Conducting Risk and Reward Analysis For Subleases

Published on Monday, 28 October 2013 10:08:26    Written by Marc
If your company or organization has a number of sites that you lease, you probably came at one point to a decision that you needed to sublease some space. Most companies that lease real estate space, whether it is for office, warehousing, or manufacturing purposes, come to this conclusion at some point, “A site or space needs to be sublet.”

Risk and rewardThe reasons can vary but the solution is always the same. You might be renting too much space and therefore decide to let it go instead of paying for the space that you are not using. Of course, as I mentioned before in past blogs, the first step before subleasing a site is to try to talk to the landlord to see if something can be negotiated. When you consider the cost of subleasing any site and the time it takes, it often makes sense to try to cut a deal with the landlord to end the lease. You might have to write a substantial check but it may be worth it.

When Negotiating Does Not Work

If you cannot make a deal with the landlord and find yourself having to sublease a site, there are a few things to consider apart from the general terms of the lease. One of these things to consider is the risk.

For example, you have an office space with four years to go on your lease and need to sublease it. You put it on the market and manage to find a potential subtenant, which comes and makes an offer on terms that are very acceptable for you. The period offered is for the full remaining four years, the rate is good, all other clauses of the offer to sublease are ok, and the best part is that they want to sign now because they need a site and narrowed their choices to two sites, yours and another one. The prospects broker wants you to sign today and your own broker is signing the same refrain. You are ok with everything but simply need to do a simple task: You will want to check their credit.

In this situation, I must have heard just about any type of excuse not to do a full credit check, from potential of losing the deal to having no reason to do it since our site was empty anyway. Without going over that list of excuses, the best advice I can give is take the time and do the credit check. Now, this will not guarantee you that you will get your rent until the end of the term, but it does add some level of security, even if it has only to know that the company is capable of paying the rent for the time being.

While on some occasions one could argue that even if the subtenant stops to pay in a few months you can always put the site back on the market, you need to remember that there are costs that you probably cannot get back, starting with the broker fees. If you agreement with the brokers are to pay them upon signage of the lease or having the subtenant taking the space, then if that subtenant defaults in six months, chances are that most of the rent you collected will go to pay the brokers and you will have little to show for in the end. Therefore, even if the credit check looks sound, you still should do a risk/reward analysis of your own so that all costs and risks are taken into consideration.

Here is an Example of a Risk Analysis

A few years ago, we had a large manufacturing site that we decided to sublease. The site was a few hundred thousand square feet and in a tough economic area. It took us almost a year to find a subtenant for a portion of the site and we managed to fit that subtenant into the portion that already had natural subdivisions, so there were no setup costs to us; the subtenant took the site as is.

About a year after that, we were starting to run low on prospects. The site was still 60% empty and we were starting to get some heat from our finance people to do something to get the site fully subleased. Therefore, we continued to prospect the market and started to lower our requirements a little. Soon, an offer came from a promoter that wanted to sublease the space to do an interior sports center. The offer that came to us seemed great on paper, a term that we wanted, a rate that was acceptable, all what we had been wishing. In that offer was the potential for us to recuperate a few million dollars in rent.

Therefore, naturally, I asked to do a credit check. We then found out it was going to be a start-up. So we asked for the business plan, which we received and read in details. After going over their plan, we started to get colder feet. When considering what they needed for their sport center, what we needed to spend to prepare the space for them, we calculated that a little more than the first year of rent would go towards paying for the site preparation. Add the broker fees and other expenses and we were seeing almost two years of rent going towards theses costs. Considering there was six years remaining to our lease that meant that on a six-year deal, we would be seeing real money for four years.

The main problem here is that we needed to shell out money upfront and then keep our fingers crossed that the subtenant remained alive for the full six years. If they defaulted after two years, we would have recuperated the equivalent of nothing, it would have been a wash. In the end, we did go back and forth for a while to try to get them to commit to security deposits, but nowhere close to what we needed and the deal died. There is a possibility that they could have succeeded in their start-up, but that was not a risk we were willing to take, at least not when considering the work we needed to do on our end first. In retrospect, it was most probably the best decision we could have taken.

If you need to sublease a site, do not just do a credit check, go over all the costs from your side and do a risk/reward analysis to see if you can still live with a situation where the subtenants defaults on the lease. Some items to consider should be:

  1. Are there any cost to divide the site (if you are subleasing a partial site)?

  2. Are there cost to fix the site (if the site lacks air conditioning for example or has items that need to be removed before the subtenant can take the space)?

  3. Will you be able to deliver the site to the subtenant according to the terms of the sublease? (For example, if you agree to subdivide the space for a certain date but run into problems with the city officials over access codes, what happens to the sublease? Do you pay the subtenant penalties for late delivery of the space?)

  4. How many months of rent do your costs (including site preparation, brokers and other costs) represent? If they represent more than one-third (1/3) of the total recuperation you will be getting from the sublease, you might rethink the situation or get some extra security deposit from the subtenant to protect yourself in the event of a default. With a good security deposit, you will at least get back some money if your subtenant goes bankrupt.

  5. Is your subtenant plan on making any addition or modification that you might stick with the bill to restore, should your subtenant default? This is something that many people do not think about. You sign a sublease, then the subtenant asks to make one modification to the site, which you approve and manage to get the landlord to approve, but not before that landlord politely informs you that the item your subtenant is modifying will need to be replaced/fixed/removed at the end of the lease and that ultimately, you, having the head lease, will be responsible for the costs.

    Take note: if your subtenant defaults or fails to do the restoration work, it will add to your costs so better to include these costs into your risk/reward analysis.

  6. Do you need to get the approval from the landlord before you sublease the site? In many cases the answer will be yes and you will need to get that before you commit to the sublease (just make it conditional to getting the approval of the landlord).

  7. Does your subtenant need to get a license or permit to operate? If it’s for simple office usage, this is generally not an issue, but if the space you are subleasing is for manufacturing, you need to remember that a few things can happen so better to include in the sublease a clause that will force your subtenant to get the proper licenses or permits within a certain time-frame or the sublease is null and void. I have seen sites where companies that were already operating in other sites go turned down on operating permits by the city for small details. If the process of getting the permits starts to drag on, you might want to cut the cord with your subtenant and put the site back on the market again.

    These elements above are a simple list of things to consider. Since each site is different, you will need to take a deep look at your site and see what can be added to this list. You might not think of every single element, but addressing the major items should give you some peace of mind.