-negotiated lease.
- Protracted Negotiations As the master landlord continues to collect rent from the sublandlord/tenant, the master landlord does not share the same level of motivation with the sublandlord/tenant and subtenant. Consequently, the documentation process to negotiate the sublease and consent agreement can take longer than negotiating a new lease.
- Dead-ends If the landlord has a right to terminate the lease (i.e., recapture right) when presented with a sublease for its consent, the subtenant may have just wasted a lot of time going down a dead-end road.
Checklist To avoid the pitfalls and enjoy the advantages of a sublease, here is a checklist that prospective subtenants and their advisors should consider. I have organized these into two categories: (1) Pre-Sublease Negotiations – during business negotiations when the prospective subtenant is still considering other properties; and (2) Documentation Negotiations – after receiving the draft sublease and consent documents. While the prospective subtenant has the leverage, they should try to negotiate many of the points in this second category before the documents are drafted.
- Who is the named Tenant?
- What is the Tenant’s corporate and financial status?
- Independently verify the measurement of the proposed space.
- Does Subtenant’s intended “use” of the premises comply with the “use” provision of the Master Lease?
- Does subtenant’s business conflict with any “no competitors” lease provision
- Who is the landlord and lender?
- Determine the amount of the sublease security deposit or Letter of Credit or better yet, get it waived. See my prior post on Tenant Lease Security Strategies
- If subtenant is financially strong and instead of a sublease, would the master landlord accept from tenant/sublandlord a termination fee (a/k/a “buyout”) to facilitate a direct lease with the prospective subtenant for terms equivalent to the sublease?
- Sublease commencement should not be a fixed date, instead it should be based upon the date after which all approvals and consents have been obtained so that subtenant can legally occupy the premises.
- Carefully review the master lease and all underlying documentation (i.e., amendments, estoppel certificates, SNDA, etc.) to identify other issues to address with the tenant/sublandlord and the master landlord.
- Are there any restrictions that would preclude the sublease?
- Confirm who owns any furniture and fixtures being included in the sublease and that it is not subject to any liens.
- Related to the sublease language, confirm that the landlord does not have the right to terminate the lease (i.e., “recapture”) for any proposed sublease.
- If the sublease approval process takes too long, can the subtenant elect to terminate and nullify the sublease a certain number of days after submission of the signed sublease?
- Request a “no default” representation by the tenant/sublandlord of both the tenant/sublandlord and the master landlord.
- Under what circumstances can the master landlord terminate the lease?
- Confirm that tenant/sublandlord may not terminate the lease, except for events such as destruction, unless with subtenant’s consent.
- Determine whether lease options and rights (i.e., renewal, building signage, expansion, parking) can be transferred to the subtenant?
- For added flexibility, can subtenant sub-lease or assign this sublease?
- If the sublease is for a portion of the total premises, is the space fully separated in accordance with applicable laws?
- For a sublet of a portion of the premises, address issues of sharing common areas, kitchen, telecommunications, etc.
- How are utilities being allocated?
- Where the subtenant is planning to make renovations to the premises, obtain as part of the consent document, the master landlord’s necessary approvals per the master lease requirements.
- While the subtenant may be required to remove any alterations, the subtenant should not be required to restore alterations made by tenant/sublandlord and/or existing before the sublease term commencement date.
- If the Master Lease is terminated, does subtenant have a reasonable time to vacate?
- Provide that tenant/sublandlord shall not agree to amend the master lease in a way that would adversely affect subtenant.
- Request a “Recognition Agreement” from the master landlord that, should there be a default in the sublease by tenant/sublandlord, the subtenant would have the right to cure and preserve the sublease.
- Master landlords are reluctant to provide such recognition agreements as it limits their rights to market the space to an outside tenant that may pay a higher rent. As an alternative to the recognition agreement, subtenant should request that master landlord provide subtenant notice of tenant/sublandlord’s defaults and allow subtenant the right to cure.
- Request that the tenant/sublandlord indemnify the subtenant for any liabilities it incurs due to default under the lease and any liabilities caused by tenant/sublandlord.
- To enforce master landlord’s obligations to provide services (i.e., HVAC, electric, etc.) and without a legal relationship with master landlord, subtenant should require that tenant/sublandlord diligently enforce the obligations of the master landlord.
- To motivate the sublandlord to enforce the master landlord obligations, does the subtenant have the right to withhold paying sublease rent if sublandlord is not diligent in enforcing?
- Additionally, should master landlord fail to provide services, subtenant should have the right to sue landlord on behalf of tenant/sublandlord, i.e., subrogation.
- Confirm that sublandlord is paying all master landlord reviews and brokerage fees associated with this transaction.
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax or architectural advice. Please consult with the appropriate professional(s).
Blackacre Advisors LLC
DISCLAIMER. Our writings are from a real estate transaction perspective and for informational purposes only. Nothing herein shall be considered legal, accounting, tax, or architectural advice. Please consult with the appropriate professional(s).