Beware of the Real Cost of Sub Dividing a Site

Published on Tuesday, 17 December 2013 10:32:26    Written by Marc
Over the years, I was often called to sublease a site that we no longer needed. At times, it was an industrial space; others it was an office floor or section of a floor, other times it was a complete building, which had a mix of office and warehouse. I found that subleasing was often more difficult than it seems. Maybe because I was not often lucky enough to find the perfect subtenant to come and lease up everything at once, most of the time we would find prospects which were interested in leasing portions of the space, but not everything.

cost of subdividingAt one point, I was starting to think that I was alone with my bad luck. I would have a small office building that I thought was the perfect size for an operation with one hundred employees, and would be unlucky enough to find a prospect that had only sixty employees. Then I would have an industrial space of 200,000 square feet and was thinking this would be perfect for a warehouse or medium sized operation, only to find prospects wanting 120,000. In addition, this situation kept repeating itself. I would go back to our real estate brokers and specify once again what we wanted but for some reason only managed to get the right subtenant, maybe only each three deals we made.

I started to talk to people doing the same work as me in other companies and came to realize that this situation is far from unusual. Actually, most of the time subtenants do not want to sublease the entire available space, except maybe when the space is a small office. When faced with this situation, there are only a few things we can do. We can either try to convince the potential subtenant to take more space or subdivide the space. Both solutions have their benefits but also their downsides. Let us analyze both potential options here:

Convince the subtenant to take more space

First, this is easier said than done, as we all know that when companies search for sites, they pretty much already have a perfect size in mind and obviously a budget to respect. However, leasing more space to the subtenant does not necessarily mean simply adding square feet to his lease at the same rate. Sometimes a potential subtenant would feel better having more space for his/her operations, either for the immediate needs or for future growth but cannot simply from a budget perspective. Sometimes leasing some additional space at a reduced cost can result in a win-win for you and for your subtenant.

For example, if you have a 30,000 square foot office space located on one single-floor of an office building. If your subtenant only needs 25,000 square feet, you might want to iron out the terms for the 25,000 square feet he/she needs and then offer the extra 5,000 square feet at a reduced price. After all, when you consider the cost of subdividing the space for those 5,000 square feet, it might be worth it to let that leftover space at a deep discount. Same thing for industrial spaces, you will have to analyze carefully if it is really worth to divide the space. In some cases were we were subleasing industrial spaces and I knew it was difficult to find good subtenants, we managed to do a sublease at full price on the space that the subtenant needed and then offered the remaining space at zero base rent, with the subtenant ending up paying only for the additional costs (operations). It might seem like a bad deal to sublease a portion of a site without getting any base rent, but you need to consider your section option.

Subdividing the space

If you have a space that you put up to be subleased, and find a potential subtenant, which offers to take only a portion of the space. If that subtenant offers you good terms and conditions, you might be tempted to jump on the occasion, accept the proposal, and plan to subdivide the space. On paper, it makes sense. You sublease a portion of the space at a good rate and then subdivide the space to get a second subtenant, which you think would also be happy to pay good rent. However, before starting this process, you need to think about a few things.

First, the cost of subdividing is more than simply the cost of putting up a wall. That is, if you get permission from your landlord. Subdividing a space means (in most countries) that you need to keep providing access to all of your subtenants in case of emergency like a fire. If your office site only had two exits in the beginning and you are subdividing it to make it into two offices, you might have to add one or even two new exits to make each office compliant with the local regulations (national/state/province/city). This can come at a steep cost. Then there are other requirements, such as washrooms.

If the washrooms are public ones located in the common area of an office building you might not have a problem, but if you are subdividing a standalone building and all washrooms are located in one area of the building, then you will need to consider the cost of adding washrooms. There are actually many other items to consider, think of server rooms, telecommunication, eating area, and the lobby. Each time you subdivide a space you must think that you are creating a new site, which that must have everything it needs for the operations of your subtenant.

If your second subtenant wants to use the data connection that you had in the office, but the cable is connected to the sever room that is located in the office space of your first subtenant, you will need to do some rework. In the end, the cost of subdividing a space can represent more than the rent you will be able to collect from the second subtenant you can bring in. In addition, to make matters worse, you also need to plan for the removal of the items you added when your lease ends. For example, if you had to install a dividing wall, install washrooms, chances are your landlord will ask you to remove everything when your lease expires, adding cost to the process.

When you consider all the costs associated with subdividing a space and then restoring it at the end of your lease, one can think that it would never make any sense to subdivide a site, but in reality, it really depends on a few factors.

  1. The remaining term on your own lease. If you have only one year left on your lease, chance are you will never be able to recuperate the costs associated with subdividing a space in that period, even if you have your second subtenant ready to sublease the remaining portion of the space.

    However, if you had a 15 year lease and for some reason you decide to sublease it after five years and still have 10 years remaining on your lease, you might have more than enough time to recuperate all the subdividing and restoration costs. One year and 10 years are extreme. Most of the time the remaining term is somewhere in between so you will need to calculate your costs of subdividing your space and see what makes sense.
  2. The quality of the subtenants. It might sound like a small detail, but whenever you decide to subdivide a space and commit to the cost of doing the work associated with this, you should make sure your subtenant is financially sound enough to pay the rent each month until the end of the sublease.

    There is nothing more frustrating than spending thousands of dollars (and sometimes hundreds of thousands) to subdivide a site for a subtenant, only to have that subtenant go bankrupt and having to go back in the market to try to find another one ASAP. While this is impossible to control, at least do a good credit check first. In some cases, I actually asked for a substantial deposit, especially if in addition to subdividing the space we needed to add items such as washrooms.

    You can ask for a deposit from the subtenant, which can be held in an interest generating account, for the benefit of your subtenant. The important element for you is to get an extra level of protection in case your subtenant goes bankrupt and you are unlucky enough to not be able to find a new subtenant until the end of your own lease. That would mean a net loss for you. Having a higher security deposit could help alleviate some of the loss here.
  3. Subdividing time. This also may sound like a detail in the process, but getting approval from local authorities (often the cities) can take much more time than most people can think. Depending on your type of site and layout, you might have to plan for escape corridors (in case of fire) which means hiring engineers, architects, making plans and having them approved by the city and after the work, having the city approve the new layout. If it was as simple as putting up a gypsum wall it would be easy, but subdividing a space also means taking into consideration electrical, HVAC, and sprinkler systems.
  4. Bottom line: If you have a site which you are trying to sublease and find a potential subtenant which only offers to lease a portion of your space, before pushing him/her away, try to analyze carefully your options. In some cases you could find that making a with the subtenant might not bring the optimal result you were expecting, but something close enough that you can live without going through the problems related to subdividing a site.

We once had to subdivide an industrial space and encountered problems with layout, emergency exits, HVAC and plumbing systems in the way, you name it. Although I have been in the field of construction and renovation all my life I was amazed at the cost of adding up all these things, but on paper, it still made sense to invest a few hundred thousand dollars to subdivide the space. However, to make matters worse, because of the way we needed to subdivide the space, none of our professionals (engineers and architects) was really sure of what the city would require. Therefore, we called in the city, which as usual offered only non-committal suggestions.

They could not tell us exactly what we needed to do and would not say what they would approve, regardless of the proposals we showed to them. We were simply turning in circles and spent many months of back and forth between the city and our professionals for nothing. In the end, we simply made a deal with our existing subtenant to take the remaining space. By the time we came back to him to suggest him to take the remaining space, we had lost so much time with the city that our subtenant’s business had increased and he was now ready to lease more space.