Six risks and terminology you should be aware of
By Scot Ginsberg
For start-up companies, companies with little operating history or companies looking to lease space for a short term, a sublease may be the way to go. Tenants who shed excess office space usually offer it at below-market rents, include furniture and tend to be less stringent on credit-worthiness than building owners.
However, it is crucial to understand that subleasing real estate has many inherent risks versus leasing space directly from a building owner. Companies that are considering subleasing space should be aware of the following risks and terminology before entering into a contractual obligation:
Tenant default: Should a tenant, or sub-landlord in this case, default on its lease obligation, the landlord will typically take one of the following actions with a subtenant who now occupies the space:
- Allow the subtenant to stay in the space on a month-to-month basis until the landlord finds a new tenant to pay a higher rate.
- Allow the subtenant to stay as a direct tenant in the space with a new lease at a higher rate.
- Terminate the sublease, requiring the subtenant to move out. Knowing the financial strength of the sub-landlord is the first step to understanding the potential risk.
No renewal and expansion rights: Renewal and/or expansion rights, which may be contained in the master lease, are personal to the original tenant and very rarely transfer to a subtenant. Can the landlord transfer these rights to a subtenant? Sure, it’s all negotiable. However, more often than not, landlords are not willing to transfer these rights to subtenants.
Recognition agreement: Subtenants who have a solid operating history may have enough leverage to obtain a recognition agreement from the landlord. Under this agreement, the landlord will recognize the subtenant and its rights under the sublease should the tenant default on its lease obligation.
Assignment: This is an entire transfer of the lease from the original tenant to the subtenant. The subtenant now becomes a direct tenant with the landlord and will inherit all of the rights and obligations under the lease. The original tenant will typically be released from its liability once the assignment is complete. A landlord is usually agreeable to an assignment with a subtenant who has an equal or greater net worth than the original tenant.
Tenant improvements: Normally, the subtenant contributes all of the money to improve or modify the space, not the sub-landlord. When investing a significant amount of capital into a space secured by a sublease, make sure a recognition agreement is in place or the sublease term has at least four years remaining, including a financially sound sub-landlord. There is nothing worse than subleasing space and investing significant dollars into tenant improvements only to have the sub-landlord default on its lease, leaving the subtenant at the mercy of the landlord. Not only can the subtenant be evicted, it will lose all of the capital invested into the tenant improvements.
Services/utilities: A subtenant usually does not have a direct claim against the landlord should the building fail to provide services or utilities. The subtenant will be forced to rely on the sub-landlord to enforce these rights, which can sometimes be a long and frustrating process.
Scot Ginsburg is Executive Vice President Jones Lang LaSalle and can be reached at email@example.com +1 858 523 2118