Tight Market Puts A New Spin On Subleasing

BY RAYMOND ATTISHA
The Norman Company

These days, reports on downtown Seattle's commercial real estate market sound like a broken record. The litany is clear and resounding: this tight market is getting even tighter. Rents continue to rocket upward, space options are diminishing, concessions are long gone and large blocks of contiguous space are scarce.

Given these new market dynamics, the role of sublease space has changed significantly.

Simply defined, sublease space is space under lease to a tenant who no longer requires it for its own use and makes it available for sublease to others. This is in contrast to traditional space which is available for lease directly from the building owner.

Today, sublease space provides major opportunities, both for tenants with unneeded space and for tenants seeking new space when very little is available from traditional developer and landlord sources.

Sublease space provides major opportunities when so little is available from traditional landlord and developer sources.

While a sublease market has always existed, it has assumed greater importance in this market and has become a major source of supply. Not surprisingly, this sublease space is being absorbed much more quickly by subtenants and much more profitably for sublandlords than it has been historically.

In 1993, Seafirst Bank found itself with approximately 250,000 square feet of excess space in Rainier Tower as a result of its merger with Security Pacific Bank. It took Seafirst 18 months to lease up the space. In contrast, following its 1996 merger with First Interstate, Wells Fargo subleased 70,000 square feet in less than two months. Rumors indicate that offers are pending on the remaining 40,000 square feet of available space.

The accelerated absorption of sublet space is driven by the hot market demand and short supply of traditional space. But two other factors are contributing to the increased profitability of the sublease market.

First, direct lease deals are less appealing than in the past. Traditional landlords have become more aggressive through higher rents, increased creditworthiness requirements or tougher positions on lease clauses.

Second, the space now available from traditional landlords is space that is already built out for a previous tenant as opposed to raw space never before occupied. This previously occupied space is referred to as second generation space. In addition to being more aggressive with rents, traditional landlords also are offering few, if any, new dollars for remodeling or tenant improvements.

Since historically, sublandlords have been reluctant to spend much on tenant improvements, forcing subtenants to take the space almost "as is," this move by traditional landlords has the effect of making sublet and traditional space much more comparable than in earlier markets.

Even though traditional space and sublease space have become more comparable and rents have gone up for both, a discount for the latter still is typical. This is influenced by the needs of both the sublandlords and subtenants.

Tenants with excess space, the sublandlords, essentially have wasting assets. Each passing month without a subtenant is a lost opportunity for revenue. They are anxious to move this space and are thus primarily focused on minimizing costs, not on long-term gains. A sure dollar today is worth more than the chance for even more dollars tomorrow.

From the subtenant's perspective, sublease space often carries quirky terms, such as a short- or odd-term length, an inexact match with the ideal size of its space need, or the absence of extension or expansion options. Even though subtenants now are more accepting of these quirks, somewhat lower rates are needed to compensate.

In contrast to the approach in a sublet, traditional landlords now can hold out for higher rates. They have appreciating assets and thus employ a leasing strategy focused less on the short-term cash flow of getting space leased immediately, and more on the increased long-term value for the property created by higher rental rates.

This leasing approach and the resulting increased rents for direct landlord leases also have made it possible for sublet rents to increase yet still be at a competitive discount.

This doesn't mean that tenants should create surplus space to offer for sublease. A tenant's needs should be determined by its business plan, not by the changing market. However, if extra space becomes available in the course of executing the business plan, subleasing in today's market can be a viable and valuable option.

One caveat, however. The length of the remaining term of a lease is the most critical factor in determining whether space can be subleased effectively. The shorter the term, the bigger the discount must be to attract a subtenant. Also, larger spaces will require longer terms. Larger tenants have more relocation expenses, need more time to amortize those costs, and also do not want to endure the disruption of leasing new space again after just a brief sublease.

In this market, a tenant can reasonably assume that with at least two years of a lease term remaining, most excess space will be absorbed relatively quickly at a decent rental rate. This is true for a tenant interested in making a few offices or even one or more floors available.

Similarly, tenants who are looking for space, especially those suffering sticker shock, need to consider sublet opportunities. They may prove to be the best or the only viable options available. Being flexible in the length of the term, location and improvements required will improve the chance of success.

By its very nature, a sublease is outside the world of traditional landlord leasing. Finding and transacting subleasing opportunities, whether as a subtenant or a sublandlord can be a daunting experience. Sublease space tends to be hidden and each has its own peculiarities.

The market is not going to loosen soon. And until it does, subleasing will remain an especially important option for many tenants.

Raymond Attisha is a member of The Norman Company's Leasing Services Group.