Commercial real estate is a very dynamic industry. Businesses themselves are always changing, which impacts the buildings they occupy. Every year, several of my clients will realize that their space is no longer functional for their needs.
Let’s say your company has just completed a reorganization, recently acquired a competitor or is experiencing exponential growth, and one of your facilities is no longer functional for your needs. Faced with the prospect of spending money unnecessarily on space you’re not using, it’s important to fully understand your options.
Surplus commercial real estate can result from a variety of situations—not just those mentioned above—creating a challenge but also an opportunity. As commercial real estate professionals, we are often tasked with marketing sublease space and helping our clients identify the best possible outcome for their excess space.
Subleases are among the more complex assignments we handle. However, with the right guidance, your company can make the most of the possibilities.
Economic Recovery Options
Companies don’t sublease space to be opportunistic or take advantage of the market, but rather as a reaction to a change in their business. If you’re facing a situation in which you have surplus space, the goal is to recover the greatest amount of rent obligation, hence cutting your losses and mitigating risk.
The result of marketing efforts will be one of two solutions: a sublease or a lease cancellation.
The ideal scenario is to sublease to a quality company that will match the remaining lease term. This will yield the greatest recovery for your company. With real estate lease rates and OPEX increasing 2-3% annually, the market can sometimes outpace an existing lease, creating a value option to prospective subtenants that need similar space. However, it takes time to complete all the steps necessary for a sublease—such as securing the master landlord’s consent—so plan accordingly.
We recently completed a successful sublease with a company that had committed to a space they couldn’t fully use. The client engaged us to market 135,000 square feet (sf) of warehouse space for sublease on a 10-year lease term, with an early termination option at five years. Within 60 days, we had a prospective subtenant and secured the sublease up to the termination option at the full rent amount. With expenses and free rent to accommodate minor improvements, our client realized a 96% recovery
In the event the would-be subtenant requires longer-term or extensive improvements for the space to work with their operation, a lease cancellation will be a better solution. In this case, the master landlord would strike a new lease with the prospective tenant and negotiate a lease cancellation with your business.
We also have a recent example of this approach. We had been engaged to market 125,000 sf of warehouse space for sublease, with only 18 months remaining on the lease. It took some time, but we procured a long-term tenant for the space, with our client paying the landlord just two months of rent to terminate the lease. In this situation, this is an ideal solution, since it removes all liability associated with remaining responsibility for the lease.
If you decide to initiate a sublease, you need to address several important items beyond the sublease rate, length of term and operating expenses (although those are always the first topics of discussion). Some top issues include:
- If the subtenant is only subleasing a portion of your overall footprint, it is better to leave utilities in your company’s name and bill internally for pro-rata share. If the subtenant is taking the entire space, transfer utilities rather than re-establish each service to avoid inspection delays.
- In the event a subtenant needs improvements, your company, as the sublandlord, would be responsible. However, most of my clients aren’t in the real estate business and don’t have the expertise to deliver improvements. A good solution is free rent in lieu of tenant improvements, which can help with the expense of needed repairs or modifications—subject to master landlord approval, of course.
Certificate of occupancy
- Before taking occupancy, the subtenant will need a CO, and the facility will need to pass inspection of life-safety systems. To avoid delays, it’s better to identify any issues that will cause an inspection to fail upfront.
- While this is typically subject to the subtenant’s credit, it’s important to consider the level of transaction expense.
- These should be outlined within the listing agreement but addressed upfront and contemplated in the original recovery analysis to avoid confusion later.
Sublease Rights in Master Lease
The “sublease and assignment” provision in the master lease outlines the rights of the tenant. It involves a few extra steps and potential pitfalls:
Credit of subtenant: The prospective subtenant must be credit worthy. Although the sublease is subordinate to the master lease and your company, as the tenant, is still on the hook for the lease, any building owner will have a hard time swapping investment-grade credit for a group that may not be able to keep up with the building expenses.Proposed use: The use needs to be compatible with the space, the property’s image and, to be honest, to the master landlord’s liking. A dirty use, or perceived unattractive use, will be a problem for a landlord and may become justification to withhold consent to the sublease.
Sublease profits: A master landlord may participate in sublease rent that exceeds the rental obligation depending on the split outlined in the master lease. Hopefully the tenant has negotiated some sort of profit share, such as a 50/50 split with the landlord; otherwise, there is no motivation to increase the rent beyond the master lease.
Landlord expenses: All landlord expenses related to consent will be tenant’s responsibility. A few thousand dollars for legal review is appropriate, so plan on it in initial assumptions.
As simple as the sublease process may appear, it can actually be one of the more difficult transactions to execute. As we have learned in working with our clients, it’s better to uncover potential issues, such as those outlined above, early in order to set expectations and avoid situations that will never get approved by the landlord.
If you decide to embark on a sublease, remember that these transactions are team efforts. Be sure to find a commercial real estate broker who is a local expert and has experience with subleases in your area. Then, throughout the process, you and your broker should err on the side of over-communication among the landlord, tenant and subtenant to ensure a successful outcome.