Sublease Conundrum

May 04, 2020

As office tenants assess the financial implications of COVID-19 on their businesses, many will be making decisions about whether to return space to the market, and if so, how much. Considering the economic challenges, including job losses, wrought by the coronavirus, it may seem likely that the amount of sublease space on the market will rise materially in the months ahead. However, the decision calculus for office tenants is not straightforward.

Limiting the spread of disease—and being more mindful of health matters generally—has become a top consideration for corporate leaders as they develop plans for returning their employees to the office. While reducing the amount of space leased per employee—and in turn reducing occupancy costs—was paramount for those who signed leases in the immediate aftermath of the Great Recession, the dense layouts that resulted increased the risk of illness. Densification of the office environment also reduced productivity for many companies, with employees routinely complaining about visual and aural distractions hampering their ability to concentrate. Privacy was lost to efficient benching setups. In a low unemployment rate environment, some firms also lost their maximum capacity to attract and retain top talent.

These considerations did not stop densification, but they did slow the trend before COVID-19 struck. Now, as decision-makers grapple with whether to place sublease space on the market, they need to consider the potential for redesigned office space. Is 150 square feet per worker appropriate in a post-COVID world, or should that figure rise? How far apart should desks be positioned? How high should partitions be to reduce the transmission of pathogens, and what does that mean for office design? Is the space devoted to common areas during the last cycle better suited to private offices once again?

At the same time, not only are tenants likely to be seeking ways to reduce costs during and after a recession, they also will be considering their experiences with remote work. Some tenant types had substantial experience with teleworking before COVID-19, but many of those that did not have been forced into an urgent experiment. To what extent has that experiment proven successful? Have employees been productive? Is it clear that some work must be done collaboratively and in person? Can some teams work remotely while others return to the office? Is a rotation feasible? To what extent is their need for space reduced if remote work becomes a larger part of their approach?

Early data suggests that while sublease inventory increased in early 2020 in most major markets, some tenants are holding back space to accommodate social distancing plans once workers return to the office, thus yielding an increase in square feet per employee for those who are present. Office sublease availability has risen in eight of nine large markets since the end of 2019, as shown in the adjacent graph, although some of that change had occurred prior to the pandemic—such as in San Francisco, where more sublease space was put on the market in January and February than in March and April, meaning the data is not yet reflecting an escalation due to COVID-19. On average, for these markets, the sublease availability rate has increased only 32 basis points in the past four months. In fact, between the week of April 20 and the week of April 27, the sublease rate was little changed, based on available data, although there may be some lag in reporting. Tenants’ generally careful approach to leasing during the recent growth cycle—with little excess space under long-term lease even before the pandemic arrived—means there is less to give back during this transition period.

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The challenge to asset owners should not be underestimated; it is very likely that the sublease rate will rise over the next few months as corporate leaders have more time to consider their real estate decisions. For context, during the past two downturns, the sublease availability rate in Manhattan nearly doubled within two years. However, sublease availability may not rise as much as economic conditions suggest it will, given the design questions noted above. While an increase in remote work likely will offset an increase in square feet per workstation to some extent, the amount of that offset will vary by industry. In summary, it is too soon to know whether changes to office design driven by COVID-19 will yield more or less net demand over the long term, although it is likely that tenants’ need to market sublease space will be more than a reversal of densification can offset. Markets with a significant coworking presence may face a relatively higher degree of difficulty during this rightsizing period.

Another action step that tenants can take, in addition to revising their workplace strategy, is carefully considering the financial implications of subleasing space in terms of write-offs and depreciation. For example, say a tenant is paying $65 per square foot on a ten-year lease term and spent $100 per square foot on construction and furniture, fixtures, and equipment (FF&E). If that tenant generates $45 per square foot in sublease rent for the final five years of the term, the total P&L impact could be a one-time write-off of $150 per square foot related to the disposition of the premises. Specifics will vary, but there are opportunities to address the potential impact on earnings in a thoughtful way.

Ultimately, the sublease conundrum for office tenants is how to control occupancy costs during a period of economic dislocation while also retaining the space needed to implement a new workplace strategy—and remain flexible enough to accommodate growth as the economy cures.

Newmark’s professionals stand ready to advise our clients on how the current crisis may affect their business planning. We invite our clients to call on us for guidance and for more market information.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, Newmark hereby notifies you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code; or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Further, under no circumstances shall Newmark be deemed a tax advisor and no information provided to you shall be deemed to be tax advice in any matter.

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