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Subleasing
Office Space
Fueled by massive corporate restructuring and downsizing, companies have
placed tens of millions of square feet of office space on the market
during recent years. It is important to know how valuation and marketing
of sublease space can differ significantly from direct lease space. Being
aware of the similarities and diversities can mean the difference between
a company signing a subtenant or continuing to pay rent through the
remaining leasehold term.
In most cases, the reason sublease office space becomes available has
nothing to do with the real estate market. Most likely, a company has
decided to downsize, change geographic locations, sell off divisions or
subsidiaries, or otherwise restructure company operations. As the office
market has begun to strengthen around the country, companies are paying
closer attention to how much leasehold obligation can be salvaged through
subletting, or similarly, positioning the space so that a lease
termination fee less than the actual leasehold value can be accomplished.
In many cases, the company automatically writes off the remaining cost of
the leasehold interest, and has no thoughts of salvaging the value of the
leasehold through subleasing the vacant space. But by subletting available
space, a company can reverse some of that lost rent. Instead of paying
rent on unused space, a sublessee may take over the terms of the lease,
turning a negative cash flow into income.
In a tight office market it may be possible to actually profit through a
sublease. However, this is the exception and not the rule. Many leases
contain either a recapture clause, or a shared sublease profit clause. In
the recapture clause situation, the tenant must undertake locating a
suitable, credit worthy replacement tenant and the landlord then has the
option to terminate the lease and sign a new lease, usually at the higher
market rate. In some instances the former tenant may even be required to
pay for the replacement tenants improvements, and in almost all cases the
financial upside goes 100% to the landlord. With a shared sublease profit
clause, a predetermined formula is set forth in the lease, with or without
the cost of leasing commissions, tenant improvements or other expenses
taken off the top before net savings are shared.
Companies may still need to look at any sublease revenue as bonus income,
but also must face the subleasing challenge realistically. Even in a tight
market some available sublease spaces are never sublet, and the tenant
company pays rent throughout the term even though the space is marketed.
This is a factor of the marketplace, and a broker who is overly optimistic
about getting a subtenant in spite of all the pitfalls is doing his or her
client a disservice.
Reviewing the Options
Sublease situations can be handled in four ways: the buyout, the sublet,
the recapture and the write-off. The first and "cleanest" from
the tenant standpoint is the buyout, in which the tenant negotiates with
the landlord for a cash settlement that releases the tenant from all
remaining leasehold obligations. Many owners in today's difficult office
market are unwilling to release a tenant without having a replacement
tenant lined up, unless the buyout price is large enough to outweigh the
risks and expenses of retenanting. The greater the credit of the existing
tenant the more reluctant most landlords are to take back the space. In
some cases, landlords will ask for the entire remaining term to be paid
upfront. For some corporate tenants, getting the lease off the books is
worth this immediate write down and cash payment.
To increase the tenant's bargaining position, the second approach,
subleasing, is used. Once a sublessee prospect is located, the tenant
approaches the landlord. Depending upon the credit of the prospect and
scope of tenant improvements needed, a buyout may be more easily
achievable because the landlord doesn't have the retenanting risk. It's
important that the tenant verify the credit for any potential sublessee
because in most cases if the subtenant defaults, the primary tenant
remains liable for the leasehold obligation.
In the recapture situation the space is aggressively marketed with the
objective of locating a longer-term tenant willing to pay market rent.
This potential tenant is brought to the landlord who then recaptures the
space, signs a lease directly with the prospect, and terminates the
existing leasehold.
The fourth approach for a tenant is to simply write off the remaining
term, pay the rent on the vacant space, and not attempt to sublet the
space. This might happen when:
- the remaining term is less than one year
- retrofit costs outweigh any potential sublease rent
- the space is small
- the company doesn't have the staff to supervise sublease activities.
The major objective to the entire subleasing process is to reduce the
remaining leasehold expense. This critical objective often gets lost in
the overall sublease process. Attempting to totally recoup the leasehold
obligation, being unwilling to go significantly below market rents, or
having emotional ties to the existing tenant improvements and their
original costs could sidetrack the lessor from the real objective of
recouping at least a portion of the rent.
Negotiating a Three-Way Deal
Subleasing is more complicated than direct leasing. For one thing, when
subleasing, additional parties are involved in the negotiation process.
Rather than a two-party, landlord-tenant negotiation, negotiations tend to
be triangular: owner-tenant-sublessee. The landlord's consent is required
for most subleases, especially if the original lease must be changed, if
the lease needs to be extended, or if the sublessee requires tenant
improvements. The tenant and sublessee may agree completely and only the
dissenting landlord prevents a successful sublease. It's important to get
the landlord's cooperation from start of negotiations. If you have
identified the landlord's goals and reservations in the initial stages,
the entire sublease process will be less painful.
