Subleasing: A Real Estate Strategy in a Post-Pandemic Economy

Originally published by the Daily Journal of Commerce on March 5, 2024.

In the ever-evolving landscape of business, flexibility is paramount. The recent widespread adoption of remote work has led companies across the country to shed office space. As companies navigate changes in market dynamics, the ability to flexibly manage real estate assets becomes increasingly valuable. One strategy that businesses often turn to is subleasing—a practice that allows tenants to lease a portion of their rented space to another party. While subleasing presents opportunities for landlords, tenants, and subtenants alike, it also comes with complexities that should be considered carefully by all parties.

Analysis of the master lease assignment and sublease provision

The master lease (i.e., the original lease between landlord and tenant) is the bedrock of any sublease agreement. The assignment and subletting provision of the master lease is a frequently negotiated section of the lease. Tenants want the flexibility to sublet or assign their interest if their future circumstances change, while landlords want control over occupancy of the space. A tenant should first analyze the master lease for explicit permissions or restrictions related to subleasing. Often, a landlord has a right to consent to subleasing, but that consent typically cannot be unreasonably withheld. Additionally, a landlord will sometimes have a “right of recapture” wherein it may terminate the master lease and take back the leased premises if the tenant requests consent to sublease the space.

Incorporation (and exclusion) of master lease terms into the sublease

If the landlord consents to the sublease, the parties should then negotiate which terms of the master lease will flow through to the sublease. Generally, a sublease incorporates all terms of the master lease unless the sublease expressly excludes them. Therefore, tenants (i.e., sublandlords) and subtenants should carefully negotiate for the exclusion of certain provisions. For example, a tenant who has a right of first offer to purchase the landlord’s property under the master lease would likely want to exclude that right from passing down to the subtenant.

Additional key issues for consideration

Though every sublease negotiation is unique, the following areas are common points for all parties to consider before entering into a sublease:

• Maintenance and repair—When a sublease incorporates the maintenance and repair provisions of a master lease, the subtenant is often responsible for nonstructural maintenance, while the landlord remains responsible for significant structural repair or replacement. However, subtenant usually must first address any issues with the tenant/sublandlord. It is important, therefore, for subtenants to negotiate for tenants/sublandlords to use “best efforts” or “commercially reasonable efforts” to get the landlord to act when necessary to address their maintenance or repair obligations.
• Permitted and restricted uses—The master lease will likely list permitted uses – as well as restricted uses – for the leased space. The subtenant should review the master lease to confirm that its intended use is permitted under the master lease. If the subtenant’s permitted use is not permitted under the master lease, then the subtenant’s right to use the space for such use may be subject to the execution of an amendment to the master lease expressly authorizing such use.
• Term—The subtenant should confirm that the proposed term of the sublease expires no later than the term of the master lease. If a subtenant desires a term longer than the master lease term, then an amendment lengthening the term of the master lease will be required.
• Landlord capture of excess rent—If the tenant/sublandlord charges the subtenant rent in excess of rent the tenant pays landlord under the master lease, the master lease often allows the landlord to capture some or all of that profit earned on the sublease rent.
• Continuing liability for tenant—Subleasing the premises typically does not relieve the tenant from liability under the master lease. Though subtenants will typically indemnify a tenant for any damage caused to the premises by the subtenant, the landlord will still look to the tenant first in the event of any damage. Accordingly, tenants should maintain appropriate insurance coverage throughout the master lease term.
• Subtenant right to cure tenant defaults—Subtenants can protect themselves from tenant defaults under the master lease by negotiating for the right to cure tenant defaults under the master lease. Furthermore, subtenants should negotiate for the right to convert the sublease into a direct lease with the landlord in the event of a tenant default.
• Non-disturbance agreements—If the landlord has a mortgage on the property that predates the master lease, a landlord default on the mortgage and foreclosure on the property would result in termination of the master lease. Such termination would also terminate the sublease, so tenants and subtenants alike should request non-disturbance agreements from the landlord’s lender to protect their leasehold interests.
• Signage—Tenants often have the right to erect on the property signage subject to guidelines established by applicable law. Subtenants who want to install their own signage should ensure that the master lease signage provisions are incorporated into the sublease and that they obtain landlord consent if necessary.
• Parking—The master lease often affords tenants specific parking rights. Subtenants should ensure that those rights and payment obligations are incorporated into the sublease for the benefit of the subtenant.

Conclusion

Subleasing can offer businesses valuable flexibility. However, navigating the complexities of subleasing requires careful examination of the master lease and thoughtful drafting of the sublease. With the help of experienced commercial real estate counsel, businesses can successfully leverage subleasing to meet their real estate goals.