Exit Series part 3: The power of subletting for corporate occupiers
26 July 2023
Exiting an office space can have implications for your business. By being well prepared and understanding your legal position, you can get it right first time and avoid any costly delays. In part three of this series, we discuss subletting, a flexible solution for corporate occupiers.
Despite the increasing shift to remote/hybrid working, physical premises remain integral for businesses and the importance of securing flexible terms when committing to space is high on the agenda. There are several options which a well-advised tenant can seek to negotiate with a landlord when agreeing lease terms. These could include a shorter lease term, the ability to assign the lease or share occupation or a right to break the lease early. Another option is the ability for a tenant to sublet their space.
What is subletting?
In general terms, subletting (also referred to as underletting) is the grant of a lease by a tenant out of its own lease to a subtenant, referred to as a sublease (or an underlease). This enables the subtenant to occupy the tenant’s space and take on some of the responsibility for it. A subletting may be of the whole or just part of the premises.
What is the legal effect of a subletting?A sublease is a separate agreement to the original lease. The original lease, between the landlord and the tenant, remains in place (subject to the sublease) with the tenant becoming the landlord of the subtenant under the sublease. A tenant remains liable to its landlord under the terms of the original lease. However, it will generally pass on those obligations and liabilities (in whole or in part, depending on the nature of the subletting) to the subtenant under the sublease.
Why might a tenant want to sublet?
These are some of the most common reasons:
- a business may need to downsize and does not require all or part of the space. Alternatively, the tenant may have experienced growth meaning it needs to relocate to a larger space. Subletting allows a tenant to recover some of the lease costs from the subtenant thereby helping with cash flow;
- a tenant may just want to dispose of its premises on a temporary basis but retain it for occupation at a later date (particularly if there is a statutory right to renew the lease at the end of the term under the Landlord and Tenant Act 1954 (the “1954 Act”);
- compared to assigning the lease, the tenant has more control over the subtenant than it would an assignee as it can impose covenants in the sublease and has a direct course of action against the subtenant if it is in breach. Assigning part of the space is also likely to be prohibited under the lease;
- in a falling rent market, it may be difficult to find an assignee as the rent payable under the lease is likely to be higher than the open market rent. It is becoming common practice that leases should enable a tenant to sublet at the market rent (rather than the passing rent payable under the lease) therefore allowing a tenant to mitigate some of its financial liabilities.
How do you know if you can sublet?
This will be governed by the terms of your lease and should be agreed as part of the heads of terms.
If during the term of the lease the need to sublet arises, then the subletting provisions in the lease would need to be analysed to check what is permitted and what the conditions are that would need to be satisfied in order to sublet. If a lease is silent on subletting, then the consent of the landlord may not be required (however that is rare in practice).
The lease may allow a tenant to sublet the whole of the space, or it may allow greater flexibility by permitting a sublet of part. Whether a premises is suitable for that part will depend on a number of factors (such as whether the premises allows for sub-division), and landlords will often want to retain a high level of control over this (usually a lease will identify what constitutes a ‘permitted part’ and will restrict the number of subtenants in occupation at any one time).
If subletting is permitted, it would usually be subject to landlord’s approval (and possibly the consent of any superior landlord there may be). So, a tenant would need to market the premises, find a suitable subtenant and then submit an application for consent to the landlord. Such an application should be made strictly in accordance with the terms of the lease to avoid any delays with the approval process.
On receipt of an application, the landlord may raise some enquiries regarding the proposed subletting. Having considered the covenant strength of the subtenant, if there are concerns over the subtenant’s ability to perform under the sublease, the lease may allow the landlord to require a guarantor for the subtenant or pay a rent deposit. The lease may also contain other restrictions and/or conditions which a landlord may require to be satisfied before it will provide its approval.
If the landlord is, in principle, happy to proceed, it will usually instruct its solicitor to prepare and issue a draft licence to sublet. This will be entered into between the landlord, the tenant and the subtenant (and possibly a superior landlord, where applicable). It will need to be completed before the sublease is granted.
What will the terms of the sublease be?
