As most businesses continue to work remotely after nearly a year, many are looking to shed excess office space, as seen by the record number of sublease spaces listed nationally. While office leases are long-term agreements, tenants do have avenues to dispose of excess office space and/or exit leases early. Outlined below are strategies tenants should consider in this regard.
The first step is to carefully review your lease (and any amendments) with your tenant representative and your attorney. It is imperative that you fully understand your rights and limitations when exiting your lease or downsizing.
Does your lease contain any express rights for you to terminate and/or reduce your space?
Early Termination Right Savvy tenants frequently have a termination option in their lease. It is usually a one-time right exercisable on a defined date with advance notice (i.e., 9 to 12 months) and payment of a termination fee. The termination fee is usually due at the time of notice, but it may be 50% at notice with the remaining 50% upon the effective termination date. The termination fee’s rationale is to reimburse the landlord for the lease transaction costs (i.e., commissions, construction allowances, concessions, and legal fees) plus a couple months’ rent to compensate for the downtime to find a replacement tenant. The termination fee formula is typically the value as of the effective date of termination of the unamortized lease transaction costs (based upon a stated discount rate), plus two to three months’ rent. If your lease was carefully negotiated, the fee formula should be well defined and possibly quantified. As a practical matter in negotiating a lease, it is prudent to create a mechanism where the parties will quantify the termination fee following the lease commencement after an accounting of all transaction costs. Otherwise, it could be a real challenge to account for these costs years after the lease is signed.
Contraction Right Another lease relief right is the contraction right. Analogous to the termination right, a contraction right allows the tenant to reduce (or contract) a defined portion of their space on a defined date. Like the termination right, most contraction rights require 9 to 12 months’ prior notice and payment of a contraction fee following the formula for the lease termination fee for the area being contracted. Additionally, a contraction fee may include the costs to subdivide the space which can be costly if it was not carefully defined in the lease.
Surrender Liability As part of your lease review, pay close attention to the lease surrender requirements. This provision will state what restoration work, if any, the tenant will need to complete upon lease termination. For tips on how you can limit your lease surrender liability, please see my blog, How Tenants Can Limit Lease Surrender Liability
Lease Buyout If you are fortunate to have such a termination and/or contraction right in your lease, but they are not available anytime soon, you still may be able to employ them in negotiating with your landlord for an early termination or contraction, i.e., “lease buyout”. Absent such rights, tenants still are free to negotiate with the landlord a lease buyout. In any lease buyout, the landlord is looking to preserve its cash flow. As a result, the buyout or termination fee generally reflects the difference between the net present value of the remaining rent obligation (including any unamortized transaction costs) under the lease and rent to recoup from a replacement tenant (less transaction costs for the replacement tenant as well as lost rent for the time to secure a replacement tenant). In today’s marketplace, however, most landlords are going to be reluctant to take back any space without a replacement tenant in hand and would not discount much (if at all) the remaining obligation for a lease buyout. That leads to our next strategy, sublease and assignment.
Sublease & Assignment Leases almost always provide a right for the tenant to sublease or assign its space. Again, you should carefully review your lease to fully understand the requirements, restrictions, and implications of subleasing or assignment. Some of the implications of sublease or assignment are loss of rights which are deemed “personal” to the tenant, i.e., building signage rights, expansion and termination rights.
It is important to understand the difference between sublease and assignment.
Assignment When a tenant assigns its lease, they are transferring their entire leasehold interest to the assignee. In which case, the assignee steps into the shoes of the tenant and pays rent directly to the landlord. Assignments typically occur during a corporate acquisition or merger. Under this circumstance, most leases do not require landlord consent provided the acquiring company is of equal or greater net worth than the assignor. Most leases, however, do not release the assignor (original tenant) from its obligations under the lease. Nonetheless, landlords will on occasion release the assignor in the Assignment Agreement where that assignee is acquiring the tenant entity or assignee is more creditworthy or is looking for additional space or a longer lease term. Ideally, from the tenant’s perspective, an assignment or release of the lease obligation is most desirable.
