by Briana Becker Stolley, Associate

As businesses continue to contract, downsize, restructure, and change geographic locations, it is common for a business to find itself in a position of having leased more space than it needs to operate.  In such a situation, a practical alterative to continuing to pay full rent for empty space is for a tenant to consider subleasing the unused space to a third party.  Subleasing can be a win-win situation for both parties, providing “bonus” income for a sublandlord to help cover or recoup its rental costs for its unused space, and simultaneously providing a subtenant with space leased at below market rental rates.  Before taking on a subtenant, however, it is important for a prospective sublandlord to understand the inherent risks in any sublease situation and how to mitigate those risks.  Additionally, there are several potential issues that a sublandlord can address in order to make its sublease space more appealing and competitive for potential subtenants.  Below is a list of ten of the most important issues for tenants, soon to be sublandlords, to consider and address for a successful sublease situation.

1.    Know Your Subtenant, Verify Credit And Get A Big One

The single most important consideration for a potential sublandlord planning to sublease space is its evaluation of the creditworthiness of the potential subtenant.  Most master leases provide that the primary tenant will remain liable for the obligations under the master lease regardless whether a subtenant pays its rent or defaults.  Further, in the event of a subtenant default, the legal relationship (or “privity of contract”) is between the sublandlord and subtenant, NOT the master landlord.  Therefore, in the event the subtenant fails to pay rent and needs to be evicted, the sublandlord will be required to pursue the eviction process without any assistance from the master landlord.  It is incumbent upon any sublandlord to evaluate carefully and comprehensively the financial strength of its potential subtenant.  Sublandlords should ask to review financial statements for the past 3-5 years and check all references.  Is the subtenant candidate profitable? How long has it been in business? Does it have the necessary financial wherewithal to comply with the rental obligations? Who are its owners? Sublandlords should also verify and confirm that the financial statements provided are for the specific entity that will sign the sublease, not for a parent or an affiliate.  If a parent or affiliate company holds the “real money,” the sublandlord should consider getting a guaranty from that parent or affiliated entity.  No matter what, in today’s market of struggling businesses (and particularly in the event of any weak or questionable credit issues) sublandlords are well advised to get as big a security deposit as possible.  Perhaps the most important sublease term for a sublandlord, a substantial security deposit can be applied to offset the sublandlord’s damages due to a subtenant’s default, including the costs of evicting a subtenant, attorney’s fees and broker’s fees incurred in connection with the sublease, and even preparing and marketing the space for a new subtenant.

2.    Look Before You Leap

A sublandlord cannot lease more than it possesses; so the existence of any sublease is entirely dependent upon the terms of the underlying master lease.  Therefore, before subleasing, review the master lease to determine whether the sublandlord has the right to sublease.  Most leases will provide that a tenant may not sublet or assign the lease without the prior written consent of the master landlord.  Many lease provisions will add that the master landlord’s consent will not be “unreasonably withheld, conditioned, or delayed,” which simply means that the landlord cannot arbitrarily withhold consent.  Sometimes master leases state that a landlord will not approve a sublease to an existing tenant in the building, or a party with whom the landlord is currently negotiating a lease, or to a subtenant that the landlord deems not to be creditworthy.  Additionally, leases could require that the tenant notify the master landlord prior to marketing the space for sublease.  Finally, the lease may provide for a “recapture right” which means that upon presentation of a sublease, the landlord has the right to take back (or “recapture”) the proposed subleased space.  Any such requirements of the master lease dealing with subletting must be fully considered in order to understand the potential issues that might prevent a prospective sublandlord from offering a final sublease.

3.    Involve A Broker To Help Market Your Space

Obtaining a creditworthy subtenant depends largely on presenting correct pricing and terms for the sublease space.  In this sluggish economy, the competition is fierce because there is ample supply of sublease space in the market.  Hitting the right price point requires indepth knowledge of other comparable buildings in the area and the open opportunities for comparable direct and sublease space in the marketplace.  It is key to market the space at a price that will bring interest from the beginning.  There is no substitute for knowing the market and submarkets when determining this price point.  Therefore, any tenant planning to sublease would be well advised to seek representation by an experienced commercial broker.  Commercial brokers will expect to be paid a percentage of the rental received by the sublandlord over the term of the sublease.  Commissions can be expensive, but brokers work to help facilitate and procure the subtenant, and the knowledge and the contacts of the broker may be well worth the money in the end.