An additional difference is the lease document. In a sublease, the
sublessee agrees to the terms and conditions in the primary lease.
Negotiating changes with the landlord adds to the transaction's
complexity, as the landlord may not make the same lease concessions for a
sublessee as he or she did when dealing with a new prospect for a direct
lease. A landlord may have granted "personal rights" to the
original tenant that are not transferable to a sublessee. This commonly
happens with amenities such as parking rights and expansion and renewal
options. The landlord may have valid reasons for initially making these
rights "personal," such as the specific credit of the tenant or
the size of space initially leased. These items should be identified at
the beginning of the sublease assignment and, if they are critical to the
leasehold, the sublessee should attempt to find out from the landlord
under what conditions these rights would be transferable.
A critical distinction between subleasing and direct leasing is the length
of the remaining lease term. In direct leasing, the landlord can offer
three-, five-, or even ten-year lease terms, with the possibility of lease
extension options. But because the sublease term is limited by the
remainder of the primary term, the value of the leasehold may be greatly
reduced if the remaining term is less than five years. Many companies do
not wish to move into an office suite for only a one- or two-year period
and then have to relocate. This problem may be alleviated if the landlord
is willing to either sign an additional new lease directly with the sublet
prospect or to sign a new lease beginning at the expiration of the
original lease.
One last difference between sublease and direct lease space is the
potential for some tenants to offer furniture and telephone systems as
part of the sublease package. This may represent substantial savings to
the prospect, and may outweigh the salvage value to the tenant if these
systems were removed from the space and sold separately.
Keeping a Competitive Edge
Available sublease space competes
not only with direct-lease office space in the marketplace, but also with
other sublease space that is offered at greatly reduced rental rates. It
might also be directly competing with the landlord's space within the same
building. In some markets, large blocks of available office space or
premier spaces are scarce. When such a space is available through a
sublease, its competitiveness and leaseability increase.
In general, benchmarks of a competitive sublease office space include:
- a remaining lease term in excess of three years
- an open layout or generic office buildout
- a flexible and cooperative landlord
- a highly motivated sublessor
A short-term lease can be a major stumbling block not only in allowing the
space to be competitive, but also in dealing with tenant improvements. The
economics of amortizing even a small amount of improvements over a short
term may be unworkable. For example, using a 12% interest rate for tenant
improvements that cost $10 per square foot, the cost to amortize the
improvements over a five-year term is $0.22 per square foot per month.
This same $10 per square foot over a 20-month sublease term is $0.55 per
square foot per month. Tenant reconstruction might additionally involve
substantial costs in retrofitting the building due to changes in the fire,
life-safety, and disability code or requirements. The landlord might view
this as an investment building, but to the tenant who is trying to cut
losses, building rest rooms for the disabled or fire-rated corridors takes
on a different meaning. These issues must be carefully analyzed in the
initial stages when a tenant is deciding whether to sublease their office
space.
The tenant may prefer to offer free rent or rent credit toward the
subtenant's tenant improvements rather than do the renovations for the
sublessee. When a space exceeds 3,000 square feet, rarely will an office
tenant move into it without any alterations, even if they include only
minor repainting, new carpeting, or minimum wall changes. IN a number of
instances the potential sublessee may not be prepared to undertake tenant
improvement construction, and the sublease opportunity may be lost if the
space is not renovated for the subtenant. Many Fortune 500 corporations
are not structured to undertake their own interior construction, including
even minor changes, and will instead prefer to relocate using a direct
lease with which the corporation is more familiar. If the sublessor can
offer tenant improvements, the sublease space may be better able to stay
competitive.
Another option is to divide the space into smaller sub-leasable areas. A
qualified architect, tenant improvement contractor, and subleasing
contractor, and subleasing specialist should be brought on board in the
very beginning to help identify costs. Their input may determine whether
the space can be subdivided, and if so, how to best do it. Having the
space planner and contractor on board in the initial stages helps to lay
out the space and identify potential subdivision strategies. The tenant
may decide that an "as-is," all-or-nothing sublet will recapture
more rent at greatly reduced rental rates than dividing the space with a
tenant improvement allowance and offering the space at dramatically higher
sublease rents. On the other hand, a tenant vacating a portion of their
space might also consider the overall economic impact of vacating the
entire space, if this greatly increases the chance that the space will be
sublet.
