Why Office Sublet Spaces May Turn Out To Be More Of A Competitive Threat Than Thought Before

Thu, 18 Mar 2021 09:09:21 -0500

It's not a secret: office space was among the most prominent victims from COVID-19. Work from home, social distancing, lockdowns, and almost every healthcare measure damaged the sector. Most experts agree that it'll take years to return to "normal"—if we ever do.

However, one subsector from office real estate has been surprisingly promising. Most advisors expected office subletting to go down with traditional leases. It seems like that's not the case. According to market analysts, office sublet spaces could become the dominant assets.

Why do they think that? That’s what we’ll find out.

Sublet or lease: What’s the difference?

Sublet refers to renting a rented property. An example would be renting an office floor and renting it to someone else. It divides the lease agreement into three levels: the landlord, the tenant, and sub-tenant.

Sublets are common when a tenant can’t stay or use the rented space, yet they’re unable (or unwilling) to break the agreement. Subletting allows tenants to collect rent from a sub-tenant and pass it to the landlord. The original tenant remains responsible.

Requirements for a sublet

Naturally, three parties are necessary for a sublease. However, a second lease agreement is necessary. The original contract remains relevant, but a new document must represent the new lease.

This new contract usually includes the landlord's firm as well. They must approve the sublet. A few requirements could become relevant depending on the sublease, but we'll go through them soon.

Having modern property management software is also a great advantage for these

What makes subleasing attractive for all parties?

It’s common for investors to believe subletting is an unnecessary complication. However, sublets allow for several benefits compared to traditional lease agreements. We also need to remember how it can become a necessity for tenants.

Subtenants

Companies often leverage subleases when they don't want to commit to a long-term lease agreement. Commercial real estate is a great example, as most terms demand for over five years. Seasonal ventures and fast growth often demand short-term contracts.

Essentially, any business dealing with short-term uncertainty benefits from sublets. It's simple; if you don't know if you want to keep a space for the next couple of years, a traditional lease can be detrimental. Willingness to use sublets also gives companies access to a broader range of options.

Sublessors

The original tenant—or sublessor—benefits similarly from sublets. For instance, their growth may call for more office or retail space. In those cases, leaving the original property might not be viable. Subleasing allows said business to move without breaking their contract.

That's not the only scenario that calls for a sublet. You could also need less space than what you rented. Subletting "leftover" space can help you keep the entire property's value and aid you with your rent payments.

Landlords

Landlords always benefit from tenants who can pay their rent when they need it. Keeping properties occupied ensure they can profit from those investments. It's easy to see why they'd be interested in subletting.

Last year, tenants being incapable of meeting rent wasn’t rare. Subletting allows tenants to meet their rent in these cases. It’s an obvious benefit for landlords, especially since it keeps them from searching and screening new tenants.

The market is starting to lean toward subletting

Earlier this month, Romania-Insider released an article about big office tenants looking to sublet spaces in Bucharest. Companies like IBM and Visteon leveraged sublets to reduce losses. One of the main problems for office owners is having to settle for cheaper rents.

Curiously, this development comes amid expectations about demand surges for office space. Demand is expected to grow up to 30% this year. So far, tenants have performed better than expected, and space optimization is becoming a consideration.

We can use this report as an example of what could happen worldwide as some industries flourish and others face turmoil. Overall, we can expect office space demand to grow as hybrid work shifts (merging remote and inhouse work) and co-working spaces become more popular.

With tenants needing to sublet their spaces, the market meets new supply, possibly lower prices than lease agreements. That's the reason why sublets can become a significant competitive threat.

Landlords could face the most significant challenge

Despite what we've mentioned, the article mentions that landlords will face higher vacancy despite increasing demand. That would cause negative value correction. The leading cause suggested is that moving to smaller spaces leaves more significant properties empty and reduces their demand.

The problem with this thesis is that landlords will still benefit from these sublets. In any case, tenants/sublessors will need to take the brunt of these transactions. If the sublet is cheaper, tenants will have to make up for the difference.

The real problem for landlords comes from upcoming office space developments. These projects add to the current supply, which could surpass demand.

The pandemic caused sublease space to increase inventory considerably

In July last year, National Real Estate Investor had already covered the considerable growth behind office sublets. Interestingly, it’s very similar to the previous report from earlier this month.

The pandemic has been responsible for countless businesses having to cut losses. The sublet market has been growing steadily in response. The article does mention that social distancing could've offset reductions by increasing demand for more space. Unfortunately, that doesn't seem to hold.

Office sublet supply grew considerably last year

Sublet activity as of the article's publication was already high. Even markets like Manhattan, which aren't too familiar with this practice, experienced significant volumes. Experts also agreed that sublet could grow prominently with time, which we've seen has been confirmed.

It’s also worth noting that some sectors experienced negligible sublet increases. It seemed to occur in markets where downsizing was already common before the pandemic. Regardless, virtually no market has been free from the subleasing trend.

The trend could be more robust in troublesome markets

Diversification has been vital during the pandemic. The subleasing trend supports that information, as the article also suggests. Subletting activity has been higher in markets focused on specific industries, like Houston and its dependence on the energy sector.

As discussed, subleases are also a way to cope with financial constraints, which are the norm with COVID-19. Troubled markets, like the energy sector, have needed to sublet their spaces to overcome financial turmoil.

What does this mean for the future?

Despite optimistic expectations for office space, the sublease market can hinder recovery considerably. New developments need to compete with these cheaper options, and that can drive demand down considerably.

However, it could also mitigate traditionally expensive markets where office rent has always been expensive. Additionally, sublease spaces could reduce possible rent drops, which were a noticeable problem in previous recessions.

Regardless, higher office supply from sublets will increase the current market supply, left by countless businesses leaving their office spaces. With potentially lower prices, they could pose a severe risk against maintaining good market demand.

Office space and recovery: Pre-COVID levels could wait until 2025

One of the main problems about sublet spaces is their disruption of the current market supply. Current forecasts are pretty pessimistic. For instance, CNBC estimates that it'll take until 2025 for office real estate to recover to pre-pandemic levels.

According to the article, office space endured more damage than the financial crisis. It peaked at 95 million sq ft. in unused space. It's estimated for this statistic to reach 215 million sq ft. before complete recovery.

What does this mean for office real estate and the current sublet trend?

The outlook is more optimistic than you might think

Interestingly, the article also mentions that office real estate can recover completely. It'll take a while, but employment growth and specific careers becoming more important will feed demand. Most experts agree that office space will never cease to be relevant.

For instance, creating a work culture and training staff is considerably more difficult if done remotely. Similarly, not everyone enjoys working from home because of the many distractions.

Hybrid work and co-working could breathe new life into office real estate

Additionally, remote work could benefit office space as it becomes “more normal” because of what we already mentioned. Many companies will offer hybrid schedules, where people can work remotely and in the office according to their chosen schedule.

This trend will likely encourage co-working spaces, and that requires repurposing office space. Therefore, office real estate could gain demand from multiple sectors, which previously threatened its relevance.

Companies might sublease offices pace to meet demand

However, we need to go back to the main subject: office sublet spaces. Many companies are likely to sublet their rented space to these growing markets. As we mentioned, this can pose a significant strike to the industry’s recovery, as sublets inflate supply.

That means companies will need to keep up with current developments and adjust their lease agreements accordingly. Luckily, this issue might be temporary. If demand surges above sublet supply, new developments will still yield profits.

Assetsoft - Blog #Sublet