August 11, 2022

Square Feet: An Unexpected Trend Toward Office Sublets

Venable is one of a number of major tenants that have recently converted sublease space into direct leases, a trend that is being driven by the tightening commercial real estate market.

Conventional wisdom holds that subleasing — in which tenants vacate their offices before the end of their lease and rent it to another tenant at a discount — has a negative impact on the market. Landlords must compete against the lower rents, while tenants bristle at the restrictive terms that often are a part of a sublease.

But the industry perspective is now shifting. Tenants are embracing subleases as a means of locking in below-market rents, while landlords, who are facing fewer vacancies, are using it to attract tenants and then converting the leases into direct deals when the subleases expire.

“Landlords don’t usually like the fact that sublease space rents for less, and tenants don’t like that the leases offer little flexibility,” said Moshe Sukenik, an executive vice president and principal at Newmark Knight Frank who represented Venable. “But there is a silver lining that can result in a win-win for everyone involved.”

Over the last 18 months, the availability of sublease space has sharply contracted. As of April, the inventory in Manhattan over all, as measured in square feet, was down nearly 40 percent compared with October 2009, according to data from Newmark Knight Frank. Downtown recorded a 40 percent drop, while in Midtown, it was 35 percent. In the Midtown south area, that figure was close to 47 percent.

“We are going to see the sublease space that is still available be rapidly absorbed,” said Mark A. Jaccom, the chief executive of the tristate region for Colliers International. He said he was working with four tenants now in sublease space in Midtown that were negotiating to convert their agreements into direct leases.

Steven M. Durels, an executive vice president and the director of leasing and real property at the SL Green Realty Corporation, said: “When doing these kinds of deals, we do not have to contribute any money to tenant improvements and we don’t have to offer any free rent” to the sublease tenants. “The inducement to the new tenant is embedded in the economics of the sublease, while for us, we eventually get full market rent with no transaction costs.”

Another method by which sublease space is being reduced is through buyouts, where tenants who want to leave before their lease expires can pay a fee to the landlord, who then re-lets the space, ideally at a higher rent. SL Green, a real estate investment trust, employed this strategy at 1185 Avenue of the Americas, where it is the landlord. Bank of America wanted to vacate two floors before its lease expired, but rather than subleasing the space, it paid SL Green a fee to be free of its lease obligation. SL Green then re-let the space, including 27,712 square feet on the second floor of the building to Ally Financial and 24,692 square feet on the 24th floor to the News Corporation. As a result, Mr. Durels said, “we were paid a buyout fee and were able to rent out the spaces at higher rents than what Bank of America had been paying us.”

“A few years ago, when we had higher vacancy rates, there wasn’t much of an incentive to get involved in sublease deals,” said Dennis Friedrich, the president and chief executive of United States commercial operations for Brookfield Office Properties. “Now that vacancy rates are much lower, we are helping existing sublease tenants convert their leases into direct deals.” Brookfield recently converted a 175,000-square-foot sublease with Commerzbank and a 250,000-square-feet sublease with OppenheimerFunds at 2 World Financial Center into long-term direct leases.

Such deals can be economical for tenants. The online high-end clearinghouse Gilt Groupe recently signed a direct 10-year lease at 2 Park Avenue after subletting space at the building for two years, doubling its offices to 100,000 square feet.

“We had a great deal on the sublease space — it was roughly a 75 percent discount to the market rents because the term was so short,” said Melanie Hughes, the chief human resources executive at Gilt Groupe. And even though Gilt is facing a rent increase by signing a direct lease for the space, “there were several compelling reasons for staying here instead of moving somewhere new,” Ms. Hughes said.

Among them: Employees had grown comfortable in the space, and there were low costs associated with any build-out since the offices came equipped with furniture from the previous tenant, Yahoo. Gilt had also already established a good working relationship with the landlord and was comfortable with the level of service at the building.

But some executives say they believe that, from a landlord’s perspective, encouraging subleasing is not good business. “Sublease space degrades the value of a building because it always rents for cheaper,” said Mitchell Arkin, an executive director of Cushman Wakefield. “No owner that I have ever worked for has thought that subleasing at a lower rent is better than signing a direct lease.”

During this downturn, however, sublease space may have proved to be somewhat less of a drag on the market. That is because there has been less of it, said James Delmonte, a vice president and director of research for the New York office of Jones Lang LaSalle. During the last downturn, sublease space peaked at 45 percent of the overall available Class A space in Midtown in 2002. This time, it peaked at just 35 percent.

“So in previous downturns, landlords couldn’t raise rents because they had to stay competitive with sublease availability,” Mr. Delmonte said. “But this time around, there isn’t as much sublease space, so landlords are raising rents more readily.”

Venable, the law firm, said a sublease-to-direct-lease transaction was the perfect fit. When the original deal was signed in October 2007, the firm had been in New York for only a handful of years, and “a sublease was a nice way to be conservative about our growth options while still committed to a presence here,” said Edmund M. O’Toole, the partner in charge of the New York office for Venable.

While the five-year sublease from the law firm Seyforth Shaw was for the 24th through 26th floors, the new, 10-year direct lease extends the offices into part of the 27th floor, for a total of nearly 62,000 square feet.

Tishman Speyer, Venable’s landlord at 1270 Avenue of the Americas, is providing the firm with two floors of temporary space while its offices undergo the multimillion-dollar renovation, which is expected to be complete by the end of November.

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