By David Klein and Jerry Milenbach
March 12, 2021
It seems like all we hear lately is another company listing some or all of its office real estate for sublease, adding to the glut of space already on the market. Unfortunately, no region is immune to the realities of how working from home has affected the office sector. However, this has provided an opportunity to explore the benefits and challenges of direct leasing of space compared to subleasing space, from both a financial and logistics perspective.
In many cases, sublease space is less expensive than a traditional office lease, which is tempting, but there are many aspects to consider before taking that route. Several key concerns are the complications of adding a third party to the contract, flexibility within the terms of the contract, onerous conditions, and the potential legal issues.
Anytime a company is giving up its office space, it should be a flag that the business may be in trouble. Prospective subtenants need to understand why the company is subleasing and do a rigorous review of the sublessor’s financial capacity to continue paying rent under the master lease upon which the sublease depends; see more about the “master lease” below.
The first factor to consider in taking on a sublease is understanding the complexity of completing and being in a three-party agreement as opposed to a two-party agreement as in a direct lease. A point to remember is that in addition to the three principals, a sublease transaction may involve three lawyers, three brokers and a multitude of added issues not seen in a two-party transaction.
As part of virtually every sublease transaction, the landlord must notify the tenant listing space for sublease if subleasing is permissible or not. While the general rule is the landlord cannot unreasonably withhold its consent to a sublease, in some jurisdictions a landlord may absolutely ban subleasing or set forth the basis for consenting, consenting with conditions, or rejecting a sublease. Moreover, the landlord may ban subleasing to certain businesses such as employment agencies and government offices, or withhold their consent to a potential sublessee it deems unprofessional or morally unfit. In other words, there is no limit on the type and number of “reasonable” conditions a landlord can require be met for the sublease to be approved!
Among these conditions, the sublessor (the tenant unloading the space) may be restricted from subleasing to any of the tenants in the building no matter who they are (which may include you as the potential subtenant) or subleasing to a subtenant at a rent less than the landlord is quoting to the market for similar building space. All perfectly legal in most jurisdictions.
Another consideration in deciding to sublease is the reduced flexibility in comparison to a direct lease. While not necessarily problematic, it takes longer to complete a sublease. In many office leases, a landlord reserves a timeframe to render its decision whether to consent or not, which is typically inflexible. With very few exceptions, a sublease requires a landlord’s consent and possibly their lender’s consent as well. This added period is typically 30 days on top of the time it takes to negotiate the sublease in the first place; so, at a minimum, a sublease takes 30 days longer than it takes to negotiate a direct lease.
Sublease premises maintenance is another area of concern. There can be delays in communication and work orders due to the three-party structure of subleases. For example, if a subtenant moves in and has problems with its space, the repair requests may have to route through extra layers. Here’s the worst case - the subtenant may be officed in a building owned and managed by the landlord with a management office right down the hall from the subtenant. But legally speaking, the subtenant’s landlord is the tenant that sublet the space to them; not the actual building owner. To receive maintenance service on the sublet space, the subtenant will need to contact their sublessor, which, in turn, must then forward the subtenant’s work request to the building owner. Imagine the frustration if the air conditioning breaks during a heat spell. The building owner’s office is down the hall, but your sublessor is out-of-state and focused on their core business, which is not your building’s real estate management. You will swelter for longer than if your relationship was direct with the Landlord under a direct lease. Bottom line, there are going to be significant delays in getting things fixed.
It is typical that the master lease may contain certain tenant rights such as lease termination and renewal, space contraction and expansion rights, and other special rights. However, it’s important to note that despite subleasing under the master lease, these rights do not automatically flow to the subtenant. Most master leases stipulate that these rights are specific to the original tenant and do not flow to a subtenant. Again, careful review is required to understand what rights are provided to a subtenant and which are not.
One of the final factors to contemplate in deciding to sublease or go the direct lease route is the potential legal difficulties if the terms of the sublease are broken. A sublease legally sits on top of a sublessor’s underlying “master lease” as it is called, like a house sits on top of a foundation. If the master lease goes into default or breach, it threatens the sublease. While a subtenant may be able to set up a legal mechanism to “cure” the sublessor’s breach of the master lease, it is an unexpected expense that may be sudden and unaffordable. At worst, an eviction of your sublessor could result in an eviction of you, the subtenant, even if you have perfectly performed under the sublease! Conversely, if the sublessor breaches the sublease with the subtenant, a subtenant’s remedies for breach may be more difficult to liquidate due to the sublessor lacking local presence or assets with which to satisfy the judgment.
These are just a few of the potential pitfalls to watch out for when looking to sublease office space. With companies listing sublease space at attractive rates left and right, business leaders should enlist a trusted real estate broker and attorney to help navigate these waters and facilitate the all-important economic and legal review. After all, when the price seems too good to be true, there may be a reason for it.
David Klein is a Senior Vice President specializing in Tenant Advisory services in the San Francisco Bay Area. His background as a transactional real estate attorney provides Transwestern with a unique depth of experience.
Jerry Milenbach is a Research Analyst for Transwestern’s Walnut Creek office, tracking local, national and global market trends to deliver acute analysis and creative insight.
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