Subleases – Part I

CO-Author:  Jon Goodman, Esq.

As businesses reduce staff or shut down locations, they often remain obligated on long term leases. Subleasing unused space helps offset continuing liability.

Subleases are often documented by simple forms specifying the premises, gross rental rate, security deposit and duration for the sublease, but then address other issues by incorporating the terms of the prime lease into the sublease through language that might read something like this: “The provisions of the Prime Lease are incorporated into this Sublease and shall be applicable to this Sublease as though Landlord under the Prime Lease were the Sublandlord under this Sublease and Tenant under the Prime Lease were the Subtenant under this Sublease.”

The subleasing of commercial space, however, is usually too complicated for such an abbreviated approach. Generic incorporation provisions often fail to adequately capture the parties’ intent. This two-part article starts by comparing subleasing to outright assignment of the lease, and then begins the discussion of the issues often overlooked in subleasing. Part II completes the discussion of the frequently sloughed details.

Sublease v. Assignment of the Lease

When a tenant has no further interest in the premises, it may consider assigning its lease to a replacement tenant. As with a sublease, an assignment of a lease generally requires the consent of the landlord. Even with the landlord’s consent, however, the original tenant is usually not released of liability under the lease. In many situations the landlord will be reluctant to let the original tenant off the hook, even when the replacement tenant is financially strong. With declining lease rates and a replacement tenant paying less for the space than the original tenant, it becomes even more difficult to negotiate a release or buyout of the original tenant’s liability.

Without a release of liability, the original tenant may want some control over the replacement tenant to protect against possible default by the replacement tenant. A sublease can provide that control, or risk management, for the original tenant who might otherwise assign its lease (although, to assure treatment as a sublease, it should be for a term that is at least one day less than the remaining term of the prime lease). Of course, a sublease will also generally be used when the replacement tenant will use only a portion of the original tenant’s space.

Details Often Overlooked by Generic “Incorporation” Provision

Consider the example where the “Original Tenant” has leased 9,000 square feet of office space on a triple net basis, for an initial 10-year term, with two options to renew, each for an additional 5 years at market rates existing at the time of the renewal. The 9,000 square feet is evenly divided over three floors of an office building. Three years into the initial term, Original Tenant has reduced staff and operations and can now fit in two of its three 3,000 square foot floors, and seeks to sublease the bottom of its three floors to “Subtenant.” Original Tenant and Subtenant strike a deal in which Subtenant will sublease the bottom floor (the “Subleased Premises”) for a flat amount per month for four of the seven remaining years of the initial term of the Prime Lease, with Subtenant having an option to extend the term of the Sublease for the last three remaining years of the initial term of the Primary Lease at market triple net pricing existing at the time of the extension of the Sublease.

In this example, the expense pass-through provisions of the Prime Lease do not apply during the initial term of the Sublease, but may have some applicability if the Subtenant exercises its option to extend the Sublease for the remaining years of the initial term of the Prime Lease. Any incorporation provision, then, should exclude those pass-through provisions for the initial term of the Sublease. Even with respect to the extended term of the Sublease, however, not all the pass-through provisions should be made applicable. Subtenant should be responsible only for the portion of the pass-through expenses that are attributable to the portion of the premises it is subleasing. Original Tenant (sometimes referred to in this article as the “Sublandlord”) should not agree to estimate, bill for, and reconcile operating expenses, or maintain and make available books and records regarding operating expenses, in the same way the Landlord does in the Prime Lease. Thought may also be needed to address issues regarding Subtenant’s rights to audit operating expenses or CAM charges, and to contest taxes.

The Prime Lease may contain other Landlord obligations that Sublandlord may not want to assume responsibility for through the generic incorporation provision. For example, an obligation to maintain the roof and structural elements of the building, an obligation to maintain the common areas, an obligation to provide janitorial or other services or utilities, the Landlord’s obligation to maintain certain insurance coverage (such as property & casualty coverage on the building), and any obligation to enforce rules and regulations, are all outside the control of Sublandlord.

With respect to obligations of the Landlord that the Sublandlord seeks to exclude, Subtenant may want to include provisions calling for Sublandlord’s cooperation in enforcing the obligations of the Landlord under the Prime Lease. Subtenant may seek authority for the Subtenant to sue the Landlord in the Sublandlord’s name, for the Subtenant’s benefit. (In giving its consent to a sublease, however, the Landlord may resist this latter concept).

The second part of this article, Subleases – Part II,completes the discussion of the details often overlooked in subleasing.

A version of this article appeared in the Colorado REALTOR® News, the monthly publication of the Colorado Association of REALTORS®.

Dave Farus is of counsel with Frascona, Joiner, Goodman and Greenstein, P.C. His practice areas include Real Estate, and Business Law. Contact Dave Farus.

Disclaimer -- Content is general information only. Information is not provided as advice for a specific matter, nor does its publication create an attorney-client relationship. Laws vary from one state to another. For legal advice on a specific matter, consult an attorney.

DAVID A. FARUS