June 30, 2009

Real Estate Alert: 10 Significant Issues To Consider Before Subleasing

Arnold & Porter Advisory

Problems With Subleasing

By Kenneth A. Neale, Esq.

Difficult economic conditions have led to a flood of sublease office space being dumped on the market in many metropolitan areas as companies look to downsize and cut costs. Sublease space generally rents at a significant discount from direct lease space. As an additional incentive, furniture may be thrown in at little or no cost. This is good news for companies in the market for office space. There are significant pitfalls in subleasing space, however, and it may well be that some deals that seem too good to be true are just that. The following is a list of ten of the most significant issues that a potential subtenant should consider before entering into a sublease.

  1. Know Your Sublandlord. A subtenant should carefully investigate the financial condition of the sublandlord before entering into a sublease. A financially weak sublandlord puts a subtenant in highly vulnerable position, particularly where the subtenant does not have a recognition agreement or right to cure from the building owner. As described in more detail below, if a sublandlord falters, a subtenant may end up losing its sublease, security deposit and more.

  2. Recognition Agreement. By its nature, a sublease is subordinate to a superior "master" lease. Without an agreement to the contrary with the building owner (sometimes referred to as the master or prime landlord), the sublease could be extinguished if the sublandlord defaults under the master lease (or if it files for bankruptcy and rejects the master lease). To protect itself in this circumstance, a subtenant should seek a recognition or non-disturbance agreement from the master landlord providing that the subtenant may continue in the sublease space under the terms of its sublease (or other agreed upon terms) even if the master lease is terminated due to a default by the sublandlord. Many master landlords, however, will resist providing such an agreement.

  3. Right to Cure. Although not as beneficial as a recognition agreement, under some circumstances, a subtenant should seek to negotiate from the master landlord a right to obtain notice of and cure defaults under the master lease. If a subtenant exercises this right, it should have the right to deduct the cost of curing the default from the rent due under the sublease. This right may be impractical, however, such as where the obligation of the sublandlord under the master lease is much greater than the obligation of the subtenant under the sublease.

  4. Specific Landlord Consent. Often a subtenant will need to make alterations to the premises to suit its needs. Alterations typically require the consent of the master landlord. A subtenant also may be seeking certain rights under the master lease, such as parking, that are considered personal to the sublandlord and thus not transferable. A subtenant should demand the master landlord's consent to these matters as a condition to the sublease.

  5. Building Services. Office building owners typically provide their tenants, at a tenant's request and cost, with additional services such as afterhours heating, ventilation and air-conditioning and extra janitorial services. As a subtenant is not in direct contract with the building owner, the owner has no obligation to provide these extra services to a subtenant unless directed to do so by the sublandlord. A subtenant should negotiate the right to request these additional services directly from the building owner.

  6. Further Subleasing. Some building owners do not like the concept of a sub-sublease or a further assignment of lease. Business realities are such, however, that it could be very important for a subtenant to preserve this right, particularly for longer term subleases.

  7. Furniture Issues. Subleases often include rights to use existing furniture. Sometimes furniture is sold to the subtenant for nominal consideration at some point during the term of the sublease. A subtenant will want to be sure that the furniture is not subject to any liens. If it is, a subtenant will be faced with the possibility that the furniture could be repossessed during the middle of the sublease term or that the furniture does not belong to it at the end of the term as expected. A subtenant also should consider whether it is in its interests to take title to the furniture during or at the end of the term. The furniture may have little value at that time, and if it belongs to the subtenant, the subtenant will be responsible for moving it out of the premises at the end of the sublease term.

  8. Master Lease Incorporation. Most subleases incorporate provisions from the master lease. Many times this incorporation is overly broad or done incorrectly. This could lead to unpleasant surprises, such as where a subtenant inadvertently agrees to limit a sublandlord's liability under a sublease to the sublandlord's interest in the property, which may well be worthless (what is a leasehold interest in a building worth, particularly where the rent being paid under the lease is greater than the fair market rental value of the premises?).

  9. Deposit. A subtenant should think twice before providing a significant cash deposit to a financially weak sublandlord. In commercial leases, cash deposits are usually commingled with other assets. If the sublandlord becomes insolvent, a subtenant may lose its deposit. A subtenant should consider a letter of credit as an alternative or negotiate the right to apply the deposit against rent during the sublease term (often at the end of the term).

  10. Waiver of Subrogation. Nearly all commercial leases contain releases and waivers of subrogation which in effect provide that neither the landlord nor the tenant (nor their property insurers) may bring suit against the other for damage to property that is covered by the property owner's insurance. This makes sense because each party should maintain property insurance on its own property (in fact, the cost of landlord's insurance is usually paid by the tenants). It is important that this concept also apply to the subtenant. Otherwise, the subtenant may find itself liable (to the landlord or its insurance company) for damage caused to the building that is covered by the landlord's insurance.

The sublease market can offer some excellent opportunities to companies in need of office space. A prospective subtenant needs to approach a sublease with caution, however, carefully considering the financial condition of the sublandlord and closely reviewing the fine print of the sublease, the master lease and the master landlord's consent document.

If you have questions about any of the issues raised in this article, contact Kenneth A. Neale at 415.677.6322 or your usual Howard Rice attorney.

Subscribe Link

Email Disclaimer