The combination of hybrid work and downsizing due to the slowing economy has left many companies with more office space than they need. What options are available for your clients that are trying to shrink their office footprint?
Your clients can try and sublease their space, but the demand may be weak due to current economic conditions. Another alternative is to try and negotiate an early lease termination with the landlord or to try and restructure the lease. What are some of the business and legal issues associated with these options?
Sublease
A tenant’s ability to sublease its space is driven primarily by market demand and, to a lesser extent, by any limitations contained in the lease. Even in the current downturn, there will be some demand for direct and sublease space as existing leases expire and tenants need to renew or relocate. Since brokers are tracking the leasing market, they are in the best position to evaluate the sublease options for their clients but here are some general observations:
Smaller spaces (between 5,000 to 15,000 square feet) might be easier to sublet because there are more companies with that sort of requirement, including professional service firms (accounting, law, engineering, consulting), financial and investment companies, and startups that can still get funding.
It may be more challenging to sublet large, commodity space because the larger companies that historically needed such space are the sorts of companies that are consolidating aggressively. Regardless of the amount of space that you are trying to sublet, the idea of flight-to-quality still applies. If your client has premier space in terms of fit, finish, functionality or location, it will be more attractive in the sublease market. Also, it may pay to aggressively price the sublease rent in order to distinguish your space from other space in the market.
Your client needs to review its lease to see if there are sublease requirements or restrictions. The landlord likely has approval rights over any proposed sublease, although most times the landlord’s consent can’t be unreasonably withheld. Some leases, however, include sublease restrictions intended to protect the landlord’s ability to market its own vacant space. A lease might prohibit marketing sublease space to existing tenants in the building or restrict the tenant from marketing sublease space at rents that are below the then-asking rents for the building. The lease may also contain use restrictions for potential subtenants, so any sublease limitations need to be considered.
Finally, think about the operational issues related to creating sublease space within the premises, such as partitioning the space, possibly separating HVAC, electricity, data/telecom and other building systems, and ingress and privacy issues. If you need to make alterations to your premises to accommodate a subtenant, you will likely need landlord approval and you will also have to determine if the alterations need to be removed at the end of the sublease term and the premises has to be restored.
Early Lease Termination
It may be challenging to get a landlord to consider an early lease termination. The relevant factors include the current lease structure (amount of space, remaining term, rent, level of tenant improvements), the
financial strength of the tenant, the financial position of the landlord, and the current leasing environment. Here are some general thoughts, although the actual outcomes can vary considerably depending on the situation:
If a strong credit tenant occupies a lot of space in a building and has many years remaining in its lease term, then it seems unlikely that the landlord will allow an early termination unless it already has a replacement tenant lined up. A landlord’s lender might also have approval rights over any early lease termination and may not allow a major tenant to vacate early.
A smaller tenant who only has a few years left on its lease may have more leverage to negotiate an early termination since the landlord has less of an economic stake in that lease. If the tenant can offer an attractive lease termination payment and the landlord recognizes that it will soon have to seek a replacement tenant anyway, it might entertain an early termination. And consider if a landlord might be willing to stagger the early lease termination, with the tenant giving up portions of its space over a period of time rather than all at once.
What might help a tenant in its early lease termination negotiations? Perhaps a landlord has financial issues where it would be willing to trade future lease payments in exchange for a significant upfront lease termination payment. It may need to fund major renovations or has to pay off a loan. Or perhaps a landlord wants to accommodate an existing tenant that seeks to expand. If you do some due diligence about the landlord and its financial position, it might help you determine if the landlord needs cash sooner rather than later or might otherwise be interested in taking back its space.
Are there any landlord defaults under the lease? If so, this may also help the tenant gain leverage in early lease termination discussions. However, bear in mind that even if the landlord is in default under its lease (perhaps it has failed to repair a leaky roof), this usually does not give the tenant the right to abate rent or vacate the premises. The tenant usually has to separately sue the landlord to enforce the lease while still paying rent.
Even if a landlord is willing to discuss an early lease termination, how much will the termination payment be? The answer will vary in each situation – we negotiated several substantial early lease terminations in 2020 and 2021, but the downturn in the current leasing environment means that the results from a year or two ago may not be relevant today.
Finally, a tenant should evaluate the financial reporting and tax implications of an early lease termination before it starts to talk to the landlord.
Play the Bankruptcy Card
A tenant that has financial problems may have leverage in early termination or lease restructuring negotiations if the landlord is concerned that the tenant might file for bankruptcy and the lease will be rejected (which means that the lease is terminated under bankruptcy laws because the tenant will either be liquidated, or the lease is not needed as part of the tenant’s reorganization). If the lease is rejected in bankruptcy, the landlord’s claims for lease rejection damages are limited to the greater of one year of rent or 15% of the rent due for the remaining lease term (capped at three years). So if the lease has 24 months remaining and the total rent due (base rent and pass throughs) is $10,000 a month, then the landlord’s claim for lease rejection damages will be capped at $120,000 (one year’s worth of rent).
Bear in mind that the landlord only has a claim for these lease rejection damages, and it is unlikely to actually recover anything close to those damages in a bankruptcy. The landlord is a general unsecured creditor, who often end up getting only pennies on the dollar for their general unsecured claims. So a landlord needs to weigh the risks of a possible bankruptcy with minimal recovery of its damages vs. accepting an early lease termination payment.
If a tenant raises the possibility of bankruptcy (whether it is an actual possibility or only a bluff to gain leverage), the landlord will want to see the tenant’s financial statements and other business information so that it can independently evaluate the risks. There are many other business and legal issues that would arise in a bankruptcy, so if this is a possible option then a tenant should seek the advice of a bankruptcy law specialist.
Restructuring the Lease
Another option is to try and restructure the lease, rather than seek an early lease termination. Restructuring your existing lease can take many forms: defer and accrue (abate some or all of the rent now, and then add the abated rent to increased rent payments later during the term), blend and extend (adjust the current rent in exchange for an extension of the lease term), consolidate and extend (surrender some excess space now in exchange for a longer term on the balance of the space), temporary rent abatement, and many other variations of these options. While a restructuring will not eliminate a tenant’s lease obligations, it may help a tenant balance its space needs with its existing and projected cash flow.
Before a landlord will consider a lease restructure, it will likely require financial statements and other information about the tenant and its future business plans. The tenant should consider requiring the landlord to sign a confidentiality and non-disclosure agreement before it releases its financial and other information.
Exposure Under Your Current Lease
In order to evaluate lease exit or restructuring options, a tenant should understand its financial exposure under its existing lease. Generally, a tenant is responsible for all of the rent due for the remaining lease term (whether it occupies the space or not), discounted to present value. A tenant can argue that this amount should be reduced because the landlord will be able, at some point, to re-lease the space. The landlord will argue that it will take much longer to re-lease the space, and at lower rents, than what the tenant proposes, and so will be less likely to adjust the amount of the lease damages.
Conclusion
If a tenant is trying to reduce its lease exposure, it can attempt to sublease the space, seek an early lease termination, or try and restructure the terms of its existing lease. Any of these approaches may be challenging given today’s weak leasing market, but a tenant should talk with its broker and attorney to evaluate the available options and see if there are strategies to help it achieve its goals.
For more information, please contact Leon Tuan.