A 12-Step Checklist for Avoiding Risk as a Subtenant

The devil is in the details when you're subleasing workspace for your company. A savvy subtenant should look past the perks of discounted rental rates or free office furniture and be aware of subleasing risks that could pose problems in the future if you're not careful.

Based on my experience as a solely tenant representative, I have identified these 12 risks that you and your real estate attorney should carefully evaluate and mitigate before signing a sublease or lease assignment agreement to occupy someone else's used workspace.

Risk #1: Determine the Sublandlord's Financial Stability

The first critical step is to perform proper due diligence and determine the sublandlord's financial stability and staying power. Without a clear picture of those factors, a sublease agreement might not be worth the paper on which it's printed.

If the sublandlord is a privately held entity, it may even be necessary for the subtenant to request and review the sublandlord's financial statements. As a potential subtenant, you also need to be prepared to present your own entity's financial statements to both the sublandlord and master landlord early in the process.

If the tenant or sublandlord cannot afford to pay its full rent, then your lease opportunity would likely be short lived, or worse, you might receive notice from the master landlord to either pay full market rental rates for the space or vacate the building with only 30 days' notice.

Risk #2: Seek to Prevent a Buy-Out of the Master Lease by the Sublandlord

This is a big “gotcha” because it's at the foundation of a sublease. The subtenant should not allow a termination or cancellation of the master lease, including via a future lease buy-out between the sublandlord and master landlord, since it would then also terminate the sublease. In the sublease agreement, the subtenant should specifically ask the sublandlord to agree to forego a lease buy-out, termination, or cancellation with the master landlord, unless the subtenant would first approve it in writing.

You need to find out as soon as possible if a lease buy-out is the sublandlord's real intention. If it is, then you might be wasting time pursuing this space at all. However, there are situations where a lease buy-out can be to your advantage, especially if you're looking for a "subsidized" direct lease with a landlord. Why? Because the landlord's cash settlement from the lease buy-out might allow the landlord to subsidize your new direct lease in some way, including rent concessions, a moving allowance, or a higher tenant improvement allowance.

Risk #3: Don't Agree to Everything in the Master Lease

As a prospective subtenant, you can't change the tenant/sublandlord's master lease, but you don't necessarily have to agree to everything contained in the master lease. It's OK to leave certain obligations in the master lease to the sublandlord and not accept them as the subtenant. However, in the sublease agreement, you'll specifically have to negotiate to exempt the subtenant from any unacceptable provisions of the master lease and essentially make them not applicable to you.

Risk #4: Don't Agree to Restore Tenant Improvements to "Original Condition"

Be very careful as the subtenant not to agree to restore the sublandlord's original tenant improvements back to their “original condition,” which means the condition before your sublandlord signed its master lease. Most subleases occur on an "as-is, where-is" basis, so agreeing to this can be a very expensive mistake at the end of a lease term if you are responsible for restoring the premises to its original condition. That obligation, if it applies, should remain with the tenant/sublandlord, and not with you.

Risk #5: "Licensing" Use of Existing IT Network Cabling

When tenants move out of leased office spaces, many office landlords now require that they remove all IT network cabling installed above the ceiling so that it doesn't cause a fire hazard or a mess of cables that will later have to be demolished at the landlord's expense. If you are going to re-use a sublandlord's installed IT network cabling in the sublease premises, then you should negotiate a simple "license" to use the cabling during the sublease term. Don't agree to a "transfer of ownership" or "sale" of the IT cabling, or you might get stuck with a big surprise bill to remove all IT cabling at the end of the sublease term.

Risk #6: Don't Agree to All of the Master Landlord's Remedies for Defaults

The sublandlord's master lease typically has a section referring to a landlord's remedies in the event of default by the tenant. Read the landlord's remedies with a very critical eye, and understand that you don't have to carte blanche grant the sublandlord exactly the same remedies in your sublease. You might need to exempt the subtenant from certain landlord's remedies noted in the master lease, and leave such remedies only in effect between the master landlord and the tenant/sublandlord.

For example, the subtenant should not be exposed to paying the master landlord back for the cost of any unamortized tenant improvements that were originally built-out for the tenant/sublandlord. The same goes for paying back any of the tenant/sublandlord's free rent, moving allowance and any other concessions that could become part of the landlord's remedies due to a default of the master lease. These remedies could add up to a large bill that the subtenant shouldn't be responsible for.

Risk #7: Negotiate Right to Remain in the Sublease Premises

In the master landlord's consent to the sublease, which is almost always required by the master lease, you should try to negotiate a right to remain in the sublease premises if the master lease might be terminated or canceled during the sublease term.

Of course, the first question that comes to mind is what would the subtenant's rental rates be if the master lease were terminated? There could be several answers—the rates could simply stay the same or change based on new ones negotiated at the "then fair market rental rates” at the time of the termination.

