More and more landlords are attempting to recoup profits from subleasing activities in their buildings. Typically, landlords require that tenants remit between 50% and 100% of the profits derived from subleasing activities. Why are landlords entitled to share in sublease profits? Landlords argue that tenants shouldn’t be in the real estate business and should not be competing with them for tenants in the building. Profit sharing, they argue, ensures that the landlord is the only one really making money from rentals in the building. In truth, profit sharing is simply a means for landlords to hedge their bets if they made a bad initial deal with the tenant or the market unexpectedly goes up over time. If tenants bear all the risk of a bad lease deal, they should reap the benefits of a good one.
At the outset, it is important to understand that sublets rarely result in profits to the tenant. As sublets are less desirable than direct deals, they typically trade at a material discount to direct deals in the market. Sublets often involve “as is, where is” arrangements where the subtenant takes the space with little or no renovations. The term is often short, the space may not be ideally configured for the subtenant’s particular use, there may be too much or too little space and the subtenant has no contractual privity with the landlord to compel performance. All of these factors create downward pressure on sublet rentals leaving little chance of profit opportunities. Nevertheless, there are instances where a sublet can provide some upside for a tenant.
Profits from sublets can result from three distinct causes:
1. The tenant may have negotiated an extremely favorable economic deal based on its unique bargaining position or leverage when the initial lease deal was cut. Thus, a 200,000sf office tenant in a distressed building may have secured extremely favorable terms that were not available to smaller tenants. Similarly, a supermarket anchoring a shopping center may negotiate a rental rate which is substantially cheaper than the rates a smaller “in line” stores could secure.
2. The market may improve dramatically over time. Thus, a long term lease negotiated in a depressed market eight years ago may end up being well below market when the economy picks up, thereby creating unique profit opportunities for the tenant.
3. The tenant may have enhanced the value of the sublet premises by investing a lot of money in the space. Thus, if a landlord leases office space to a tenant at $25/sf with a $20/sf improvement allowance and the tenant spends an additional $50/sf of its own money improving the space it is quite possible that the “market” for this enhanced space is now $30/sf. Is this $5/sf rental premium a “profit” or is it simply reflective of the tenant’s additional investment?
Lease negotiations reflect a balance of risk allocations over a relatively long period of time. In each negotiation, the parties have to make educated guesses about what the future holds and decide how they want to hedge that bet. Once the lease is signed, the tenant is locked into a fixed rental structure regardless of whether the rental market subsequently goes up or down. Landlords too should be required to live with the deal they have cut. They should not be allowed to keep the fruits of an above market lease deal and also take away the tenant’s fruits of a below market deal. In no event should a landlord reap the benefits of a tenant’s additional investment in the space (i.e., scenario 3 above).
For more information contact Glenn Blumenfeld