Sublease Under a sublease, the tenant (sublandlord) transfers to the subtenant all or a portion of its space for a period less than the full lease term. The subtenant has no contractual relationship with the landlord. Instead, the subtenant pays its sublease rent (which is commonly discounted from the rent due under the prime lease) to the tenant (sublandlord). The tenant (sublandlord) remains responsible for directly fulfilling its obligations under the lease to the landlord. Subleases require consent of the landlord which typically cannot be unreasonably withheld or conditioned. Given that the sublease is subordinate to the prime lease, there are inherent risks to both the sublandlord and subtenant. Namely, if the sublandlord fails to perform its obligations under the prime lease resulting in default and lease termination, then the sublease is terminated. For further insights as to what subtenants should consider, please see my blog, Subtenant’s Guide to a Great Deal. Likewise, where the subtenant fails to perform under the sublease, the sublandlord remains obligated to fulfill its obligations under the prime lease. Subtenants can also cause defaults in the prime lease which should be addressed in the Sublease. In addition to negotiating the sublease between sublandlord and subtenant, a separate Consent Agreement is required to be negotiated among landlord, tenant, and subtenant. In any 3-party negotiation with differing levels of motivation, this can be a challenging and time-consuming process.
License Agreement Alternative – “Co-Working” As a less desirable alternative and if your space lends itself to a co-working, space sharing environment with multiple users, you may want to consider a license agreement as opposed to a sublease. A license agreement is commonly used by co-working companies for their customers’ use of the office space and shared services. While a license agreement would still trigger (under most leases) the landlord’s consent and approval, unlike a sublease, it does not convey a property interest which has certain legal implications. Instead, a license agreement for real property provides only a privilege to use the property for a particular purpose and is revocable at will. The advantage to the tenant is that it can more easily terminate a non-performing occupant of the space. The advantage to the occupant or licensee, like any co-working arrangement, is that it is short-term and flexible. License agreements have certain legal requirements and the process is more than simply renaming a lease form as a “License”. Be sure to consult with your attorney on the specific requirements.
Here is a checklist to successfully exit your lease or downsize:
- Read and understand the lease!
- What are the landlord’s approval processes and requirements?
- Are there any lease restrictions that would prohibit a sublease or assignment to certain companies and/or neighboring tenants?
- Is there any landlord review fee stated in the lease?
- While unlikely, if sublease rent exceeds prime lease rent, who keeps the profit? Relatedly, are sublease expenses deducted from “profit” calculation?
- Hire an experienced real estate broker without conflicts of interest, i.e., is not the landlord’s agent or an agent with competing properties.
- Instead of the traditional lease commission compensation to your broker, which is typically a percentage of the lease value, consider a contingent fee based upon the savings achieved which will better align your goals with your broker’s compensation.
- For a sublease or assignment of a portion of the Premises, does the lease allow the landlord to terminate the lease (a/k/a “recapture”) in the event of a proposed sublease or assignment?
- To facilitate a quick sublease/assignment, can all the furniture remain?
- Create a marketing campaign to include listing on CoStar and other property databases.
- Have your broker create a virtual tour of the space through such services as Matterport, which is particularly important in our COVID world.
- Have your broker prepare a pre-approved Sublease or Assignment Proposal so that you can immediately provide key business terms to any prospects.
- Likewise, have your attorney ready to draft a Sublease and/or Assignment document. Note, landlords typically have their own form Consent Agreement they insist upon using.
- As tenant/sublessor remains liable under the prime lease, it is important that the prospective subtenant/assignee be fully vetted as to its ownership structure, financial strength, and reputation. Note, most leases will require that tenant provide the landlord with financial statements for the proposed subtenant/assignee as the landlord wants to be very mindful of any occupants in the building who would not be compatible with other tenants or result in additional costs or liability to landlord.
- Is the subtenant/assignee’s proposed use permitted under the Lease?
- Are there any non-compete clauses in the Lease that would prohibit the Sublease/Assignment to the subtenant/assignee?
With an eye toward negotiating a buyout of your lease, work with your landlord, as they will be motivated to keep the building leased-up for the long-term.
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).