CorporateInsight September 2003

The prolonged slowdown in employment among office users has created one of the largest sublease inventories in history--136 million sf nationally, or approximately 25% of the total available space. And the prognosis is not encouraging.

Many highly regarded economists and real estate professionals believe it will take until 2005 for demand to return to more normal levels and that the revival will be driven by tenants with needs and tastes that differ from those of even a few years ago. As a result, tenants with surplus space must contend with a market that offers little tenant demand and, often, sublease space that is improperly configured for today's tenant.

Facing these problems, such tenants have basically two options: market their excess space in an already flooded sublease market or approach the building owner with a proposal to buy out of their obligation. Though both options have advantages, it is the second option that seems to be gaining popularity in Los Angeles and other markets with substantial amounts of sublease space.

The cost to the tenant of subleasing a space equals the sum of (1) rent paid during the period it takes to sublease the space; (2) the difference between the sublease rent and rent due under the lease; (3) broker commissions; (4) any tenant improvement allowance for the sublessee; and (5) the contingent liability for a subtenant's default. In a slow leasing market and weak economy, therefore, the risks associated with (1), (2) and (5) rise.

The cost to the tenant of a buyout, however, equals, with few exceptions, the difference between the tenant's liability under the lease and the sum of the estimated cost to relet the premises (for which the tenant must compensate the building owner), including down time, commissions and tenant improvements and any difference in rental rate between the current market rent and the contracted lease rent.

The cost of a buyout, then, equals, in a perfect world, the cost of subleasing the space but without the liability for a subtenant that defaults, without the uncertainty about when a subtenant may be found, without the risk that the market may continue to slide and without the risk that the lease term may, with time, dwindle to an unmarketable duration. For in a buyout, the parties agree on the time frame needed to relet the premises, the fair market value of the premises and monetary compensation to the owner to completely offset both. It's that simple.

So why would a building owner be willing to take on these risks? And why would it be more efficient for a tenant to pay an owner to take these risks while forgoing the possibility of reaping possible rewards later on? Because an owner is often better situated to bear them.

The reasons for this are several. First, building owners include in their cash-flow projections down time between tenants, so they will often have already budgeted for the money lost on the vacant space. This is not true of the typical tenant. Second, the rent from a particular space often makes up a smaller proportion of an owner's portfolio income than it does of a tenant's income. Thus, at typical vacancy levels, the marginal cost of carrying space often cuts less deeply for an owner than for a tenant. Third, because financial desperation often fractures the negotiating stance of sublessors, and because potential tenants know this, new tenants will typically secure a cheaper deal from a sublessor than from an owner. In other words, a weak negotiating position lets the building's value slip through the cracks in the sublessor's negotiating position.

This last reason, the financial straits of sublessors, leads also to a strategic consideration: Owners do best when they keep sublease space to a minimum, since it makes them compete with below-market rents that they cannot match. For example, at 5900 Wilshire Blvd., a 400,000-sf, class A building in the Miracle Mile submarket of Los Angeles, 100,000 feet of sublease space competes head on with a like amount of direct vacancy. Yet the sublease space is being marketed at an asking rent 40% to 50% below the asking rent for space available directly, making it almost impossible for the owner to lease any of its own vacant space at desired rates.

Adding more weight to the argument for seeking a buyout, the Federal Accounting Standards Board recently ruled that, as of December 31, 2002, companies must write off the cost of unused real estate either when they terminate their lease or when they stop using the space. Under the prior rules, companies were not required to account for unused space until they "developed a facility exit plan," which amounted to letting tenants time their real-estate losses against earnings. Now that latitude no longer exists. Once space becomes vacant, says the FASB, a company must write it off. This removes the accounting rationale for delayed divestment.

Of course, some owners will be less receptive to a buyout offer than others, preferring to retain a known income stream to the risk of releasing their space in a weak market. But conditions like those described create powerful incentives for savvy tenants and sophisticated owners to investigate terminations. It's an agreement that can be a winner for both parties.

Serge Vishmid is a multi-market, office-transaction specialist in the West Los Angeles office of Grubb & Ellis.

References to market data included in this article are obtained from Grubb & Ellis' research analysts who routinely track local and national trends in the office market. Click http://www.grubb-ellis.com to find out more about Grubb & Ellis's research.