Often Overlooked Sublease Issues For Office Tenants

Originally published by David J. Weiner.

With oil prices still far below their highs of a few years ago, many energy companies—some of which expanded rapidly when oil was north of $100 a barrel—now find themselves with more office space than they can reasonably use (or even afford).  In order to mitigate their lease exposure, these companies are looking to sublease a portion of their office space.

As of Q1 2017, there are approximately 10.8 million square feet of office space available for sublease in the Greater Houston area.  Of that total, approximately forty-two percent (42%) is located in West Houston, including in the Energy Corridor (20%), Westchase (12%) and West Belt (7%) markets.[1]

When drafting and negotiating an office sublease, a tenant must carefully think through a variety of issues, beyond those relating to the creditworthiness of its prospective subtenant, the rent it will receive, and whether the landlord will consent to the sublease.  This blog post identifies just a few often overlooked—but very important—issues a tenant must address in an office sublease.

1. Subleased Premises; Maintenance and Repairs – What Am I Subleasing? And Who Does What?

When the entire premises are being subleased, the tenant can simply pass through (most of) its obligations under the lease to its subtenant, including its maintenance and repair obligations.  The lease obligations can be incorporated by reference into the sublease.

However, when only a portion of the premises is being subleased, a tenant must be careful how it expresses the scope of the subtenant’s rights and obligations under the sublease.  For instance, if a tenant is leasing an entire floor, the lease may not expressly address how access to elevators, stairwells and restrooms on that floor will be shared.  If the tenant intends to sublease a portion of that floor, the sublease will need to set out the parties’ respective rights to such areas.  The same can be said about any maintenance and repair obligations, as there may be certain items that relate to the entire premises but are not necessarily located within the subleased portion of the premises.

When drafting a partial sublease, the “subleased premises” should be specifically described (i.e., by number of square feet, by floor, etc.).  An exhibit that graphically depicts the subleased premises in relation to the other premises leased by the tenant is also advisable.

The tenant can run into trouble when negotiating the coordination of maintenance and repairs of the premises or common areas in a sublease.  For instance, many subtenants request that the tenant perform any and all repairs that the landlord is required to perform under the lease.  However, many of such repairs (such as elevator maintenance) cannot be performed by the tenant but rather must be performed by the landlord or its designated contractors.  Unless there is a specific maintenance obligation with respect to an item exclusively serving its premises, the tenant should agree only to use commercially reasonable efforts to (a) promptly notify the landlord of the need for maintenance or repairs and (b) enforce its rights under the lease, on behalf of the subtenant, for the landlord to perform such maintenance or repairs.

2. Sublease Term – When Does it End?

When the term of the sublease ends prior to the lease term, the tenant may face issues in taking over the premises and continuing its occupancy for the remainder of the lease term.  If the lease contains a continuous operations clause, this could be a material concern for which the tenant must plan.  The parties should have a strategy in place for the tenant to resume occupancy of the premises while minimizing the impact of the subtenant vacating.

The passing through of extension options under a lease to the subtenant can create many issues for the tenant that should be addressed in the drafting stage of the sublease.  A tenant must carefully consider whether to give its subtenant the same extension option rights that it has under the lease, especially if the sublease rent is less than (or is calculated differently than) the rent under the lease.  If the tenant is subsidizing its subtenant, the last thing it needs is to be forced to continue subsidizing that subtenant for another five to ten years!  Therefore, unless the tenant has a strong desire to ultimately retain the subleased premises even after the expiration of an extension term, it is advisable that the tenant not grant any extension options under a sublease that would require the tenant to exercise its own extension options under its lease.

Even if the tenant is comfortable granting its subtenant extension option rights, the subtenant’s deadline for exercising its extension option(s) under the sublease should be far enough in advance of the tenant’s exercise deadline under the lease in order for the tenant to have sufficient time to determine whether the subtenant is interested in extending the sublease term and to effectively exercise its own extension option under the lease.  This can be done either by using a specific time period greater than the time period set forth in the lease (e.g., 150 days in advance under the sublease when the lease requires 90 days’ advance notice for the exercise of an option) or by adding a time period to whatever is required under the lease (e.g., 30 days before the extension option exercise deadline under the lease).

