Joshua Stein (Joshua.email@example.com) is a real estate and finance partner with Latham & Watkins LLP. He is also the editor and primary author of the New York State Bar Association's guide to commercial leasing and the author of four books and numerous articles on commercial real estate law and practice. For details, visit www.real-estate-law.com.
Subleasing: How to Make the Deal
Corporate downsizing has left many tenants with unused space to sublease. But you need to know the ground rules first.
December 1, 2009
Banks are looking for more money down and better credit scores—exactly the opposite of what many households are capable of bringing to the table because of the struggling economy.
That puts real estate practitioners who are familiar with rent-to-own transactions in the perfect position, two specialists say.
"How do you put together deals when homes aren't selling and buyers aren't qualified?" asks Wendy Patton, a real estate broker in Clarkston, Mich., and a lease-to-own trainer. "You make it possible for the two of them to meet in the middle."
In today's economy, many tenants want to shrink rather than grow. That often means they need a broker to help them value, structure, negotiate, and close a subleasing transaction. Aside from the practical challenges of finding just the right subtenant, subleases raise many legal issues that may not be apparent at first.
Key Issues to Consider Before Subleasing
Any sublease transaction starts with the tenant's existing lease. The existing lease defines and limits what the tenant has available to sublease. If the lease limits how much electricity the tenant can consume, the same limits will apply to the subtenant. If the lease prohibits certain activities, then the same prohibitions will limit the subtenant. For example, if a retail lease permits only the sale of petunias, then the subtenant can't sell pansies. In the worst case, a very restrictive lease will severely hinder any subleasing program. Then the tenant or broker will need to persuade the landlord to modify the lease or agree to waive some restrictions.
The subleasing broker should remember that any sublease leaves practically everyone unhappy. The broker can add tremendous value by assuring that the tenant has considered alternatives to subleasing, such as returning space to the landlord or assigning the entire lease. Either option might involve a payment to the landlord, coupled with rent adjustments. And to make one of these alternative transactions work, the tenant or its broker may need to persuade the landlord to enter into a direct lease with the new tenant for some period after the end of the existing lease term. Any commission agreement between the tenant and the subleasing broker should cover these alternative exit strategies.
Common Restrictions on Subleasing
If subleasing remains the tenant's best option, a careful broker will next review the tenant's lease for any limitations on the sublease process. Trouble can start as soon as the tenant starts marketing the space. For example, leases often limit the tenant's advertising program, particularly any publication of an asking price that is below the landlord's. A minority of leases include a special zinger for brokers: The tenant must hire the landlord as its broker to sublease the space.
Another common lease provision requires the tenant to give the landlord notice when the tenant plans to sublease. The landlord then has the option to take back, or recapture, the space from the tenant. Although few landlords would exercise this right in today's market, the tenant should remember to give the required notice. Failure to do so could produce expense, delays, embarrassment, and lost deals down the line.
A sublease will usually require the landlord's consent—either when the sublease is otherwise final or (preferably) when the tenant and the proposed subtenant have just signed a term sheet. A smart broker will check with the landlord at the beginning of the sublease process to smooth the way.
Many leases say the landlord will "not unreasonably withheld consent" to subleasing. That means the landlord shouldn't be able to extract a fee or other concession for consenting to a proposed sublease. The landlord can, however, still withhold consent for an objective reason that would lead a typical landlord to reject this particular subtenant. For example, if the subtenant's credit seems so weak that the subtenant is likely to default, a landlord might validly reject that particular subtenant.
Even if a proposed subtenant seems acceptable, a smart broker should look ahead to the landlord's concerns. Will the sublease interfere with other tenancies by disrupting the occupancy mix? Will it increase the landlord's costs by, for example, requiring the landlord to provide services in the building for more hours a week? Balkanize space in the building? Create too much pedestrian traffic (in an office building)?
By considering the concerns of the tenant, the subtenant, and the landlord, and by educating the landlord about the need for flexibility in today's weak market, an astute subleasing broker can structure a sublease deal that will work for everyone.