Sublease, Terminate, or Restructure

Subleasing is the most common approach occupiers take in mitigating the cost of underutilized space.  Yet in San Francisco, it has become increasingly difficult to sublease office space.  With recoveries ranging from 0 to 25%, companies must consider the full spectrum of options.  Remember, too, sublease recoveries can be expensive to execute (fees and concessions); and, in subleasing, the occupier takes on a variety of risks that can prove costly (e.g., subtenant default). 
 
An alternative to subleasing is terminating the lease early.  But when sublease markets are challenging, the viability of an early termination diminishes (if it’s hard for the tenant to find a subtenant it’s also likely difficult for the landlord to find a new tenant).  These days, occupiers are often surprised to learn their landlord is unwilling to accept an early termination even when they agree to pay most of the remaining lease obligation.  Landlords may be facing a vacancy dynamic that is so unfavorable as to discourage any level of risk taking.  Even where a landlord may otherwise be inclined toward a more entrepreneurial posture, when there is a lender involved, the lender may prohibit the termination.  Tenants still have the option of taking a full impairment loss by abandoning the lease and paying in full.  But why would a company do such a thing?  Several reasons.  Firstly, if there is no utilization of the space, it has no sublease value, and the company is otherwise booking losses, it may wish to package the lease impairment with other losses to get it out of the way.  Another reason is this action can free the occupier to take a totally new approach to its real estate.  These days the future occupancy scenario usually looks vastly different than the pre-pandemic use case.  A fresh start can be powerful in creating a workplace that is compelling in the context of earning the commute.
 
Restructuring the lease is something we’ve written a lot about previously.  This is most relevant for occupiers who are paying above market rent, have between 2 and 4 years of remaining lease term, and are willing to offer between 3 and 10 years of additional term beyond the in-place expiration.  The basic trade here is one of landlord-funded concessions which may include reduced space, reduced rent, and/or landlord contributions toward tenant improvements in exchange for more term. 
 
Vetting the options requires good underwriting and engagement with the finance team, especially when assessing the timing of impairment charges.  Today, despite shifts in office usage and dramatic changes in the market dynamic, most companies still have mechanisms for enhancing their space and reducing their cost now, even when they have remaining lease term.  But it’s become more challenging to know which approach will yield the best result.  A competent real estate advisory partner can help navigate and vet all options.