Dealing With Sublease Space in Your Office Building
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Dealing With Sublease Space in Your Office Building
Managing the rent roll is a high priority for all office building owners. High occupancy levels and efficient management drive net operating income performance and there are several variables which the astute investor pays close attention to. One of those variables that perhaps doesn’t get as much attention as vacancy, time-on-market, operating expenses or rent growth, is sublease space, our topic for this week’s post.
From an operational perspective, subleases add an extra level of complexity and additional risk to the property owner. In a sublease, three parties have to agree to terms rather than two, as in a direct lease, and the financial distress of the sublessor often creates the sublease scenario in the first place. A lessee/sublessor may already be struggling to meet its rent obligations while it seeks a subtenant, and may not be in a position to offer market-driven concessions to a subtenant to complete the sublease transaction. So, while the property is being marketed for sublease, it is out of the lessor/landlord’s direct control as the risk of default increases with time.
That said, the likelihood of a successful sublease depends on more than just the financial capability of the lessee/sublessor. The configuration and condition of the space relative to the competitive set also figure into the equation, as does the time remaining on the existing lease. Shorter-term subleases are particularly difficult because demand from prospective sub-lessees diminishes with time. The shorter the term, the greater the challenge, as most tenants in the market for space are concerned about having to suffer the cost of an additional move, even if they get a bargain rate on a sublease that is shorter than two years. So, the risk of lessee walking away from the lease obligation increase as the remaining term of the lease decreases.
For property owners, the availability of sublease space can also increase the time-on-market for their direct lease vacancies. This can be especially detrimental in properties that already have significant direct vacancy because it adds an extra increment of competition for prospective tenants. That is exacerbated by the fact that sublease space is often offered at below-market rates as an inducement for quicker lease-up and as a means of mitigating shorter lease terms that increase exposure to additional moving costs if the subtenant can’t strike a new deal with the landlord on a direct lease beyond the term of the sublease. Most owners are loathed to pre-negotiate new leases that would commence upon the termination of the existing lease. They prefer to wait on committing to terms, which gives them a chance to strike a market deal and gain a strategic advantage over the subtenant who has the cost of additional move to consider during direct lease negotiations.
Perhaps the best solution to the sublease conundrum for all concerned is the lease termination/buyout of the existing tenant with the simultaneous negotiation of a new direct lease with the prospective subtenant. If done successfully, the landlord gets a new tenant at acceptable terms, the subtenant can negotiate for terms and conditions that fit their needs and the original tenant is relieved of its obligation altogether.
Typically, the property owner negotiates a lump sum buyout with the existing tenant that covers unamortized improvements and brokerage commissions, along with a fixed termination fee in return for his willingness to terminate the lease. Most tenants prefer this method because it represents a clean break and the lease liability comes off their balance sheet as a liability. Owners prefer it because they regain full control over their space and can negotiate a deal based on current market conditions, which today favor landlords in most submarkets.
At the end of the day, the best sublease is the one that never happens. Property owners, managers, and brokers who build strong, ongoing relationships with all their tenants are able to identify potential threats or opportunities to optimize their tenant rosters before the sublease option is even contemplated. Good communication is key. It could be that a tenant looking to downsize could do so before getting into trouble, or the property owner may have a chance to keep expanding tenants by offering alternative space in their project before they decide to vacate and offer their space for sublease. The landlord may even have other qualified prospective tenants, but have no space to lease to them. By staying in touch with the situation on the ground at all times, all options are open and a preemptive approach to rent roll management can be executed.