In the case of negotiated rates, it's advisable for the subtenant to get them paired with the "baseball method" of arbitration, just in case the subtenant and the master landlord cannot reach an accord on the then fair market rental rates. Under the baseball method of arbitration, it would become a “winner takes all” situation, and an arbitrator would select either the master landlord's or the subtenant's proposed rental rates, typically without any averaging of the parties' proposed rental rates.

Risk #8: Seek Rights to Sub-Sublease the Space

For future flexibility, you should attempt to negotiate rights to re-sublease or re-assign the sublease premises (including a portion of it) to a successor subtenant(s) or assignee(s). It's not always possible, and even if you can win this provision, you'll likely still have to obtain the written consent of the sublandlord and probably the Master Landlord, too. If so, then you or your real estate attorney should seek to make sure such consent in the sublease agreement, and the master landlord's consent to sublease, are "not to be unreasonably withheld, delayed or conditioned" by the other party.

In a sub-sublease agreement, it's a good idea to specify the time allowed to obtain written approvals and consent from the sublandlord and master landlord. I recommend giving each a five-day deadline, or ten business days total. Otherwise, too much time could kill your pending deal with a sub-subtenant.

Since sub-sublease rights might be difficult to mitigate in a sublease agreement, I normally would not recommend making it a "deal breaker" issue.

Risk #9: Retain Sublandlord's Rights to Renew & Expand

There is a very low likelihood of achieving success here, so we have never tried too hard to mitigate this risk. Nevertheless, a very creditworthy, attractive subtenant might get the master landlord to agree not to extinguish the tenant /sublandlord's rights to renew and rights to expand. Almost all of the time, both of these rights in the master lease go away when a sublease or assignment occurs. If the subtenant or assignee is a bigger, more creditworthy entity than the tenant/sublandlord, then a master landlord just might waive its rights in the master lease to eliminate the sublandlord or assignor's rights to renewals and expansions.

Risk #10: Remove Future Conflict over Tenant Improvements

Technical though it may be, this risk could potentially arise. Let's say that the sublease and master lease both expire but the subtenant wants to remain in the sublease premises and sign a new direct lease with the master landlord. What then happens to the existing tenant improvements, which the subtenant wants to keep in place, if the tenant/sublandlord is required under its master lease to restore the premises to “original condition” upon expiration of the master lease?

The sublease agreement and/or the landlord's consent to sublease should address this possibility upfront in writing, and you as the subtenant should not wait until expiration of the master lease to attempt to unravel the conflict in your favor.

Risk #11: Get Rights to Cure Sublandlord's Defaults and Right to Self Help

The subtenant should seek to obtain rights to cure defaults of the master lease by the tenant/sublandlord, which also requires that the subtenant would receive a timely written notice from the master landlord of any default by the tenant/sublandlord. This, however, does not deal with an important aspect of curing a sublandlord's default of the master lease, which is how would the subtenant get repaid by the tenant/sublandlord for curing such a default? Consequently, the notice provision also needs to be paired with a reimbursement provision to make the subtenant whole.

As part of mitigating this risk the subtenant should also seek the right of self help as part of its rights to cure. This would allow the subtenant to perform any necessary remedial or repair work and then deduct from its sublease rent in order to get reimbursed by the sublandlord for the subtenant's reasonable expenses. However, note that getting a right of self help is not easy or common, although in principle, it should be easier for a subtenant to achieve than for a direct tenant dealing with a landlord. Rather than being able to deduct from its sublease rent, a subtenant might have to negotiate a different process for getting reimbursed by the sublandlord for curing the sublandlord's default of the master lease.

Risk #12: Negotiate Higher Liability Limit on Sublandlord's Indemnification

To see what the subtenant's recourse would be in the event of a default of the master lease by the tenant/sublandlord, you should look carefully at the "indemnification provision" in the master lease. Typically, a master lease would limit the master landlord's liability exposure to the master landlord's "interest in the property,” meaning the master landlord's equity value in the property, which could be very low if the property had recently been refinanced.

Consequently, if this same provision would pass-through the sublease agreement to the subtenant, it would also apply to the subtenant in the event of a default by the sublandlord. If so, then a subtenant's financial recourse against its sublandlord would be limited to the "sublandlord's interest in the property." Unfortunately, the value of the sublandlord's interest would only be the sublandlord's master lease, which would be worth almost nothing. Therefore, the subtenant should seek to negotiate a higher liability limit from the sublandlord in the sublease agreement.

About the Author: William Gary
Successfully negotiating over 440 transactions during more than 30 years in the industry, William Gary's commercial real estate experience includes time at Cushman & Wakefield, Frederick Ross Company (now Newmark Knight Frank), Iliff, Thorn & Company (now CBRE), and CoRE Partners.