How to Avoid Leasing Competition with Tenant that Wants to Sublet Space

As finding tenants to fill vacancies gets harder, your own tenants could make the situation worse for you by competing with your leasing efforts. For example, your tenants could try to sublet to the prospective tenants that you're courting. Or they may try to sublet to another tenant in your building or center.

You can minimize leasing competition with your tenants by adding four protections to your lease's sublet clause, say New York City attorneys Neil E. Botwinoff, Sheri P. Chromow, and Robert P. Reichman, and Seattle attorney Richard Moore. Here's a checklist of those four protections, and lease language you can use to add them to your lease. We'll also tell you about compromise approaches to consider if a strong, desirable tenant balks at these protections.

Four Protections to Include in Sublet Clause

* Create Sublet Rent Floor

Don't let the tenant sublet space at a rent that's less than the rent you're asking for other vacant spaces in your building or center, says Moore. Otherwise, you may lose prospective tenants to cheaper rents offered by the tenant, he warns. You also risk devaluing the building or center, says Botwinoff.

To keep the tenant from undercutting your rents, set a sublet rent floor—that is, the lowest rent you'll let the tenant charge, says Moore. Set the sublet rent floor at the greater of the following: 1) Your then current rental rate for comparable space in the building or center; or 2) The minimum rent the tenant is paying at that time, he says.

Model Lease Language

In no event may Tenant sublet all or any portion of the Premises at a square foot rental rate less than the greater of:

• a. Landlord's prevailing rental rate for comparable space in the [Building/Center], as determined by Landlord, in its sole and absolute discretion; or

• b. The current Minimum Rent under this Lease, as of the date of Tenant's sublet request.

Moore suggests that if your rental rates for new tenants are typically higher than rental rates for renewal tenants, you should consider changing the opening language of Paragraph (a), above, to read as follows: “Landlord's prevailing rental rate offered to new tenants for comparable space in the [Building/Center].…”

Practical Pointer: Expect a savvy tenant to ask that you list criteria for “comparable space,” rather than allow you to determine on your own when the space is comparable, says Moore. For instance, the tenant may want comparable space to be of a size, location, and quality comparable to its own space and leased for a term comparable to the term of the proposed sublet, he says. Alternatively, the tenant may request that you be reasonable in your determination of comparable space, he says.

Compromise approach: No sublet rent floor if low vacancy rate, short-term sublet, or small portion of space sublet. A savvy tenant may balk at a sublet rent floor. The tenant will want free rein to set the sublet rental rate as low as it wants. The tenant will argue that sublet rent is its business decision, not yours. It may also point out that sublet space is less valuable than prime space, says Botwinoff. For example, it's less desirable because there's a risk that the subtenant could be kicked out of the space if the prime lease terminates, he explains. Plus the subtenant has no direct relationship with you, so it can't force you to perform your obligations under the prime lease, he adds.

In response, Moore says that you can consider agreeing that the sublet rent floor won't apply if, at the time of the sublet request:

• There's a low vacancy rate in your building or center;

• The sublet term will be very short; or

• The sublet applies to only a small portion of the tenant's space.

A low vacancy rate is usually an indicator of a strong market—so you probably won't be desperate to attract prospective tenants, notes Moore. You'll have to negotiate how low the vacancy rate must be. For example, you may consider a vacancy rate of less than 10 percent of your building or center as being low, he says. You'll also have to negotiate how short the sublet term must be—Moore recommends no more than 24 months. And you'll have to negotiate how little of the tenant's space can be sublet without the sublet rent floor applying—Moore recommends no more than 25 percent of the tenant's space.

If you agree to this compromise, add the following language at the end of the Model Lease Language that sets out the sublet rent floor:

Model Lease Language

c. Notwithstanding the foregoing, if:

• (i) The vacancy rate in the [Building/Center] is less than [insert %, e.g., 10] percent;

• (ii) The proposed sublet is for a term less than [insert #, e.g., 24] months; or

• (iii) The proposed sublet applies to less than [insert %, e.g., 25] percent of the Premises,

as of the date of Tenant's sublet request, then the limitation set forth in this Clause shall not apply.

