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Profits and Pitfalls of Subleasing

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The article below is one that I wrote in February 1993.  I found it interesting that it still holds true not only for the Seattle are, but most office markets, too.

Almost 20 percent of the vacant office space in Bellevue and Seattle is available for sublease. Massive corporate restructuring, downsizing and mergers mean that many Puget Sound firms need less space than anticipated. Yet they find themselves locked into expensive long-term leases. It makes a lot of sense to find a way to recoup on space that would otherwise stand empty.

Even at 20 percent, sublease space in the market is underestimated. When any space is vacant or is soon to be available due to a pending move, it is included in our vacancy rate analysis. But often sublease opportunities are poorly marketed and publicized. Space with less than one year remaining in the lease is often not marketed at all. So tenants willing and able to relocate and go through the complications of a sublease transaction will find plenty of attractive possibilities around town.

"Attractive" is not a word you would hear from building owners, who often view subleases as bad news. Rates are typically at least 15 percent lower than direct leases. An owner therefore finds himself competing with existing tenants for new tenants. It's an uphill battle, because the landlord is usually at an economical disadvantage.

Rental rates for sublease space in some of the newest buildings in downtown Seattle, for example, can run as little as $12 per square foot, complete with full service. This is a whopping one-third savings over the average downtown rate of $18 for similar office facilities.

Garth Olsen of Cushman & Wakefield, leasing agent for the remaining 100,000 square feet of AT&T sublease space in the AT&T Gateway Tower downtown, says that his firm is asking between $14 and $15 per square foot. This includes a generous tenant improvement allowance with a lease that runs through the year 2000.

On the other hand, the landlord has a starting price of $18 per square foot. The building is only 54 percent full after two and a half years. Having to compete against your major tenants to lease space adds insult to injury.

Getting a Good Deal

Despite the obvious economic benefits, there are some challenges in negotiating a wise sublease. If costs were equal, it would be more desirable to deal directly with a landlord than to sublease, since there are fewer risks and complications involved. Direct lease space negotiations are two-way between landlord and tenant. In a sublease arrangement, however, transactions become three-way, with all the inherent pitfalls of any triangulated relationship. "In most leases, the original tenant is still ultimately liable for rental payments, even after the space has been subleased," said Craig Michalak, a prominent Eastside broker. "If the subtenant pays less than the face rate of the original lease, the original tenant must make up the difference." He points out that the subtenant, in turn, needs to be concerned with the financial stability of the original tenant. The subtenant may find themselves stuck making overage rental payments, or could end up with default problems that cannot easily be cures. In a worst-case scenario, they could be forced to move.

For companies like the Hogan Company, a Bellevue communications firm, subleasing 7,800 square feet of office space for the past three years has been a good decision. "I looked at everything available that was the right size for us," said Walter Hogan, president. "My final decision was based on cost. We were able to move into our space as is, and saved more than 20 percent over doing a direct deal. I'm very pleased with how everything worked out, and highly recommend a similar arrangement to others."

Hogan was lucky. It's unlikely that the layout and site of an office will exactly match a new tenant's needs, especially in offices greater than 5,000 square feet. When the space can't be used as is, an appropriate allowance for tenant improvements needs to be included in the sublease. Otherwise, the 'financial benefits of a reduced rental can quickly vanish. A typical downtown tenant improvement allowance is around $25 per square foot. Using a 10 percent annual interest rate over a five-year lease amortizes to $6.37 per square foot per year in rent. In other words, more than $6 of each rental payment goes to help the landlord payoff tenant improvements. When the remaining term is less than three years, these expenditures can cause the effective rental cost to increase significantly if the tenant has to foot the bill. What seemed at first glance to be a good deal becomes a very expensive proposition.

Remaining terms of less than two years are the norm for sublease space. But spaces offered by major users often have remaining terms and expansion options that reach well into the next century. In these cases, it's worthwhile to calculate very carefully the pros and cons of various tenant improvement options. Long-term subleases can make sense even when the subtenant ends up paying for improvements. When improvements are amortized over many years, the results of a sublease can become much more beneficial than anything that could have been obtained directly through the landlord.

Two of the larger companies in town with large amounts of sublease space available are AT&T, with 100,000 square feet, and Seattle First National Bank's Security Pacific Bank space, with 200,000 square feet. AT&T's space became available due to a reorganization of the company's work force. SeaFirst's space is the result of their well-publicized merger with Security Pacific Bank. Both leases have a long time to run...;, about seven and a half years for AT&T, and about 25 years for the bank. In SeaFirst's case, there is little probability of finding firms willing to commit for a quarter of a century. So they can be expected to be flexible on the length of term for subleases.
SeaFirst is in the process of finalizing their leasing strategy and selecting a leasing representative. They have already done well, subleasing 150,000 square feet of their original 350,000 square feet to West One Bank and other smaller subtenants. SeaFirst views their property more as owned than as leased. They have therefore decided not to disrupt the market by undercutting prices for competitive space. In other words, they are taking a long-term ownership approach, rather than opting for a quick fix that could result in both hard feelings and financial drawbacks in the long run.

Outstanding opportunities await any business owner willing to consider subleasing space. But risks are certainly present too. Anyone interested in investigating subleased property would be wise to consult a real estate professional as well as an attorney; to make sure that the deal is really as good as it looks.

Office Leasing Tips , Office Rental , Office Space , Office Space Negotiations , Sublease Office Space

1 response to “Profits and Pitfalls of Subleasing”

  1. Andrea Guillot Says:
    Isn't it great how the same "profits and pitfalls" hold true for most markets even over 10 years later? Thanks for reposting this--the advice is definitely needed, especially with the current status of the market.