A primer for property managers: So your tenant wants to sublease?
Real estate giants from CB Richard Ellis Services, AMO(R) to Cushman & Wakefield report rising vacancy rates as a national trend. The dot-com bust has sent sublease markets soaring. The California Silicon Valley Business Times says, "a second wave is pounding the office marker...more established companies are dumping grandiose expansion plans...Others are swooping in for good deals-and moving into fully stocked offices. All you have to bring is your coffee cup,' quipped San Jose, CA broker Mark Ritchie."
Sublease or Assignment?
Subleases and assignments are oft-misunderstood creatures. The Commercial Lease Law Insider, an industry publication, defines assignment as a transfer of a tenant's entire remaining lease term. An assignment transfers a tenants entire interest in the lease (square feet, term, rent, etc.). With assignment, the landlord can look directly to the assignee to comply with the terms of the lease. The assignor may, or may not, be released from liability If not, then there has been a credit enhancement, to the extent of the assignee's credit, because both assignor and assignee have responsibility for any lease default.
A sublease transfers less than the entire term and interest in a lease. In general, a subtenant has no legal relationship with the landlord. The sublessor retains responsibility for the lease and its obligations. The landlord can only pursue the sublessor (absent any other agreement that allows sublease rents to be paid the landlord if the sublessor defaults) for past due rent or for any other default. Likewise, the sublessee does not have direct rights against the landlord but rather must look to its sublessor for resolution of any issues.
The resulting relationships mimic a large extended family. Think of a triangular dinner table with landlord, sublessor (tenant) and sublessee (subtenant) seated on each side. They're accompanied by their respective brokers, attorneys and representatives, which can make for chaotic gatherings. (Note: Sublease is the situation most commonly encountered by real estate professionals, and for the purposes of this article the subsequent terms "sublease", "sublessor" and "subtenant" refer to both sublease and assignment.)
In a sublease scenario, the landlord generally experiences several possibilities. First, the tenant may hire his own broker and sublease the space. Second, the landlord may recapture all or part of the space and release it to another company. Third, the landlord may negotiate a lease termination with the existing company and then release the space. Clearly, the second and third options pose risks if the landlord recaptures space on a speculative basis. Unless there's a compelling reason--such as a pending tenant bankruptcy or a substitute tenant in the wings-landlords generally do not assume speculative space.
Landlords often prefer to keep their tenant "on the hook", and let the tenant assume inherent leasing risks of competition, tenant improvement and leasing commissions, etc. Sublease markets are more densely populated with start-up firms, smaller companies, and those reluctant to make long-term lease commitments. Generally these companies pose higher credit risks.
Landlords can benefit from what brokers term "incubator" space. Landlords get to know subleasing companies as building occupants, but without a formal agreement. Each can evaluate if they'd like to pursue a direct relationship at the close of the sublease term.
Most leases allow for the landlord to share in all or part of the sublease profits, in order to discourage tenants from competing with them in the real estate business. Actual profit, proves the exception rather than the rule. Significant sublease space can wreak havoc for owners if sublease rates dramatically undercut direct space rates.
Grizzled real estate veterans recognize timing plays a crucial role. At the beginning of the term, it's easy to sublease because the tenant can offer a nearly full lease term.
Also, the recently signed lease rent is presumably close to market rent so the tenant isn't faced with significantly discounted sublease rates. Similarly, sublease "pain" is minimal during the last year of the lease term-the tenant has only a few remaining months before its lease obligation expires. Space is virtually impossible to sublease for less than a year, unless a landlord is willing to extend the term (or the tenant has a non-personal extension right).
By telling the tenant what information will be required for a sublease review, you'll prove yourself an ally. Last minute information requests slow the process and anger tenants in their unfamiliar role as sublessor.
Standard commercial lease clauses usually obligate tenants to provide the name and legal entity of the subtenant, nature of the proposed business, a current balance sheet and income statements along with other financial information and a copy of the proposed sublease document. Many landlords also require a signed Consent-to-Sublease form. Tenants often fail to consult the lease and are unaware of these requirements.
It is important to check the lease for deadlines pertaining to sublease approval. You don't want to unwittingly agree to a subtenant because the landlord has missed a deadline to notify the tenant of sublease approval or disapproval.
A Word on Reasonableness
Most states apply a reasonableness standard to approving or disapproving subleases. While a lease may contain wording prohibiting a tenant from subleasing to certain groups such as to existing tenants or government entities, many of these caveats are unenforceable. The Commercial Lease Law Insider advises, "simply let the tenant know what information you need and tell the tenant that you'll review the request and get back to him. Avoid spur-of-the-moment opinions." Imagine yourself arrested: anything you say can be used against you to prove you acted unreasonably.
