Understanding Your Local Office Market Can Lead to Better Subleasing Decisions.
In the current rapidly changing commercial real estate market, it is more important than ever that landlords and tenants understand the complexities of marketing and negotiating office subleases. Commercial real estate professionals need to be fully equipped to address all of their clients' needs, as they are asked with ever-increasing frequency to solve the problem of excess space.
The mention of sublease to a prospective tenant is synonymous with big discount, regardless of market conditions. In representing clients with excess space, commercial real estate professionals should help minimize losses when the market dictates a discount. The factors affecting subleases are numerous, including rental rates, tenant finish, remaining lease term, space configuration, market conditions, absorption, and the motivations of the parties. These factors, especially market conditions, make marketing sublease space difficult. Only after thoroughly analyzing all aspects of a situation can a sublease be signed with positive benefits for all parties.
Subleasing presents commercial real estate professionals with several unique challenges. They include:
- understanding the local economy in terms of job losses and gains as well as supply and demand of space;
- taking into account unplanned financial impacts;
- mastering the terms of the prime lease, sublease, and lease details; and
- positioning the sublease space in an already overcrowded market.
Understanding the Market
In a tight or contracting economy, tenants look to cut losses and will absorb discounts that are dictated by the marketplace. The discount amount is based on the supply and demand principle — as demand decreases and supply increases, rents go down and vacancies increase.
Across the country, cities such as Denver, Boston, Austin, Texas, and San Francisco have experienced substantial in- creases in available sublease space. Typically, national discounts range from 20 percent to 50 percent of the remaining lease obligation and can be reflected in lower effective rates, free rent, cash incentives, free furniture, and possible credit enhancements.
The major factor affecting the market is job growth or, in today's market, job cutbacks. For example, last year, Sprint announced more than 3,000 job cuts in the greater Kansas City area. According to local economic agencies, this has a multiplier effect of 1.8 additional jobs, and the potential loss could be in the range of 5,400 total jobs. Based on 215 square feet per person, this potentially could impact 1.1 million sf of office space in the local market in the coming year. The multiplier effect is important, as every job lost affects other jobs.
Comparing vacant space and new construction with the historical absorption, usually expressed in years of supply, can help determine the depth and length of the current market downturn as well as the marketing time for sublease space. As the office vacancy rate can shift dramatically in a short period of time, historical absorption figures can provide a look at the amount of time necessary for the market to absorb additional space and the amount of excess inventory it can handle.
A thorough financial analysis helps to determine the best terms to negotiate the sublease.
For example, a tenant has vacated a 25,000-sf suite with three years remaining of increasing rents at $20, $21, and $22 per square foot per month. Current market conditions dictate a rent of $19.50 psf and six months of free rent. A 7 percent discount rate reflects the internal cost of funds.
The present value of the differential ($323,259) represents the difference between the market and the contract rent and in this instance, is a negative amount. It represents approximately 21 percent of the remaining lease obligation. This present value can form the financial basis for initial discussions with the landlord for a lease termination fee. It also can serve as a benchmark during sublease negotiations to determine the viability of each transaction.
If the tenant wants its financial liability released, only the landlord can solve this problem. With the proposed offer of $323,259, the tenant can approach the landlord with a termination offer based on an estimate of market conditions. Once the landlord responds, for example, with a counter offer of $485,000, the tenant knows its cost to terminate the lease. The tenant now has a benchmark against which to weigh any sublease offers and the risks incurred with each. If the tenant can secure a creditworthy sublessee with a longer lease proposal, the landlord's proposal of $485,000 may be more negotiable.
Before making the decision to sublease, the following financial issues should be examined.
Credit Ratings of the Sublessor and Potential Sublessee.
If the proposed sublessee has a better credit rating than the sublessor, this will have value to the landlord if the sublessee wants an extended term. A credit sublessee will request in almost all instances that the landlord notify the sublessee if there is a default by the sublessor.
Landlord's Willingness to Accept the Subtenant at the End of the Sublease.
If the remaining sublease term is short, a potential sublessee will want the landlord's commitment to extend the lease past the expiring term. Without this commitment, the potential sublessee is faced with either a negotiation or possible relocation upon the expiration of the initial term, either of which is a highly undesirable situation.
Sublessor's Willingness to Guarantee Its Obligations Past the Term of the Prime Lease.
As an incentive for the landlord to provide an additional term to a potential sublessee, the current tenant may want to consider providing a guarantee to the landlord for the extended term, especially if the sublessee has been current on its obligations.
Possibility That the Sublessor Will Go Bankrupt.
