Limit Tenant’s Ability to Sublet to Potentially Competitive Replacement

In this economy, it’s tough enough to fill your center with tenants, without inadvertently letting existing ones sublet space to businesses and restaurants that compete with your leasing efforts. For example, if you’re searching for a tenant to fill vacant restaurant space at your center, but another restaurant tenant decides to sublet its space, you’ll both be, in essence, competing for the same tenant—a restaurant that wants to lease space in your desirable location but wants to get a competitive price. And if the current tenant is charging less rent for the space—and you haven’t limited the rights of the current tenant in such a way that will prevent it from subletting at your peril—you’ll lose out.

Without limited sublet rights, your tenant could try to sublet to not only the prospective tenants that you’re courting, but also another tenant in your building or center. Don’t let your tenant make a vacancy situation worse for you; minimize leasing competition with your tenants by adding four protections to your lease’s sublet clause.

Establish Rent Floor for Sublet

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. Otherwise, you may lose prospective tenants to cheaper rents offered by the tenant. You also risk devaluing the building or center, warns New York attorney Neil E. Botwinoff. To keep the tenant from undercutting your rents, you can set a sublet rent floor—that is, the lowest rent you’ll let the tenant charge.

A savvy tenant may balk at a sublet rent floor, warns Botwinoff. The tenant will want free rein to set the sublet rental rate as low as it wants and 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. For example, it’s less desirable because there’s a risk that the subtenant could be forced to leave 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. 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.

To keep the tenant from undercutting your rents, set a sublet rent floor like this after asking your attorney:

Give two options. Set the sublet rent floor at the greater of your then current rental rate for comparable space in the building or center, or the minimum rent the tenant is paying at that time.

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.

Use prevailing rate. 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: “Landlord’s prevailing rental rate offered to new tenants for comparable space in the [Building/Center].…”

Comparable space. 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. 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. Alternatively, the tenant may request that you be reasonable in your determination of comparable space.

Vacancy rate. If the commercial real estate market in your area is strong enough that you’re able to easily find tenants, or you have a particularly desirable property that’s made it easy to keep fully leased, you probably won’t be desperate to attract prospective tenants. 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. You’ll also have to negotiate how short the sublet term must be, such as 24 months at the longest. And you’ll have to negotiate how little of the tenant’s space can be sublet without the sublet rent floor applying, such as no more than 25 percent of the tenant’s space.

To do this, add the following language at the end of the clause 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.

Remember to make the tenant agree to keep the sublet rent confidential. 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: “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. Address 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. These costs may include broker’s commissions, tenant improvement allowances, free rent, and other lease concessions.

For example, the 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.

If you decide to make this compromise, you would use the following language instead of the model language above:

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, and rent concessions) as determined by Landlord, in its sole and absolute discretion.

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. This can help you avoid a future dispute with the tenant over the amount of the leasing costs.

Prohibit Sublets to Other Occupants, 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. 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. You should bar the tenant from subletting to any affiliate of any existing occupant in the building or center. Otherwise, you could end up with a tenant that, rather than subletting directly to an existing occupant, has the existing occupant form a new affiliate. The tenant then sublets to the affiliate—which may be nothing more than a shell company. 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.

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. That will cover any shell company the occupant might form. To do so, add this language:

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.

If you need to compromise, allow the tenant to sublet to a 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. 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].

Exclude Recent Prospects from Tenant’s Choices

Bar the tenant from subletting to any prospect that you or your broker are or have been negotiating with. The tenant will probably 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.

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].

If the tenant claims that six months is too long, you can compromise on a shorter time. Botwinoff has negotiated it down to as few 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. 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.

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.

Specify Broker to Use

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.

Keep in mind, however, that a tenant may be unwilling to pay you or your managing agent a brokerage fee. 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.

Insider Source

Neil E. Botwinoff, Esq.: Tannenbaum Helpern Syracuse & Hirschtritt LLP, 900 Third Ave., New York, NY 10022; www.thsh.com.