In today’s market, subleases are a common strategy to relieve obligations for any type of space that is no longer used or needed. Unfortunately, in a down market, finding subtenants can be particularly challenging. Often, the focus for occupiers is on what the “recovery ratio” is; that is the relationship between their remaining obligation and the net sublease income. However, what can be achieved is highly dependent upon the underlying rent in the obligation (is it above or below “market”?) and what is achievable in the sublease marketplace (how much direct and sublease space is available?). As you evaluate and negotiate sublease terms, and when you may be thinking you would be better off waiting until the next subtenant comes along, you may want to reconsider. Each month that you don’t sublease the space, you are losing more money than you would be if you already had a sublease in place. Plus, as the sublease term becomes shorter, the sublease becomes less attractive to potential subtenants, compared to a longer-term sublease. Consider the following hypothetical office lease example.
You have moved out of a space with a lease obligation for 10,000 square feet, and you have it on the market for sublease. You have three years remaining on the lease and your net rental rate is $30.00/SF (square foot). Operating expenses are $18.00/SF. Your remaining obligation is $1.44 million (10,000 SF x $48.00/SF gross rate x 3 years). You have an offer from a subtenant at $14.00/SF, net, and the lease will begin in 4 months. After you factor in the commissions to the subtenant and sublandlord broker, your net sublease income is approximately $802,000, which is a sublease recovery of 56% ($802,000/$1,440,000). You may be surprised that the recovery ratio is so high, given that you have a $30.00/SF rental rate and the sublease rate is $14.00/SF, but keep in mind that the subtenant is also paying for 100% of your operating expense obligation. On a present value basis, your sublease recovery ratio is slightly less at 55%, due to the up-front commissions you must pay.
You think you should be able to get a higher sublease rate, but the subtenant won’t budge. But, let’s look at the math. If it takes you another two months to find a replacement subtenant that will sublease 6 months from now, you will have to get a rate of $16.13/SF to achieve the same 56% nominal recovery ratio, a rate that is 15% higher. And on a present value basis at a 7% discount rate (discounted monthly), you will have to get a rate of $16.32/SF to achieve the same 55% recovery ratio, a rate that is 17% higher. The relationship is not linear either, since you have a fixed expiration date. If it takes you another four months to find a replacement subtenant that will sublease 8 months from now, you will have to negotiate a rate of $18.57/SF to achieve the same 56% nominal recovery ratio, a rate that is 33% higher. And on a present value basis at a 7% discount rate, you will have to negotiate a rate of $18.98/SF to achieve the same 55% recovery ratio, a rate that is 36% higher.
The shorter the remaining lease term, the more significant these relative increases will be to achieve the same recovery ratio. If you have a longer remaining lease term, the relative increases will be less, but are still significant. Here is the same comparison as above, but assuming you have five years left on your lease. To breakeven to your 57% PV recovery ratio two months later, you would have to negotiate a sublease rate which is 10% higher, and four months later, you’d have to negotiate a sublease rate which is 20% higher.
Given the above information, you may want to think twice about “holding out” for that replacement subtenant, unless you feel confident that the market sublease rate is significantly higher than what has been offered. Each month you don’t sublease the space and have no offsetting sublease income to your lease obligation means you have to achieve a much higher rate on the eventual sublease to achieve the same recovery that you would have with that subtenant willing to sign today.