If the sublessor is in financial distress, the landlord may be in a better position to strike a deal, get possession of the space, and proceed. From a brokerage standpoint, there is no sense in representing a sublessor in financial distress.
Sublessor's Ability to Pay Concessions and the Commission.
If the sublessor is in financial distress, cash conservation usually is the highest priority, and the payment of concessions, such as tenant finish or moving costs, may not be possible.
By combining this basic financial analysis with market conditions, tenants can evaluate their options, including negotiating a lease termination agreement, creating a benchmark for management to pursue other options, or establishing the parameters for sublease negotiations.
If a tenant is creditworthy and has a binding lease, especially with accelerating rents and a falling market, the landlord probably will have very little motivation to consider a termination fee and release the tenant of liability.
Evaluating the Product
In a highly competitive market, the functionality and flexibility of the excess space is important. Space that is clean, divisible, and free of specialized areas or equipment is more attractive to a wide variety of users.
Other vital considerations are the terms and conditions of the prime lease agreement, especially landlord and tenant obligations. The lease may impose marketing restrictions, use restrictions, a lengthy approval process, and other issues that can affect the ability to deliver the space in a reasonable period of time. In addition, all accompanying documents such as subordination non-disturbance agreements, estoppels, and other exhibits should be reviewed thoroughly.
Both the landlord and the tenant must confirm in writing that the lease is in full force and effect. The parties also must confirm that a sublease will not trigger any additional issues with the landlord, such as co-tenancy problems with other tenants, percentage of occupancy, underwriting with the lender, and exclusive uses or expansion rights granted to other tenants.
Landlords should be advised of the sublease offering as they most likely will participate in all negotiations. They may be willing to offer short-term concessions such as rent reductions, tenant finish, or structured rental schedules to attract tenants. Keeping in mind that a landlord's prime objectives are income retention, stability, and growth, most realize that there are substantial costs for re-tenanting. In exchange for long income stability with possible rent increases and reduced tenant finish costs, a landlord may be willing to spend fewer dollars today instead of higher costs in the future. In an uncertain market, landlords will make longer commitments to either retain or attract credit tenants.
Such concessions benefit landlords by increasing the property's marketing exposure, broadening the ability to attract a creditworthy tenant for a longer term, and shortening the lease up or down time.
Typically, compensation is based on income generated from the sublease or the liability released in the termination or cancellation agreement. Compensation must be clearly explained in the contract for engagement or listing agreement for both of these instances.
Again, basic leasing rules apply, such as if the client has the authority and financial capacity to enter into the agreement. Another important aspect of the sublease listing is whether the client already has attempted a buyout or termination, and if so, under what terms and conditions was the landlord willing to accept a termination.
If the tenant and landlord have been unable to reach an agreement, the tenant should know the guidelines under which the landlord will provide a lease termination, thereby establishing a benchmark for future sublease negotiations. The client then can be advised whether or not the landlord's expectations are achievable based on the current market conditions. If they are not, the tenant's decision to get the best sublease terms may be the only decision. If the terms are achievable, the parties then can work toward accomplishing them. These are not only financial considerations but also issues of use, credit, tenant finish, and timing.
The tenant will have more leverage in negotiating a lease termination with the landlord by having a creditworthy sublessee for the space rather than trying to negotiate a termination without one. The tenant may have to pay tenant finish costs and commissions in addition to a termination fee, but the tenant has come to the landlord with an income stream that may satisfy the landlord's objectives.
The compensation to cover various events should be defined clearly. For example, consider a lease termination in which the compensation may be based on the remaining lease liability as compared to a leasing fee for a sublease. If the sublease requires additional term over what is remaining on the lease and the landlord will not participate, it is difficult to determine how to evaluate compensation. Typically subleases are more difficult and may merit additional incentives to the brokers.
Many factors affect the marketability of sublease space, such as other sublease offerings, new construction, the slowing growth of industries, and the arrival of full-service office suites. These full-service office suites offer term flexibility, easy documentation, no initial capital, no tenant finish costs, and state-of-the-art technology. They may attract tenants that previously would have been candidates for sublease space.
The space offering needs to be positioned in the marketplace by class, size distribution, location, and amenities. The most competitively priced spaces in the best locations always lease first. Clients should be shown examples of competing offerings to make them aware of the concessions being offered. Other considerations are the timing of the space availability and the remaining lease term.
Commercial real estate professionals should ensure that sublease space is given maximum exposure to the marketplace. A targeted marketing program that includes electronically distributing PDF images of the space, mailing printed brochures, and making personal telephone calls should focus on cooperating the efforts of brokers, adjacent tenants, competitors, the various development agencies, and the owner.