Subleasing real estate often looks like a good solution for growing companies to find short term space at below market rates. There are several inherent risks, however, for subtenants who agree to sublease space from a primary tenant (who becomes the sublessor) that’s in a precarious fiscal position.
If the sublessor stops paying or files for bankruptcy, the sublease is often null and void because the landlord typically approves it on the condition that they get their entire face rate per the primary lease. If the sublessor files for Chapter 11 bankruptcy reorganization, they can walk away from any leases that aren’t “… conducive to their financial health and ongoing operations.” That means a sublessee could find itself lease-less at a moment’s notice.
We saw this happen several times after the dotcom bust in the early 2000s.
To safeguard against this risk, the sublessee should consider several strategies. At a minimum, the sublessee should have the right to assume the prime tenant’s position and complete the term of the lease per the original terms. However, that erases the economic benefit to the sublessee (the discount off the initial face rate of the primary lease), and to keep the space the sublessee must likely increase its rent to the scheduled amounts in the prime lease.
4 Ways to Safeguard When Subleasing Real Estate
There are four ways to hedge against that possible outcome that every subtenant, and their legal counsel, should consider before agreeing to any sublease:
1. Get a reverse security deposit from the sublessor to guarantee the sublessee the difference between the discounted rate and the original face rate in the primary lease over the term. That amount would burn off over time as the sublessor pays rent and the money is returned to the sublessor in tranches.
2. Have the sublessor post a letter of credit to the sublessee in the amount of the discount between the negotiated sublease rate and the face rate of the prime lease. Such letters of credit typically cost 1 to 3 percent per year, and the amount can be reduced as the remaining term dwindles. Note that the letter of credit amount would be reduced against the borrowing limits of the sublessor, which is a matter that the sublessor must address in light of its overall financial situation.
3. Negotiate a buyout of the lease and have the sublessee enter into a direct lease with the landlord by quantifying the difference between the sublease rate and prime lease face rates, discounted to today’s dollars. The sublessor then pays that amount to the landlord to be released from the obligation of their lease. Then, the landlord can enter into a direct lease with the subtenant (who now becomes a direct tenant), and apply that payment to the new lease.
4. “Make it a wrap.” The sublessee could enter into both a sublease with the sublessor and a direct lease with the landlord. This is helpful in the event a sublessee wants to secure further rights to the space beyond the duration of the sublease. To accomplish this, the sublessee still has to take one of the above actions first and then adds a direct lease with the landlord for the term beyond the sublease.
Protecting a client’s rights by considering these scenarios, and possible solutions, before signing a sublease is a valuable service that a professional tenant rep broker can provide. T. Bradley Fulkerson
