Bruce Bagdasarian | April 23, 2012
Subleasing is a common tool both for tenants who are trying to downsize by becoming sublandlords and for tenants who are seeking temporary space or looking to upgrade the quality of their space or location by becoming subtenants; this is particularly common during a recession. Tenants and prospective subtenants should evaluate the nuances – and potential pitfalls -of these types of arrangements before blindly heading down that path. Below are some key issues to consider before entering into a sublease.
Evaluate Restrictions on Subleasing
Most prime (original) leases prohibit subleasing without the consent of the landlord while providing that the landlord shall not unreasonably withhold its consent. In addition, there may be detailed provisions about financial and other criteria which a subtenant must satisfy to be considered “acceptable.” Typically, the proposed subtenant’s use must be the same as the tenant’s (for example, an office use must continue as an office use). And, in the retail context, the prime lease often contains use restrictions prohibiting one tenant from competing with another tenant in the applicable retail center. Some leases prohibit a tenant from subleasing only a part of their space.
So, the first task for a tenant seeking to sublease is to determine whether the prime lease permits a sublease. The second task is to determine what restrictions and requirements there are for subtenants. The third task is finding a suitable subtenant (who fits within the prime lease terms for “acceptable”). It is prudent to get the landlord’s written consent to any subleasing arrangement.
Beware of Recapture Clauses
Some prime leases contain recapture clauses that permit the landlord, upon receipt of notice of tenant’s intention to sublease all or a portion of its space, to terminate the prime lease with respect to the space to be subleased – the rationale being that the landlord shouldn’t have to compete with the tenant in leasing space. While this may be welcomed by a tenant looking to shed space, it is not good news to a tenant which enjoys a below market lease and is looking to temporarily sublease space until the company returns to good health and resumes growth. Nor is it welcomed by the tenant paying below market rent and planning to generate income off the sublease.
Even if a prime lease does not contain a recapture clause, it may require that the tenant/sublandlord turn over to landlord 100% any rent received from its sublease over and beyond its prime lease rent, thereby preventing the tenant from profiting on the leasing of its space. A provision that the landlord and the tenant share 50% of the excess rent is common and more equitable.
Review Original Lease Terms
The subtenant will be subject to the terms of the prime lease as well as the terms of the sublease, so an interested subtenant should review the prime lease and the sublease together to see whether the collective terms are satisfactory. If there are disconnects between the two leases, unexpected problems or liabilities may arise. For example, while most landlords have certain maintenance and other obligations (such as providing heating, cooling and hot and cold water), most subleases provide that the sublandlord is not responsible if the landlord fails to provide such services. Since the subtenant has no direct contractual relationship with the landlord, it cannot enforce the prime lease. Therefore, for its own protections, the subtenant must require that the sublandlord use reasonable efforts to cause the landlord to provide those services.
Risk of Bankruptcy/Foreclosure/Lease Default
The subtenant is always at risk of the sublandlord (tenant) defaulting under the prime lease, or filing for bankruptcy. The subtenant also has the risk of the landlord filing bankruptcy.
If the sublandlord defaults under the lease, the landlord can terminate the lease, which terminates the sublease and the subtenant’s right to occupy the premises. This unfortunate result can occur regardless of whether subtenant has defaulted under the sublease. If the tenant/sublandlord files for bankruptcy and rejects the prime lease, the same result follows. Should the landlord file for bankruptcy and reject the prime lease, the lease won’t terminate, but the landlord will be relieved of performing any further obligations under the prime lease, such as common area maintenance. Under this scenario, the subtenant may choose to terminate the lease. If the subtenant needs or wants to stay in this space despite landlord’s bankruptcy, the subtenant will have to contract with third parties to provide these services, incurring additional and unanticipated costs.
To guard against the risk of termination of the sublease and the loss of the right to occupy the premises, the subtenant can ask that the prime landlord provide a non-disturbance agreement. Under a non-disturbance agreement, if the subtenant is not in default under the sublease, the landlord agrees to recognize the tenant and not disturb its tenancy, regardless of whether the prime lease has been terminated. While a non-disturbance agreement makes great sense, it is not always an option. Sublandlords and landlords may not want to consider a non-disturbance agreement if the rent under the sublease is below market or if the sublease space is insignificant. If the landlord is not willing to agree to a non-disturbance agreement, then the subtenant should at least try to obtain from the landlord an agreement that the landlord will provide notice of any default under the prime lease and time for the subtenant to cure the default.
Another risk is the default by prime landlord under its mortgage, which can result in a foreclosure of the mortgage and termination of the prime lease and sublease. The tenant/sublandlord can protect its lease (and its subtenant’s lease) from termination by obtaining a subordination, non-disturbance and attornment agreement (an “SNDA”) which, in short, requires the lender to honor the prime lease and not disturb the tenancy of the non-defaulting tenant. The SNDA protects the tenant and subtenant. If the tenant does not have the protections of an SNDA, the subtenant can try to obtain one, but unless the subtenant is a significant and “desirable” tenant from the lender’s perspective, it’s unlikely a lender will be cooperative.
Additional Subtenant Protections
The subtenant should also ask that the sublandlord agree not to cancel the prime lease or amend it in any manner that may adversely affect the subtenant. If the prime lease has renewal options, the subtenant may also want the sublandlord/tenant to agree to exercise those renewal options, if requested.
Finally, the subtenant should seek to obtain representations and warranties from the sublandlord. It is common to confirm amendments to the prime lease, including the good standing of both sublandlord and prime landlord under the prime lease, and whether there is any pending litigation or likely pending litigation that might affect subtenant’s use or enjoyment of the property, and validity of the sublease.
Construction Considerations
The sublandlord and subtenant should determine whether construction needs to be performed to make the space usable by the subtenant or to separate the subleased space from the original leased premises. In some prime leases, the sublandlord will have adequate flexibility to perform such construction, but many require that the sublandlord obtain the consent of the prime landlord before such work can be performed. It also may impose requirements on any construction (such as construction plan approval and various types of insurance).
Typical Forms of Sublease
Subleases take two basic forms. One is a short form that incorporates the terms of the lease in totality. The other is a more tailored version that addresses many of the key lease provisions as needed and incorporates the lease to the extent not modified. The former version works better where 100% of the leased space is subleased; the latter version is more appropriate when a portion of the leased space is subleased and where obligations under the lease (for rent, additional rent, maintenance, etc.) need to be allocated between the tenant and subtenant.
Conclusion
Subleasing is a particularly attractive tool during a recession, both for the tenants in cost cutting mode and tenants looking for new, less expensive space or temporary space. Many tenants and subtenants assume that since the lease is in place, it should be a simple matter to transfer the terms thereof to the subleased space. In fact, the proper negotiation of a sublease involves a multi-faceted analysis of the lease, the subtenant’s operations, the need to alter provisions of the lease to fit the deal and the need for consents or other documents from the landlord or the landlord’s lender. To avoid surprises and eliminate or lessen risks, proposed sublandlords and subtenants, and their counsel, should address the issues outlined above.