Practical Pointer: If you agree to this compromise, make the tenant agree to keep the sublet rent confidential, says Chromow. Otherwise, if prospective tenants learn that the tenant's sublet rent is lower than the rents you're asking, you may have a tough time getting those higher rents.

Compromise approach: Set sublet rent floor at “net effective” rental rate. Another objection that a tenant may raise to a sublet rent floor is that the amount you're setting is unfairly high. Another possible compromise addresses that concern by setting the sublet rent floor at the “net effective” rent in the building or center. This is the net rent for space in your building or center after subtracting certain of your leasing costs, as amortized over the life of the lease, Reichman explains. These costs may include broker's commissions, tenant improvement allowances, free rent, and other lease concessions.

Example: Rent for the tenant's space or comparable space in your building or center is $40 per square foot for a 10-year lease. But you're currently offering your new tenants a tenant improvement allowance of $20 per square foot. Plus you'll pay a broker's commission that works out to $10 per square foot. And you'll give new tenants three months' free rent—the equivalent of $10 per square foot. So your up-front costs total $40 per square foot. After amortizing these costs over 10 years ($40 ÷ 10 = $4), your net effective rent would be only $36 ($40 – $4) per square foot.

For this compromise, you would use the following language instead of the model language on p. 1:

Model Lease Language

a. The sublet rent shall be set at no less than:

• (i) The then current Minimum Rent under this Lease; or

• (ii) The then “net effective” prevailing rental rate for comparable space in the [Building/Center], as determined by Landlord, in its sole and absolute discretion,

as of the date of Tenant's sublet request.

b. For purposes of Paragraph a hereof, the “net effective” rate shall mean the rental rate being offered by Landlord for new leases in the [Building/ Center], less those costs generally incurred by Landlord in connection with a direct lease of space in the [Building/Center] (including, without limitation, broker's fees, construction costs, rent concessions) as determined by Landlord, in its sole and absolute discretion.

Practical Pointer: If the tenant argues that the net effective rental rate formula is too vague, you can agree to use a percentage of the prevailing rental rate—say, 90 percent. The 10 percent reduction will be an estimate of your leasing costs, Reichman explains. This can help you avoid a future dispute with the tenant over the amount of the leasing costs.

* No Sublets to Other Occupants or Tenant's Affiliates

Bar your tenant from subletting to any existing occupants—that is, other tenants, subtenants, assignees, or licensees in the building or center. The tenant may argue that a neighboring tenant that wants to expand is its most logical prospect for a sublet, says Chromow. That may be true, but the tenants in your building or center are your most logical prospects, as well, says Botwinoff. And you're the one who brought them to the building or center in the first place, he adds.

The same holds true for current subtenants, assignees, or licensees in the building or center. Any current building occupant looking to expand or move within your building is a good prospect for you, too.

But expressly barring sublets only to “existing occupants” may not be enough protection for you, says Reichman. You should bar the tenant from subletting to any affiliate of any existing occupant in the building or center, he says. Here's the scheme that a tenant could concoct: Rather than sublet directly to an existing occupant, the tenant has the existing occupant form a new affiliate. The tenant then sublets to the affiliate—which may be nothing more than a shell company, warns Reichman. Once that occurs, you lose out on getting a desirable, potential customer for your unoccupied space because the existing occupant's expansion needs have already been met by your tenant, he says.

To prevent that from occurring, define an “affiliate” in the lease to mean any corporation or other business that directly or indirectly controls, is controlled by, or is under the same control as any occupant in the building, Reichman suggests. That will cover any shell company the occupant might form, he says.

Model Lease Language

In no event shall proposed subtenant be an existing occupant of any space in the [Building/Center] or an Affiliate of any such occupant. For purposes of this Paragraph, an “Affiliate” means a corporation or other business entity that directly or indirectly controls, is controlled by, or is under common control with such occupant.

Compromise approach: Sublet to limited group of tenants/subtenants. A smart tenant may want the right to sublet to an existing occupant if you have no comparable available space at the time of the tenant's sublet request. If you agree to this, make sure that you add this limit: Say the tenant can sublet only to another occupant that's located in an adjacent space or in the space directly above or below the tenant, says Chromow. By doing so, you're accommodating the tenant by allowing it to reach its most logical in-house target—the expanding neighbor—but you're still keeping tight controls on its ability to take your prospective tenants.

