With overall rental rates having fallen nearly 30% and vacancy rates risen roughly 150% between Q4 of 2019 and Q1 of 2021, the leasing of office space in San Francisco undisputedly remains a tenant’s market. Of the approximately 20.2 million square feet of available office space in San Francisco, nearly 45% is comprised of sublease offerings. For companies in the market for office space, special factors should be considered when evaluating sublease opportunities. The following outlines the primary benefits and potential risks of subleasing office space in San Francisco.
- Discounted Rental Rates. Sublease offerings traditionally undercut the prevailing market rates for direct deals with a master landlord and offer the greatest benefit to a sub-tenant. Sub-landlords are generally more inclined to provide a substantial period of rent abatement as compared to master landlords.
- Flight to Quality. With discounted rental rates comes the opportunity for a sub-tenant to lease higher-quality space it otherwise would not be able to afford, enhancing the image of the sub-tenant company without paying the premium a master landlord would otherwise require.
- Plug and Play. A sublease may provide the sub-tenant with the option of using – often at no additional charge – existing furnishings, fixtures and wiring within the sublet premises. Such “plug and play” opportunities are a benefit to a sub-tenant’s bottom line, and may allow for a more efficient, seamless relocation and/or opening.
- Less Detailed Lease Negotiation. Sublease agreements are typically shorter in length and more simplified as compared to master leases.
- Master Landlord and/or Lender Consent. Proposed subleases generally require the consent of the Master Landlord, which poses a risk of uncertainty for both prospective sub-landlords and sub-tenants seeking to enter into a sublease agreement. Further, in instances where an approved sublease requires the sub-tenant to first obtain sub-landlord consent (e.g., making alterations to the premises), prior consent of the master landlord will also be necessary. Depending on the terms of the master lease, approval of master landlord’s lender may be required in certain instances.
- Recapture and Termination Rights. Depending on the terms of the master lease, the master landlord may have the right to recapture the premises and/or terminate the master lease in the event a request to sublease is made.
- Sub-Tenant is Subject to Master Lease. Sub-tenants are responsible for complying with the sublease agreement as well as the master lease. As a sub-tenant, it is important to review the master lease to avoid unexpected obligations and limitations (e.g., insurance requirements, operating expense pass throughs, relocation rights, requirements to restore the premises to original condition, burdensome indemnity provisions, etc.).
- Less Opportunity for Improvements. Generally, sub-landlords are less inclined to offer a Tenant Improvement Allowance, requiring the sub-tenant to instead sublease the premises on an “as-is” basis.
- Eviction and/or Attornment Issues. A breach of the master lease by sub-landlord may result in the sub-tenant being unexpectedly evicted (if master landlord terminates the master lease) or having to attorn to the master landlord (if required by the sublease and authorized by the master lease).
- Potential Tax Pass-Through Obligations. Master landlords may pass through to the sub-landlord those taxes generated pursuant to San Francisco’s Early Childcare and Educational Commercial Rents Tax Ordinance and the Gross Receipts Tax Ordinance. Depending on the terms of the sublease agreement, sub-landlord may in turn pass through such costs to sub-tenant.
- Increased Documentation. While the sublease agreement is usually less involved than a master lease, a review of the master lease is also necessary, and possibly a separate attornment and/or lender consent agreement.
- No Direct Recourse Against Master Landlord. Because a sub-tenant is not in privity of contract with the master landlord, sub-tenants do not have any direct remedies against the master landlord. This can be especially problematic when there are poor or defective building conditions and/or service issues, as the sub-tenant finds itself at the mercy of the sub-landlord to seek recourse from master landlord on sub-tenant’s behalf.
- Allocation of Expenses Disputes. Issues may arise regarding whether the sub-landlord or sub-tenant is responsible for paying certain operating costs passed through by the master landlord.
Companies considering a sublease in San Francisco should make clear in any such agreement which party will be responsible for what costs and understand how the terms of the master lease may impact their sub-tenancy. Without a meaningful evaluation of the above risk factors, the boon of discounted rent that accompanies a sublease could quickly be erased by unexpected costs and obligations over the course of the sublease term.
Please contact Michael Corbett by email at email@example.com for answers to any questions related to this update.
Authored by Reuben, Junius & Rose, LLP Attorney Michael Corbett.
The issues discussed in this update are not intended to be legal advice and no attorney-client relationship is established with the recipient. Readers should consult with legal counsel before relying on any of the information contained herein. Reuben, Junius & Rose, LLP is a full service real estate law firm. We specialize in land use, development and entitlement law. We also provide a wide range of transactional services, including leasing, acquisitions and sales, formation of limited liability companies and other entities, lending/workout assistance, subdivision and condominium work.