TAKE THE GUESSWORK OUT OF SUB-LEASING
Now is the time for facility managers to display their true talents and worth to their organisations by reducing accommodation costs. Alienating leases and leased areas not required by way of sub-leasing, assignment or terminations has become a priority. But, as this process commences, a word of warning: Don’t commit to new smaller premises, even at significantly reduced rentals, until planned subleases and/or terminations of leases have been finalised. Too often there is ‘slip between cup and lip’ and suddenly the company is paying rental on two premises, resulting in higher, not lower, accommodation costs!
GETTING STARTED
Do not be disappointed if your landlord is not interested in entertaining any prospects of an early lease termination unless there is an explicit pre-agreed clause in the lease agreement. Landlords have also suffered significantly during this financial hiatus and are under immense pressure from their financing sources to show stability in their portfolio and tenants. Even a termination with a good up-front payment and future rental growth prospects may be seen as weaknesses in the security of the future rental flows from the portfolio.
Start by reviewing the relevant lease agreements in detail to fully understand your rights in being able to sub-lease or assign all or part of your leased premises. These conditions may be fairly onerous, so do not make assumptions. In most leases landlords need to display reasonableness in consenting to a sublease or assignment proposal provided their position is not weakened in any way. However, there is seldom any onus on landlords to assist in the process or display any flexibility in consenting to any such proposed arrangements. It is important to distinguish the difference between assignment and sub-leasing clauses. With assignments the incoming tenant fully takes over all the rights and obligations covered by the lease agreement. Landlords are reluctant to agree to such assignment unless the incoming tenant has a better covenant than the outgoing tenant. Assignment is relevant to the entire premises and not part of the premises such as part of a floor or a few floors out of many.
Most often the issue of lease term becomes the centre of a three-way negotiation. The new sub-lessee has the expectation of a certain term; the remaining term of the lease is predetermined; and although the landlord may be eager for a longer term he will extract a price for ‘reluctantly’ agreeing to this extension. Remember there may even be a disincentive for a landlord to agree to a sub-lease if there is other vacant space in the building. You may be in competition with your landlord – but you still need to get his approval.
In preparation for the leasing campaign it is important to do the proper analysis of likely financial outcome. In particular, be diligent in assessing the accounting treatment of any loss on rental or furniture fit-out write-off. As per accounting standards the full extent of these losses may need to be accounted for as soon as they are recognised, even if the actual losses will only occur over some years into the future. So, having managed to achieve a good level of recurrent savings, your directors may not be that pleased with having to recognise three or more years’ losses in one year. Be sure you know what the company’s financial objectives are before getting too far down the sub-leasing route.
MAKE-GOOD OBLIGATIONS
‘Make-good’ obligations at the end of the lease are another financial obligation trap. The cost of removing existing furnishings and fit-out and the rectification of any resultant damage the premises can be large. It may be possible to have this obligation transferred to the sub-lessee, but generally this is difficult unless the new tenant ends up with a longer lease direct with the landlord. These three-way negotiations are always a challenge!
In setting your sub-leasing objectives it is important to be realistic in determining the rental target levels that are to be achieved. It does not make sense at this stage of the property cycle to follow the market rental trends. With a diminishing lease term and relatively short period to secure a sub-lessee, it is important to lead the market with the rental deal on offer. Landlords can afford to be more strategic in their approach to secure new long-term tenants. Target rental levels should be ‘highly attractive’ to potential sub-lessees. In most market conditions this will probably require that a loss be taken on the rental for the remainder of the lease period.
Because of the potential complexities in sub-leases, leasing agents are often less than enthusiastic about or committed to sub-leasing mandates. Something needs to be on offer to somehow ‘catch the attention’ of the leasing agent. This may be letting them know that there will be a quick and easy deal; or there is an additional leasing incentive; or whatever else may work. In the current market there are many premises available for sub-leasing and agents have a very broad selection of sub-lease premises to show prospective clients. The key to success may be the initiative displayed in capturing the agents’ focus and imagination.
ALLOW FOR MARKETING COSTS
In the sub-leasing budget, provisions need to be included for marketing costs to cover signage, brochures and the agent’s fees. In addition, be aware that you may need to provide a lease incentive to the incoming tenant of 20 to 30 percent of the rental for the agreed lease term. This may be problematic if the agreed lease term as approved by the landlord is longer than the outstanding period of the current lease term. The landlord may not be prepared to contribute any leasing incentive (or even agent’s fees) even though benefit is being received. In these situations it is unlikely that the financial business case for the sub-lease will make sense. In certain circumstances the lessee incentive may be provided in the form of the existing fit-out – but only if the design and layout suits the new tenant. The allocations of these up-front costs are challenging negotiation points and critical inputs into the sub-leasing business case. Generally, it is easier to sub-lease smaller areas compared to whole floors and/or multiple floors. There is usually more tenant demand in the smaller suite search categories – albeit there may be more supply of suite available. As a rule the larger the accommodation requirement the more sophisticated the tenant; the more robust the search; and the more inflexible the commitment for new premises is likely to be. Also, the longer the sub-lease period, the more likely that the business case will make financial sense. For relatively short remaining periods it often makes more sense to ‘sit it out’ until the lease expires. It is important to do detailed analysis and business case appraisal prior to embarking on any sub-leasing and/or assignment campaign. Often, the potential revenues do not justify the up-front costs and efforts involved – particularly if the objectives of the landlord and tenants are not aligned. Do not expect the landlord’s commercial imperatives to coincide with your sub-leasing financial objectives. The reality is that the landlord does not have to assist in the process other than display some reasonableness – usually the landlord has the luxury of time and can wait until the market up-swing is more evident before commencing the tenancy search.