4.    Get Landlord’s Up-Front Cooperation

Subleasing is often more complicated than direct leasing because it is a third party arrangement involving the landlord (or “master landlord”), the sublandlord, and the subtenant.  A difficult landlord can object and prevent a sublease from being signed even where the sublandlord and subtenant have agreed on all business terms.  As discussed above, the landlord’s consent is required for subletting under most leases, so it is important to get the landlord’s consent and cooperation at the very beginning of the sublease process.  Once the tenant has identified a potential sublease relationship, the tenant should discuss its intentions for subleasing with its landlord prior to negotiating with a subtenant.  If the objectives (and possible objections) of the landlord are addressed at the outset, the entire sublease process will be far more efficient.

5.    Define The Subleased Space And Rights

This may sound obvious and most subleases include a graphic depiction of the subleased space attached as an exhibit to the sublease.  But many subleases neglect to include whether the subtenant will have the right to common areas such as restrooms, conference rooms, and kitchens.  Will the subtenant require roof rights or signage? If the master lease contains these rights in favor of the tenant without prohibiting the assignment thereof, a tenant may be free to negotiate the assignment of such rights as well.  In order to avoid disputes and misunderstandings between you and your subtenant, be very specific about defining exactly what space, along with what rights, are included in the sublease.

6.    Consider Including Personal Property

Many tenants subleasing unneeded space also have unneeded equipment, telephone systems, and furniture.  In a market flooded with used furniture and equipment, a tenant will likely generate far more value by attempting to include its furniture and equipment in the sublease arrangement (or sell it to the subtenant) than by trying to sell it on the open salvage market.  The marketability and competitiveness of the subleased space is usually greater when furnished because it results in significant savings for the subtenant.  Start-ups and expanding subtenants often consider furnished space especially attractive.

7.    Condition Of The Space: “As Is” vs. Build-Out

Conventional procedure for tenant improvements is that the landlord either performs the build-out or offers the tenant an improvement allowance, and then includes the amortized costs of the build-out or allowance over the term of the lease in the rental rate.  The economics of amortizing any build-out over a relatively short remaining term (as is typical in a sublease situation) are often prohibitive to offering build-out to a subtenant.  Additionally, there is an inherent substantial risk that the sublandlord will perform build-out for a subtenant up front, and then the subtenant will default under the sublease, making it impossible for the sublandlord to recoup its investment in the build out.  For these reasons, except in unusual situations (such as where a sublease has a large remaining term), sublandlords may prefer to deliver the space in “As Is” condition.  Failing that, in the event a subtenant insists on a build-out, sublandlord should consider offering free rent or some other economic concession.

8.    Do Not Ignore Utilities

Sublandlord should be careful to address and allocate properly the services and utilities which are provided to the entire subleased space as between sublandlord and subtenant.  If the sublease space is not separately metered, can a separate meter be installed (and at which party’s cost)? How will the sublandlord and subtenant handle after-hours HVAC fees charged by the master landlord?

9.    Insurance Issues

Insurance and liability problems can be extremely costly and are easily avoided.  Make sure the potential subtenant has adequate insurance to comply with terms of the insurance provisions in the master lease.  Do not sign a sublease without receiving a valid insurance certificate naming sublandlord as an additional insured and proving that the subtenant carries the appropriate coverage to comply with the terms of the master lease.

10.    Decent Documentation

After the parties have agreed to the business terms, it is imperative that a solid and tight sublease document is prepared for execution.  It is common practice for the sublandlord to provide the initial draft the document, which can be a real advantage for the sublandlord.  Be advised that form subleases do not comprehensively address the complicated issues involved in most sublease transactions.  In order to protect your business properly from the risks involved with subleasing, an experienced real estate attorney should be hired to draft the sublease document.

Conclusion

Rental rates for subleased space are typically below market and there is always risk for any business owner in taking on a subtenant.  With proper preparation, appropriate due diligence, careful sublease negotiation and preparation, and a substantial security deposit the risks can be lessened considerably; making subleasing a viable opportunity for a business owner to mitigate its lease expenses for unused space and better survive a down economy.


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The information or opinion provided in this article is the author's own and not necessarily that of Watt, Tieder, Hoffar & Fitzgerald, LLP. The author is solely responsible for the information and opinion that he or she has provided. The information contained herein does not replace seeking specific legal counsel to directly address individual client needs.