Model Lease Language

In no event shall Tenant sublet all or any portion of the Premises to any existing occupant of any space in the [Building/Center], unless, at the time of Tenant's sublet request, such existing occupant is occupying the Premises identified as of the date of this Lease, as [insert identifying numbers of spaces that are adjacent to and directly above or below tenant's space, e.g., Suite 401, 403, 502, or 302].

* No Sublet to Your Recent Prospects

Bar the tenant from subletting to any prospect that you or your broker are or have been negotiating with, says Chromow. The tenant will likely demand that this bar apply only to prospects with which you've been negotiating recently—not to any prospective tenant with which you've ever had contact. That's reasonable, but you'll have to negotiate with your tenant what “recently” means, she says.

Botwinoff recommends barring sublets to any prospect with which you've negotiated over the past six months about leasing space in the building or center. If you've had no contact with the prospect in the past six months, the deal probably isn't active, he adds.

Model Lease Language

In no event shall Tenant sublet all or a portion of the Premises to a person or entity with whom Landlord or its agent is negotiating or has negotiated within the past [insert time period, e.g., six months] regarding a lease, purchase, or license of space in the [Building/Center].

Compromise approach: Shorter period. If the tenant claims that six months is too long, you can compromise on a shorter time. Botwinoff has negotiated it down to as little as three months. In deciding how far to go, consider the size of your building or center and the current state of the leasing market, he says. For example, with a bigger building or center—which usually has more vacancies—and a slow leasing market, you'll want to stay as close to the six-month period as possible.

Compromise approach: Active negotiations only. Another possible compromise is to agree to bar sublets only to prospective tenants with which you're “actively” negotiating, says Botwinoff. This type of provision would apply only to prospects with which you're currently in the midst of meaningful lease negotiations, he explains.

Practical Pointer: You'll need to keep proof of which prospective tenants you've negotiated with, and when. So make sure that you and your broker or managing agent keep detailed records about all contacts with prospective tenants—including the time and date you showed them space, says Chromow.

* Require Tenant to Use You, Your Agent, or Broker as Its Broker

Make the tenant use you, your managing agent (if the managing agent has the ability to do so), or a third-party broker of your choice as the exclusive broker in any sublet, says Botwinoff. This gives you better control over whom the subtenant will be, he explains. For instance, you can ensure that a proposed subtenant isn't another tenant or recent prospect or someone you wouldn't want in the building or center in the first place, he says.

This also lets you market your building or center to the fullest extent possible, Botwinoff says. After all, you (or your managing agent) are in the best position to market the tenant's space because you're most familiar with the building or center, its tenant mix, and the market, he says. And as an added—and not insignificant—bonus, you may be able to collect a broker's commission from the tenant, he explains.

Model Lease Language

Tenant agrees to use Landlord or, at Landlord's option, either the then managing agent of the [Building/Center] or a third-party real estate broker designated by Landlord, as Tenant's exclusive renting agent to effectuate any such sublet. Tenant shall pay to Landlord or such managing agent or broker, as the case may be, the then standard and customary fee or commission upon execution of any such sublease.

Practical Pointer: A tenant may be unwilling to pay you or your managing agent a brokerage fee, says Reichman. Or it may be unwilling to have you control the space as its broker. Depending on the tenant's leverage, you may need to forgo the fee or limit the term that you, your managing agent, or your designated broker acts as its broker to only, say, the first 90 days that the space is on the market, he notes.

CLLI Sources

Neil E. Botwinoff, Esq.: Partner, Tannenbaum Helpern Syracuse & Hirschtritt LLP, 900 Third Ave., New York, NY 10022; (212) 508-6700.

Sheri P. Chromow, Esq.: Partner, Katten Muchin Zavis Rosenman, 575 Madison Ave., New York, NY 10022; (212) 940-8800.

Richard A. Moore, Esq.: Buck & Gordon LLP, 902 Waterfront Pl., 1011 Western Ave., Seattle, WA 98104-1097; (206) 382-9540.

Robert P. Reichman, Esq.: Partner, Siller Wilk LLP, 675 Third Ave., 9th Fl., New York, NY 10017-5704; (212) 421-2233.