How to Ensure Your Fair Share of a Tenant’s Sublet Profits

Tenants can come up with clever ways to deprive landlords of sublet profits.

Subleasing space can be a profit center for commercial tenants. That’s why landlords often negotiate for a fair share of those profits. While agreeing in principle, tenants may seek to structure their sublet arrangements so as to deliberately reduce profits in a bid to deflate the landlord’s share. Tenants may also set up the arrangement in a way that forces the landlord to wait several months to receive their profits on the deal. You can guard against these schemes by negotiating a sublet provision like our Model Lease Clause. Here’s a look at the strategy and how to deploy it.

Sublease Rent Calculation Pitfalls

Tenants can come up with clever ways to deprive landlords of sublet profits. Typically, such profits are calculated by subtracting the rent the tenant owes the landlord from the sublet rent. But what seems like a straightforward calculation can become complicated when the tenant furnishes the subtenant with not just space but also equipment and services. To the extent the sublet rent incorporates the value of these add-ons, tenants will likely insist on deducting those amounts from sublet rent for purposes of calculating sublet profits. While this is reasonable in principle, the danger is that the tenant will abuse these deduction rights to artificially reduce sublet profits to keep your share as low as possible. 

Guard Against Inflated Service Costs

The first danger is that the tenant will inflate the costs of the services it provides the subtenant. Thus, for example, a tenant that charges a subtenant fair market value for the subleased space and services may inflate the portion attributable to services and reduce the portion attributable to the space. Result: The sublet rent and landlord’s profits are artificially low.

Example: A tenant sublets a portion of its space for which it pays the landlord $3,500 per month to a subtenant for $8,000 per month. The sublet rent includes not just the value of the space but also 100 hours of services that the tenant provides the subtenant each month. The fair market value of secretarial services is $30 per hour, or $3,000 per month. So, the landlord might expect the monthly net sublet rent (i.e., the monthly net sublet rent less the monthly payments for services) to be $5,000 ($8,000 sublet rent - $3,000 services). That would yield a monthly sublet profit of $1,500 ($5,000 monthly net sublet rent - $3,500 sublet rent) for you to split with the tenant.

But the tenant may claim that the actual value of secretarial services was $40 per hour for 100 hours, or $4,000 per month. Under that valuation, monthly net sublet rent would be $4,000 rather than $5,000, leaving only $500 ($4,000 - $3,500) in monthly sublet profits.

Solution: Ensure your lease requires the tenant to count any amount over fair market value of services toward the monthly net sublet rent [Clause, par. b(2)]. Such language would force the tenant to calculate the value of secretarial services at the market rate of $30 per hour. 

Guard Against Hidden Profit from Depreciated Equipment

Similar problems may arise when a tenant sells or leases copy machines, computers, furniture, and other equipment to the subtenant under the sublet arrangement and includes the sales price or lease charge in sublet rent. The price or charge may be much higher than necessary to recover the tenant’s unreimbursed costs for the equipment—that is, the amount that the tenant hasn’t yet recovered via depreciation on its federal tax return. Subsequently, deducting this overinflated sales price or lease charge from the sublet rent for purposes of calculating sublet profits results in the landlord’s receiving less than its fair share of those profits.

Example: A tenant that pays you $3,000 per month in rent signs a five-year sublease agreement charging the subtenant $5,000 per month, including $500 for furniture provided to the subtenant. After deducting the $500 furniture charge, the sublet rent would be $4,500. The landlord gets a share of the $1,500 monthly sublet profit ($4,500 - $3,000). But the furniture is old and has an undepreciated value of only $100 per month. As a result, the landlord loses out on its share of the $400 monthly profit the tenant is making from the $500 monthly furniture rental fee.

Solution: Require the tenant to subtract only the amount necessary to recover its unreimbursed cost of the furniture. Thus, in the example above, the unreimbursed cost would be $100. Then, add any profit over that $100 to the sublet amount used to calculate the sublet profit [Clause, par. b(1)].

Example: Using the same facts in the last example, the monthly net sublet rent after deducting the unreimbursed furniture costs would be $4,900 ($5,000 - $100), resulting in the landlord’s receiving $1,900 ($4,900 - $3,000) as its share of the sublet profit.

Get Right to Review Tenant’s Tax Return

Ensure that the lease clause gives you the right to review the tenant’s tax returns to confirm the depreciated value of the equipment or furniture it leases to the subtenant [Clause, par. d]. While tenants are likely to agree to this demand, attorneys counsel that they may also insist on providing the applicable pages rather than the whole tax return. That’s an acceptable compromise.

Another step you can take is to require the tenant to furnish a breakdown of its sublet rent at the time of the sublease. Ask the tenant to provide this breakdown before you consent to the sublease. That breakdown should include a list of all services and equipment sales and rentals included in the sublet rent and the exact charge for each. But first check with your attorney to ensure that such a demand doesn’t expose you to risk of liability for unreasonably denying consent to a sublet under state or local law.

Require Tenant to Amortize Transaction Costs Over Sublet Term

Another threat to sublet profits to guard against is the tenant’s demand for a right to deduct brokerage commissions, attorney’s fees, alteration costs, and other transaction costs from sublet profits. Whether you agree to this is largely a business point subject to negotiation. However, attorneys advise that if you do allow tenants to deduct transaction costs from sublet profits, insist that they amortize those costs on a straight-line basis over the term of the sublease [Clause, par. a]. Without this protection, tenant transaction costs may be too high and you may not get any share of sublet profits in the early stages of the sublease.

Example: A tenant that pays monthly rent of $3,500 sublets its space to a subtenant for 10 years at $5,000 per month in rent. That would yield sublet profits of $1,500 per month ($5,000 - $3,500). But to secure the deal, the tenant pays out $15,000 in brokerage commissions and other transaction costs. Recovering these costs will take 10 months—10 x $1,500. So, if you let the tenant deduct those transaction costs from sublet profits, you won’t see a dime in profit payments for the first 10 months of the sublease.

That changes, however, if you require the tenant to amortize its $15,000 in transaction costs on a straight-line basis over the entire 10 years of the sublease. Under such a method, the tenant’s transaction cost deduction would be limited to $125 per month ($15,000 ÷ 120 months), leaving you a sublet profit share of $1,375 ($1,500 - $125) per month starting with the first month of the sublet. While it doesn’t affect the total share you receive over the life of the sublease, requiring straight-line amortization ensures that you start collecting your share right away without having to wait.