Determine Financial Status
Ascertain exactly why your tenant wishes to sublease. Is the headquarters moving cross-country? Is the office an acquisition target? Is the company unprofitable? Strike quickly to ascertain the tenant's current financial status.
For public companies, get the latest 10k and 10Q reports (public annual and quarterly reports, respectively). For private firms, ask the tenant for cash flow, balance statement and income statements, preferably for the last two years so you can study trends. Check how promptly the tenant remits monthly rent. Credit reports, albeit limited and often biased, supply a source of additional information. If you need help analyzing financial information, forward it to leasing personnel, legal personnel and other appropriate landlord parties.
The financial health of the sublessor will, in large part, dictate how the landlord views a sublease. Precarious sublessors mean landlords need to scrutinize sublessee's credit-worthiness. In some instances, it may be to the landlord's advantage to recapture and release space rather than contend with the ominous "Chapter 11" and a fiscally unstable tenant attempting to subtenant. A non-rent paying sublessee might force a financially insecure sublessor down the slippery slope of default. Even financially responsible sublessors can land a defaulting sublessee who is then protected in the space under bankruptcy and reorganization laws.
Play Detective on Use
One of the landlord's most important considerations is the proposed subtenant's office use. Some leases disallow certain uses, such as a violation of any "exclusive" rights of an existing tenant or a subtenant detrimental to the building's image. The proposed delicatessen subtenant may make a mean spinach salad, but its presence violates an existing restaurant's non-compete clause. And, while a subtenant may be creditworthy, its image may be unacceptable for the landlord's property. An attorney-leased building may not appreciate wiggling deliveries for the second floor dog-grooming services.
Ascertain whether or not a proposed subtenant's office use is appropriate for a property by visiting their current business. Don't be placated by a floor plan copy; nothing replaces a personal on-site visit.
Consent-to-Sublease Forms Offer Protection
Consent-to-sublease documents, signed by the landlord, the sublessor and sublessee, usually span a few pages. The most important clause states that the sublease shall be subject and subordinate at all times to the provisions, covenants and conditions of the original lease agreement signed by the landlord and tenant. With this statement, the landlord protects itself against conflicting statements in the sublease agreement. Consents often contain further statements to clarify the sublesssor isn't released from master lease liability and that the landlord can disapprove further subleases. Consents usually confirm that all of the landlord's remedies in the event of a default remain as specified in the master lease. Wizened landlords also get the right to receive rent from subtenants in the event of any breach by the sublessor. Landlords may seek indemnification for any claims arising from the sublease.
Review the Sublease
Although the Consent-to-Sublease form is intended to prevail over conflicting language between the master lease and the sublease, you will still want to review the sublease. Problem subleases create issues for the sublessor; causing a domino effect for the landlord. An ounce of scrutiny is worth a pound of litigation to ensure that the sublessor hasn't expanded rights allowed under the master lease. The landlord may have granted "personal" rights to the tenant that are not intended to extend to any subtenant. Examples include parking and extension rights. Landlords may also examine the sublessee's insurance coverage as required by the sublease. The Holdover clause should also have a stiff penalty to encourage the subtenant to vacate the premises at the end of the sublease term.
Some landlords end-run this issue by providing sublessors with a standard sublease document. This strategy can backfire though; because if there is a later dispute, the sublessor can claim less responsibility by saying he abided by the landlord's imposed sublease form. Most landlords prefer that sublessors provide their own documents.
Consider that subleases allow a tenant to mitigate a rent obligation while providing the landlord with a potential long-term direct tenant. Talk about the quintessential definition of "win-win". So when a tenant calls wanting to sublease, look beyond the administrative choreseize it as an opportunity to protect a property's downside.
Alice Devine, CPM[R], RPA has oveyears of leasing and property management experience. She holds a BA in Economics from the University of California at Berkeley and can be reached at aadevine@pacbell, net.
RELATED ARTICLE: Build Tenant Relationships during the Sublease Process
* Inform Tenant of review requirements
* Give Tenant the Consent-to-Sublease form early to eliminate surprise paperwork
* Notify Tenant of anticipated sublease review costs (e.g. attorney fees)
* Ask Tenant if they'd like any extra services to enhance the suite marketability (e.g. carpets cleaned, paint, extra trash removal). Some services may be billable.
* Relay tenant broker name and contact information to landlord's leasing personnel ASAP
* Make Tenant a floor plan copy so Tenant can generate a marketing flier
* Offer to provide Tenant with extra suite keys (for broker showings)
* Be gracious to prospective subtenants; they may be your tenant one day!
* Alert landlord signatories of pending documents to speed response times
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|Publication:||Journal of Property Management|
|Date:||Nov 1, 2001|
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