Commercial Subleases: Coping with the Subordination Risk
The decline in the commercial rental market in the recent economic downturn has not been without its silver lining. Some businesses-newly emerging or having successfully weathered the economic storm-are eager to implement long-term growth plans by taking advantage of the low rents and high volume of available space. As these businesses begin to explore the current leasing market, they may be intrigued by attractive space being offered to be sublet by their current occupants who can no longer carry their lease obligations or are otherwise trying to unload excess space. Should businesses shy away from subleases in favor of a direct lease with a building owner?
Subleases are initially appealing since sublease rental rates are traditionally cheaper than direct lease rates. However, prospective subtenants should be aware that these lower rates reflect legal, logistical and operational disadvantages inherent in the sublease arrangement. While a full analysis of these risks should be performed by the subtenant’s attorneys and real estate consultants on a case-by-case basis, this article will address one fundamental risk common to all subleases, and suggest how a prudent subtenant can attempt to alleviate some of that risk.
As a matter of contract law, subleases are “subject and subordinate” to the underlying lease. In essence, this means that a sublease remains in effect only for so long as the underlying lease remains in effect. If the term of the underlying lease expires, or is cancelled on account of the tenant’s default or for any other reason, the sublease will automatically terminate. The subtenant will be required to surrender possession of its premises and, depending on the terms of its sublease, may be required to restore the premises to the condition they are required to be returned to the landlord upon the expiration of the term.
While there is no way to completely mitigate against this subordination risk, the subtenant can take some measures that afford some partial protection. Although it is always prudent to perform due diligence on a party with whom you are about to enter into a contract, it is especially important to do so before entering into a sublease. Due to the subordination risk a subtenant can lose its entire estate if its sublandlord fails to perform under the lease, and a subtenant needs to be confident that its sublandlord is in a position, financially and operationally, to perform all of its obligations under the lease. If the sublease rent is not sufficient to support the financial obligations under the lease on its own, and/or the sublandlord’s business is showing signs of vulnerability, the subtenant should be aware that its subleasehold estate may be precarious.
If the underlying lease is cancelled, and such cancellation is due to a default by the sublandlord, the subtenant should ask that the sublandlord fully indemnify it for any losses or damages it incurs on account of such cancellation. Of course, this indemnity is only as valuable as the credit supporting it; if the underlying lease was cancelled on account of a default by the tenant, there is probably no real credit to rely on. Therefore, a subtenant should also consider requesting a notice and cure period during which the overlandlord will agree to notify the subtenant of any defaults by the sublandlord, and to accept the subtenant’s performance of the sublandlord’s lease obligations. This would allow the subtenant to control its ability to remain in the premises. To avoid having to chase the sublandlord to recoup the expenses it incurs to cure the default under the underlying lease, the subtenant should request the right to offset the amount it expended from the sublease rent.
In certain specific circumstances, it may be appropriate for the subtenant to request a recognition agreement from the overlandlord. Protection under a recognition from an overlandlord works in a similar manner as a non-disturbance agreement from a mortgagee. A recognition agreement will provide that if the underlying lease is cancelled due to the sublandlord’s defaults, the overlandlord will “recognize and not disturb” the subtenant’s possession of the premises provided that the subtenant is not in default of its sublease. One crucial difference between the non-disturbance agreement granted by a mortgagee, and a recognition agreement granted by an overlandlord, is that in the latter case, the parties need to determine whether the recognition agreement will be based on the terms (including the rent) set forth in the sublease or, as the overlandlord will likely prefer, on the terms of the underlying lease.
Overlandlords are understandably very reluctant to provide a recognition agreement, and typically entertain the subtenant’s request only under very specific circumstances. Obviously, the rental rate upon which the recognition agreement will be based has to be consistent with present market conditions. Other criteria that will be taken into account is the creditworthiness and business reputation of the subtenant, whether it is making a significant investment in the premises, and whether the sublease is for a sufficient term. Depending on the dynamics of the overlandlord’s relationship with the tenant (i.e., perhaps the tenant has additional space in the building and the landlord has an incentive to keep the tenant happy), the subtenant may be able to solicit the tenant to act as its advocate.
Note that even if an overlandlord were to provide a recognition agreement, such recognition agreement is not completely protective as it has its limitations. Specifically, an overlandlord will not want to assume liabilities for pre-existing conditions, including existing defaults, rent concessions or work allowances, and will likely require additional notice and cure periods before a subtenant can exercise its remedies against the landlord under the sublease. Nevertheless, these limitations are often negotiated and the benefits of the recognition agreement still outweigh the burdens herein described.
Businesses scouring the leasing market should not instinctively resist otherwise appealing sublease deals. They should understand the subordination risk inherent in their subleases, but also seek ways to mitigate its consequences.
Notice: The purpose of this newsletter is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. The Advisory should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.