Another issue relating to extension options that can create problems for the tenant in a sublease context is when the extension term rent under the lease is based on a (yet-to-be-determined) fair market value calculation.  If the sublease contains a fixed extension term rent, then the tenant will be going into the extension term rent determination under its lease not yet knowing how significant its subsidy will be over the length of the extension term.  The tenant should strongly consider requiring its subtenant to pay whatever its own extension term rent is under the lease.  In such instances, the tenant should include language in its sublease whereby its subtenant expressly acknowledges that the rent attributable to certain extension terms may not be known at the time of the subtenant’s option exercise deadline and that the subtenant nevertheless agrees to be bound by the terms of the lease with respect to determining such rent.  Furthermore, the tenant may want to obtain a release of liability from the subtenant for any failure to negotiate for a lower rent.

3. Surrender Obligations and Holdover – Will You Be Left Holding the Bag?

When the parties intend for the term of the sublease to end at the same time as the lease term, the tenant should consider the timing of surrendering and vacating the premises.  Any failure to timely vacate the premises will likely result in the creation of a tenancy at sufferance, which may require the now-defaulting tenant to pay holdover rent.  The tenant may want to factor in some time to address this issue by making the sublease term expire one or more days prior to the expiration of the lease term.

In a coterminous sublease, since the subtenant has the right to occupy the premises until the very last day of the lease term, there is little time for the tenant to enter the premises and remove all of the subtenant’s property should the subtenant fail to do so.  Furthermore, to the extent that the tenant had previously made alterations to the premises the removal of which are expressly excluded from the subtenant’s obligations under the sublease, the tenant will need time to enter the premises to perform its own surrender obligations to return the premises in the condition required under the lease.

Typically, the tenant will want to pass through all surrender obligations under the lease to its subtenant.  However, there may be certain circumstances under which the tenant will want to either impose additional surrender obligations on its subtenant or undertake itself certain of the surrender obligations under the lease.

If the subtenant’s use of the premises required some additional form of alteration to the premises that was not originally contemplated in the lease, such additional alterations may need to be specifically identified in the sublease surrender provisions.

Conversely, if the tenant had made certain alterations to the premises that are required to be removed upon the expiration or termination of the lease, the tenant may need to retain the obligation to remove such specific alterations.  The subtenant may want such language included in order to minimize its own surrender obligations; or the tenant may want such language included if the alterations have some continuing value beyond the expiration or termination of the lease.

Even when a tenant is agreeable to a different calculation of sublease rent than it owes under the lease, it can be seriously harmed when a subtenant fails to timely surrender the premises and holds over beyond the expiration of the lease term if the holdover rent under the sublease is not properly addressed.

Most leases determine holdover rent based on a percentage of the base rent under the lease.  Unfortunately, far too often, the drafting of the sublease will carry over a similar calculation of holdover rent to the sublease, but based on the (presumably lower) sublease base rent.  This would result in the subtenant—which is the party occupying the premises and therefore controlling the length of the holdover tenancy—owing far less holdover rent to the tenant than is owed to the landlord under the lease.

The tenant should either require at least the same holdover rent required under the terms of the lease or require a holdover rent based on a higher percentage of the sublease base rent than tenant must pay under the lease (e.g., two hundred percent (200%) of the sublease rent as opposed to one hundred fifty percent (150%) of the base rent under the lease) so that the tenant will have a margin of safety when owing holdover rent.  It is preferable to require a higher holdover rent of the subtenant, since the tenant will likely incur some cost or expense associated with the holdover in addition to the payment of holdover rent under the lease, such as defense costs associated with any lease enforcement action by the landlord.  Requiring holdover rent at least in the amount of 110% of any of tenant’s holdover rent obligations and other costs associated with such holdover is suggested.

[1] Statistics courtesy of CBRE.

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