The first key point is that the term of the sublease must expire before the lease term expires. If the sublease term is equal to or greater than the lease term this may result in the unintended assignment of the lease to the subtenant (which could have detrimental consequences for all).
The term of the sublease should also allow sufficient time for the tenant to re-occupy and comply within any reinstatement obligations in its lease if the tenant is vacating at the end of the term. This will therefore need to be factored in.
Whilst the terms of the sublease will be subject to negotiation between the tenant and subtenant, they are often dictated by the terms of the lease. The terms of the lease will therefore need to be checked carefully. The sort of things which you could expect to see in subletting provision include:
- a restriction on what rent a subtenant can be charged. The lease may require an open market sublease rent or require that it is no less than the passing rent payable under the lease (however, the latter should always be resisted when negotiating heads of terms);
- a requirement that the sublease rent be reviewed in accordance with any rent review provisions in the lease and for any reviewed rent to be approved by the landlord;
- it may say whether a rent free or other concession may be granted to the subtenant;
- a prohibition on paying any premium or a reverse premium for the sublease;
- restrictions on what a subtenant can do with the sublet premises in terms of its ability to assign, further sublet or share occupation (as the landlord will want to avoid creating an unduly complex title and management structure);
- a requirement that the sublease is excluded from the security of tenure provisions in the 1954 Act;
- a prohibition on the sublease being varied or surrendered without the landlord’s consent; and
- a requirement that the landlord approves the form of the sublease.
Landlords will always require a significant amount of control of the subletting terms because a subtenant could inadvertently become a direct tenant of the landlord if the lease is forfeited, disclaimed or surrendered or the sublease is granted within the security of tenure provisions of the 1954 Act and the subtenant is entitled to a new lease at the end of the sublease term.
The subletting terms agreed can have a material impact on the ability to sublet if required. This is why it is so important to seek legal advice when negotiating the terms of the lease to ensure that the provisions are not too onerous so as to prevent or impede the ability to sublet.
Are there downsides to subletting?
- Loss of control – the tenant loses a degree of control over how the space is used and occupied. If the subtenant does something which puts the tenant in breach of its lease, then the tenant remains liable to its landlord. Whilst the tenant may have a remedy against the subtenant under the sublease (a landlord would also usually require a direct covenant to comply with the sublease from the subtenant in the licence to sublet), if the subtenant cannot remedy a breach (e.g., if the subtenant has gone insolvent), the landlord will still have recourse against the tenant.
It is therefore important that a tenant satisfies itself (as much as it can) through its own due diligence that a proposed subtenant is likely to be able to comply and if there are any doubts, consider what additional security it may want from the subtenant.
- Costs – the landlord will require its legal and other professional costs to be covered (but it cannot charge a premium as a condition of giving its consent unless dealings are absolutely prohibited in the lease). These could include legal fees for preparing and agreeing the licence to sublet, a licence for alterations (if the tenant or subtenant need to carry out works) and possibly for surveyor and/or managing agent. They could reach fairly significant sums.
Are there any other factors to consider?
- Alterations – if subletting part, works may be required to sub-divide the premises. The subtenant may also want to carry out its own fit-out works. The alterations clause in the lease will therefore need to be checked to ensure any proposed alterations are permitted under the lease. There may be a requirement for the landlord to consent to the works (usually done via a licence for alterations) and this should be obtained at the same time as the licence to sublet.
- Break option – if the tenant has a tenant break option in its lease, then it will need to ensure that any sublease contains a landlord break option so that it can validly exercise its tenant break and hand back the premises to its landlord with vacant possession on the break date.
Reaching an agreement on subletting terms is a balancing exercise between competing interests; a tenant’s desire to be flexible and a landlord’s need to retain some control and ensure there is no impact on the value of their investment.
It is therefore key for tenants to ensure that subletting rights are negotiated at heads of terms stage and that legal advice is obtained when negotiating the subletting provisions in the lease. This will help ensure that balanced terms are agreed which all parties are comfortable with.
Our Real Estate team has years of experience negotiating heads of terms and leases as well as advising on subletting and other lease terms. We’d be happy to help with any queries you may have regarding your office space.
Click here to read the final part in the series where we explore the intricacies and challenges surrounding lease surrenders.