Sublease Rent Is Lower Than Contract Rent
Owner
User
Will buy out
Won ’ t buy out
Contract Lower Than Market
• Wants new user
• Wants higher rent
• Likes user
• Wants security
Every situation is unique , but many tenants consider subleasing for a few common reasons :
• Need more space . If a client has outgrown their space , they will need to relocate to accommodate a growing business with greater needs . In this case , a sublease can cover all or a portion of the existing location .
• Need less space . A business headed in a smaller , leaner direction could also benefit from a sublease . Think of an office building in April 2020 — the business may have required every employee to work for home for months or longer , so 10,000 or 20,000 sf of office space is no longer a necessity .
• Things change . A tenant may look to sublease if their business model has changed significantly . Think of Walmart as an example . When these stores started to include groceries , their footprints greatly increased , leading to the spread of Supercenters . Walmart subleased many Division 1 stores to smaller retailers while they looked at larger facilities .
• Costs need to be cut . Some businesses may have to sublease some or all their space to stay afloat during difficult economic times .
• The space is obsolete . A tenant may look to sublease if a space or building is obsolete due to changing technology or business needs .
To pursue a sublease , a tenant must first make sure the landlord is properly notified . Language in the lease should detail what this entails — whether the landlord needs to give permission in writing or other parameters are established . The tenant or user of the space also needs to consider who profits from the lease in the event the sublease rent is above the contract rent . Will that go to the tenant or landlord ? Conversely ,
Contract Higher Than Market
• Wants better user
Will buy out • Wants better space • Wants lower rent
Won ’ t buy out
• Enjoys bargain rent
• Can sublet at a profit
• Enjoys excess rent
• Doesn ’ t want new user at lower rent
• Enjoys space
• Wants security
if there is a reduction in rental income , how will the primary tenant account for the difference ?
But other issues in the real estate market may complicate the subleasing process . You may not be able to find a new tenant for a space . Imagine if you were looking to sublease a boutique retail property in May 2020 , for example , amid COVID-19 shutdowns .
To see how this plays out , let ’ s look at a case where a tenant was able to sublease a property for less than the existing lease . How would you determine the value of that sublease in today ’ s dollars ?
In this case , there are eight years left on a lease that ’ s $ 50,000 per year . The sublease agreement is for $ 45,000 a year . Assuming the primary tenant ’ s discount rate is
How Much Would the Tenant Pay to Terminate the Lease ?
EOY Market Rent Contract Rent Difference 1 $ 150,000 $ 200,000 ($ 50,000 )
2 |
$ 150,000 |
$ 200,000 |
($ 50,000 ) |
3 |
$ 150,000 |
$ 200,000 |
($ 50,000 ) |
4 |
$ 150,000 |
$ 200,000 |
($ 50,000 ) |
5 |
$ 150,000 |
$ 200,000 |
($ 50,000 ) |
|
|
Present Value at 7 % |
($ 205,010 ) |
10 percent , the difference in present value of the two leases equals negative $ 26,675 . This total is crucial when considering if a sublease is the correct path forward .
TALKING ABOUT A BUYOUT If a sublease doesn ’ t make sense , a buyout could be another exit strategy for tenants . A more drastic move in some ways , a buyout can give a landlord / owner a chance to possibly lease at a higher rate , thereby increasing their building value , while tenants can exit leases that have become burdensome .
Prime candidates for buyouts include big-box stores that have closed permanently , such as JCPenney , Sears , and Kmart . Other situations could include a retailer moving from brick-and-mortar to online sales . H & M , for instance , has closed a significant number of stores as it emphasizes e-commerce .
Looking at a second case study , imagine the tenant owes the landlord $ 1 million over five years . From the perspective of the tenant , who desires to exit the property , if the landlord could lease the space to another occupant for $ 150,000 a year , that is a shortfall of $ 50,000 a year or $ 205,010 in today ’ s money when discounted at 7 percent . But from the landlord ’ s perspective , the tenant owes them $ 1 million . Even if the landlord agreed to discount the remaining rent owed at the same discount rate of 7 percent , they would be owed $ 820,039 today .
By comparing these two figures , you ’ ve established a negotiating range . In determining what to accept on a buyout , the landlord must consider multiple variables .
• What additional value might come from a stronger tenant ?
• How long might the space be vacant ?
• Can the property be repositioned with a different user ?
Additionally , if the property is leased for $ 150,000 per year , instead of $ 200,000 , the net operating income is reduced by $ 50,000 per year . This shortfall could cause problems if the landlord has a loan with a debt-service coverage ratio and loan-to-value ratio requirement . Most loans have covenants that require certain benchmarks throughout the term of the loan . If these aren ’ t met , a default or capital call may occur .
The volatility across commercial real estate markets doesn ’ t appear to be going away soon . Reworking leases , subleasing , and buyouts are skills that many CRE professionals need to have in their toolboxes . Knowing the goals of all involved parties — including tenants , landlords , owners , and other parties , including financing — will help you advise clients when deciding the best course of action as the industry enters a post-COVID world .
Soozi Jones Walker , CCIM , SIOR President and broker of Commercial
Executives Real Estate Services in Las Vegas Contact her at soozi @ cevegas . com .
Editor ’ s note : This article was adapted from the CCIM Institute course , “ Surviving
Volatile Markets Mitigating Lease Risk ,” a new online , self-paced course from
CCIM Institute ’ s Ward Center for Real Estate Studies .
CIREMAGAZINE . COM COMMERCIAL INVESTMENT REAL ESTATE MAGAZINE 33