The sublease dilemma

It is no secret that the current housing slow-down and recent credit crunch is having negative impacts on many northern Nevada businesses; the scores of empty South Meadows offices demonstrate this. Homebuilders and home loan lenders, many of whom made their riches during the exuberant home-buying craze, are now facing leaner times. Stricter lending criteria has made it more difficult for home buyers to gain financing. This new lending criteria, coupled with an already lackluster housing market has resulted in significant financial hardships for some of Northern Nevada's largest companies. In order to mitigate the damages of this economic down-shift, northern Nevada's homebuilders, title companies, home loan lenders, architects, and more have restructured and therefore have had to lay off or relocate large portions of their staff. The question I am sure you are asking is, "What about those long-term leases those companies signed?" That is a good question, and the answer is, "subleasing."

The housing and credit-related companies mentioned above, along with several other local companies, have recently put more than 100,000 square feet of sublease space on the South Meadows sub-market. These companies are not looking to maximize rent per square foot on their space, but instead to mitigate their losses. As a result, sublessors are looking for a swift lease-up, evidenced by their willingness to undercut market rates by as much as 25 percent. These below-market rents present a great opportunity for businesses looking to expand into the Reno market; however, this also presents a serious dilemma for landlords who now must compete with these new vacancies.

How does a tenant take advantage of these opportunities? The tenant must understand the advantages and disadvantages associated with a sublease. The obvious advantage is that most sublease space is offered at below-market rents. Another advantage is that sublease space is often offered on a shorter term, giving companies the flexibility to sublease office space for shorter periods. Landlords are generally looking for three- to five-year terms, which often do not correspond with a company's expected expansion, contraction or unforeseen market fluctuations. However, companies must determine if shorter lease terms are in their best interest. They must anticipate an often significant rise in their lease rate once the sublease has expired and they are forced to renegotiate a new rate directly with the landlord. In addition, perhaps the costs associated with moving outweigh the benefits of the reduced lease rate, especially if that reduced lease rate is only for a temporary period.

When companies are forced to offer their space for sublease, they are most often offering their space at a lease rate below their contract rate. For this reason and to mitigate further sublessor carrying costs, abundant tenant improvements are rarely feasible. The lack of tenant improvement allowances in offered sublease vacancies makes it difficult for many companies to capitalize on sublease opportunities. However, if we continue to see a negative net absorption, (the amount of office space coming available to the market relative to the amount being leased) it will be interesting to see if even sublessors begin offering tenant improvement allowances comparable to those of landlords.

Lease rates in South Meadows have historically held strong relative to market norm fluctuations in new construction and vacancy absorption. Yet, in order to compete with this new sublease vacancy, office rents may do something they haven't in a very long time - decrease. The South Meadows submarket will feel the greatest effects due to the largest concentration of available sublease space being located on Double R Boulevard at Park Center East and on Professional Circle at Northern Nevada Corporate Center. Landlords will have a difficult time competing with the sublease vacancies, and they will need to offer greater incentives if they plan to fill their vacancies.

How does a landlord compete with sublease vacancies offered at a 15 to 25 percent discount? The first step is to become more aggressive when offering tenant improvement allowances, especially in spaces that are in shell condition. With construction costs at all time highs, landlords will need to offer greater tenant improvement allowances to attract those companies with specific build-out requirements. Landlords should also become more flexible on length of term. Much of the sublease space on the market is a result of long-term contracts signed two to three years ago. Companies are realizing the risks associated with long-term leasing contracts and are taking exit strategies more seriously when expanding. The ability to reanalyze office space requirements after a shorter period of time is becoming more important to companies, especially in those companies most susceptible to economic fluctuations. Landlords should also consider staged square footage take down scenarios to attract those companies with high growth potential, as well as staged rent, in which the lease rate is lower during the beginning of a term and higher during the end of the term.

It is yet to be determined how quickly this sublease space will be absorbed if at all. The South Meadows market experienced a negative net absorption in mid-year 2007, and with Employers Insurance vacating approximately 80,000 square feet next summer, we could see negative net absorption through mid 2008. Vacancy rates on the south end of town are rising, and as this supply of office space increases, demand for it will decrease, most likely benefiting future tenants.

Matt Grimes is an associate in the office properties group of NAI Alliance. Contact him at mgrimes@naialliance.com.