Companies interested in leasing, subleasing, purchasing or selling office space in the Bay Area

The Art of Subleasing Office Space

The sublease market has been one of the few “growth” opportunities in the office sector during the past few years. 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.

Making it Worthwhile For the Broker

Generally, a sublease may take three to five times more effort than does a direct listing. Therefore, it might be prudent for the corporation faced with subleasing to consider paying a higher commission if this will increase the chance of successfully subleasing the space. Subleasing commissions are always negotiable, but generally speaking, in order for sublease space to compete with direct leasing, commissions should also be competitive. There is a greater chance that a sublet space won’t lease than there is that a direct-lease space will not lease. The longer it takes to sublet a pace, the shorter the remaining term, which lowers the chance the space will be sublet. Conversely, with direct space, the longer it remains vacant the more motivated the landlord becomes to have it leased.

Brokers have the contacts and bring the potential sublessees to the property, so it may be beneficial to offer a competitive commission to entice brokers to keep the space in mind. As an example, an agent faced with placing a prospect in a direct lease that would earn a 5% commission fee for a five-year term might consider a 10% fee equivalent compensation for a 30-month sublease. When the additional complications of the sublease transaction are considered, the fee might be 15% to 20%. Again, each circumstance is unique, but unless a company is willing to compensate brokers may not be as eager to bring in potential sublessees. The tenant should keep this in mind when determining sublease compensation packages.

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 Space

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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