Marketing Sublease Space
In almost every case where a corporation decides against listing their
sublet space with a qualified leasing specialist and attempts to market
the space on its own or through an "open-listing" system, the
space is never sublet. A company may chose to market the space on its own
because it is trying to save sublease commissions, or to justify the
employment of their in-house real estate staff. The fact of the
marketplace is that office brokers represent 60% to 90% of al the office
tenants, depending on geographical market differences. This means a
company will almost have to pay a sublease commission if they want the
best exposure for their space. It seems to be a better use of the firm's
money to have the space listed and marketed professionally, with the
listing agent sharing his or her fee with the procuring agent. In the case
of non-listed or open-listed (with no one agent responsible) sublease
space, an out-of-sight, out-of-mind effect comes into play and often no
agents show these spaces to prospective tenants. The corporation usually
does not have someone with time or expertise to do all the marketing
activities needed to sublease office space, and that is why most Fortune
500 corporations list excess space with a professional leasing firm.
The sublease space should be in well-maintained, marketable condition.
While it is usually not prudent to renovate the space prior to obtaining a
subtenant, shampooing the carpets, repainting, and other minor repairs are
monies well spent. The sublessor should keep the lights in good working
order so that the space can be shown, and give the keys to the subleasing
agent so that all parts of the vacant space are readily accessible. For
major space presentations, it might be wise to turn on the HVAC system
before the tour so that the space is comfortable for viewing. Debris
should be removed and the vacant space shouldn't be used to warehouse old
equipment and supplies; this weakens the marketing of the space.
Many of the marketing functions in direct office building leasing also
apply to subleasing. Marketing materials, including fliers and floor
plans, are prepared and distributed to the office brokers active in the
marketplace. For larger sublease spaces, marketing may occur on a regional
or national basis as well. Mailers are sent to office tenants on the
listing broker's mailing list and handed out during personal cold calls to
businesses in the building where the space is located and to neighboring
office tenants. For larger sublease assignments, the tenant should provide
the broker 10 to 20 sets of blueprints of the as-built space plans so that
there are fewer delays in getting needed materials when a prospect
expresses interest in the space. It may also be a good idea to produce a
color brochure for larger assignments, which can cost one to three dollars
per brochure when ordered in quantities of 1,000 or more. This will give
the space and all marketing efforts a professional presence.
A broker open house is one way to generate prospect activity, depending
upon the size of the sublease space and its remaining term. For smaller
spaces a broker open house is usually not practical, but for larger spaces
this can be quite beneficial. The objective of these affairs is to make
the brokerage community aware of the sublet space availability in order to
compete with direct space marketing at a competitive level. To illustrate,
one such broker open house for a 40,000-square-foot, single-tenant
building cost $8,000; it offered elaborate food, weekend trips for all
attendees, and a Hawaiian week-for-two as the grand door prize; and 80% of
the most experienced agents in the market attended.
In a tight office market where the vacancy rate is less than 10% a
sublease may provide office space otherwise unavailable. On the other
hand, in a rapidly rising office rental market where the lease term has
two or three years to run, landlords may be unwilling to commit to fixed
rent lease extensions, opting instead to wait out the lease expiration to
obtain much higher future rental rates.
Putting a Price Tag on the
Space for rent
Factors that help determine the price of the sublease space include the
existing layout, the condition of the local office market, the length
remaining on the primary lease, and the overall contract rent as compared
with market rents. In some instances the space might be priced at or above
contract rate and still be competitive. This might occur if the original
lease rate was below market, if transferable landlord concessions were
substantial, or if the office space was in a particularly well-located and
desirable building. But in most cases a discount is involved, and this can
range from 20% to 75% of the current lease rate. The leasing agent will be
able to provide market survey information that will enable the tenant to
price the sublease space appropriately. Because a sublease is
time-sensitive, it might be prudent to aggressively market the space with
the price substantially discounted from the onset of the sublet. An
alternate strategy would be to market the space at a slight discount if
the space still remains available after 90 days.
A tenant may offer different prices for subdivided space that has
different floors or different views. For example, large blocks for space
might be offered at a lower rental rate than smaller areas. Careful
initial planning is important-if the premium space is leased first, the
remaining space may be rendered almost unleaseable.
Lease is More
Subleasing office space
has taken on increasing importance in the overall office marketplace due
to recent corporate restructuring. Downsizing and relocating companies are
more often than ever before considering subleasing as a viable alternative
to writing off the costs of a vacated leasehold. By being aware of the
similarities and differences between subleasing and direct leasing and by
using appropriate marketing and pricing strategies, you will greatly
increase the chance of signing a successful sublease.
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