Why subleasing a building is a lot like a sale at Nordstrom

Sublease listings remind me of a half-yearly sale at Nordstrom.

You better get there early in the markdowns to get a deal of selection and price. The longer you wait, the higher the price gets, but the selection wanes until your only choice is an XS purple long-sleeve tee.

But … The price is unbeatable. If you’re like I am, an XS tee only has once use — that of a dish rag. But I digress.

Much has been ballyhooed about the amount of industrial space coming back to the market, so I did a little research. My trusty spreadsheet is not quite as robust as Jonathan Lansner’s, but I made it work.

As a quick review, a sublease is a remnant sale of sorts. When an occupant originates a lease agreement, the contracts vary in length.

Depending on the size of the premises, lease terms range from two to 10 years. Many times, smaller buildings mean shorter leases. If an occupant can’t — or doesn’t choose to — fulfill the term obligation, they’re faced with three choices: A buyout from the owner, a default or a sublease.

A buyout is best for the tenant as they are relieved of the remainder for a fraction of the cost. Since the owner takes the risk and expense of finding a replacement, the situation must be quite compelling.

A default is least palatable for both parties while subleasing is a nice compromise. The tenant markets the excess space in hopes of locating a surrogate to live out its lease term.

So, on to the numbers.

Presently, in all of Orange County, there exist 92 listings in excess of 50,000 square feet. Of these 92, 12 are subleases or 13%.

Los Angeles County came in at 497 listings with 73 subleases or 14.6%. Inland markets, spanning that vast swatch of industrial space to our east, clocked in at 245 listings, of which 34 were subleases or 13.8%.

Most of the givebacks appear in square footage above 100,000 square feet. In the IE that percentage jumps to 16%!

OK, you might be wondering, why does this matter? Allow me to expand on a few reasons.

Market impact

The most valuable subleases in the industrial market closely mimic that of a direct lease.

By that, I mean the term is long enough for an occupant to spread his moving costs over time.

Using our Nordstrom half-yearly sale as an example, a beautiful suit in your exact size at a 30% discount is much more appealing than one two sizes too big, which will then need expensive alterations.

Your savings are eaten up by the expense of making the suit fit. Plus, in some cases, all sales are final, and you can’t take advantage of a generous return policy. Subleases are similar because all sales are final. Your benefit is in the discounted price, not in other concessions such as tenant improvements.

Additionally, subleases have a downward push on market lease rates.

Of the 12 buildings available for sublease in Orange County, all will trade at a rate significantly less than than direct listings. With a few of these, the discounts can be explained as anomalies.

However, if a large percentage of leasing activity is within these remnants, an adjustment of pricing occurs because the pricing is driving demand.

Occupant considerations

In a sublease arrangement, the tenant becomes the sub-landlord, and the surrogate becomes a sub-tenant.

Many occupant/sub-landlords price their sublease at a slight discount vs. a direct lease with an owner. In my opinion, this is a mistake, because a sub-lease needs to pop and provide a shock and awe price to attract demand.

To affect a sublease, you must seek and gain approval from the owner of the property. This approval may not be unreasonably withheld, but it’s a step that must be accomplished. An unauthorized sublease can create a default, which is never advisable.

With your surrogate in place, don’t forget that you, as the tenant, are still ultimately responsible for the lease obligation. Yes, you’ve located someone to pay the rent in your stead. However, if they fail to pay rent or break another lease covenant, the owner may look to you for a remedy.

Owner considerations

If your tenant is financially viable and has simply outgrown your building, thus the need for a sublease and your position is generally pretty solid.

If, however, your occupant is struggling for other reasons, such as a downturn in business or an industry collapse, it’s important to pay close attention to their process of locating a surrogate.

Depending on your tenant’s lease rate compared with current market rents, it might make business sense to allow your tenant to buy out of their obligation.

Under this circumstance, the owner takes the risk of finding a new occupant but avoids a potential bankruptcy by a tenant, which could tie up the real estate for several months.

Ultimately, the owner has the right to approve anyone seeking to sublease his or her building. As mentioned in the paragraph above, this cannot be unreasonably withheld, but it’s well within an owner’s purview to require a use compatible with your building to be sought along with a financially viable group.

Allen Buchanan is a principal and commercial real estate broker at Lee & Associates, Orange. He can be reached at 714.564.7104 or abuchanan@lee-associates.com.