Recapture & Profit-Sharing Provisions

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Most commercial leases contain Assignment and Subletting provisions which allow the tenant to (sub)lease a portion of or the entire leased premises to another party, known as an assignee or subtenant/sublessee. In most (if not all) cases, landlords must consent to the sublease or assignment. Language governing that consent can range from “in landlord’s sole discretion” to “not to be unreasonably withheld, conditioned, or delayed.” In addition to required consent, two of the most important rights available to landlords under the Assignment and Subletting section of the lease are Recapture provisions and Profit-Sharing provisions. They allow landlords to maintain control of the space/property and mitigate the impact of below market lease rates thereby allowing them to maximize the resale value of their asset.

Recapture provisions allow the landlord to terminate the lease and retake possession of the leased premises. There are a number of “triggers” that allow the landlord to exercise their right, including but not limited to, events of default, failure to maintain a certain gross sales revenue (in cases of percentage rent), etc. but in this case we’re focused on the instance in which the tenant requests the right to sublet or assign the lease.

Profit-Sharing provisions require the tenant to share any net profits from subleasing or assigning the leased premises. Generally, it’s 50/50 and the key term is “net” profits, which means that the tenant’s expenses in procuring a(n) subtenant/assignee, i.e. brokerage commissions, free rent, improvement allowances, and other considerations are subtracted from the gross rental value.

There are multiple issues for the landlord to consider when determining which right to exercise. Certainly the recapture right provides greater control over the space, but profit-sharing may be preferable in certain cases. The goal is maximizing value and/by minimizing risk.

Who secures the lease? Who’s the tenant? Who’s the proposed subtenant/assignee? Does the tenant have a personal guaranty? How much time is left on the lease? Is this an assignment or a sublet? What’s the difference? Why is the tenant seeking to sublease or assign the lease? What is the opportunity cost of releasing the premises? These considerations are intermarried but form models for decision-making.

The landlord’s primary goal is to collect (at least) the contract rent from the lease. The stronger party financially is the one with the greatest likelihood of doing so. If Google leased more space than it needed initially and requests the right to sublet a portion of their space, the landlord will prefer to share in the net profits from a sublease rather than recapture the space, regardless of the difference between the market rent and contract rent. In many cases though, landlords will need to consider the financials of two relatively similar parties. Generally, the minimum requirement for consent to a sublet/assignment is that the proposed subtenant/assignee have a financial net worth/strength equal to the tenant at the time of lease commencement. In cases where two parties are comparable financially the difference between market rents and the contract rent will govern the landlord’s decision.

Related to the landlord’s primary goal of collecting rent is the risk of default. The reason behind the tenant’s request to sublease or assign the leased premises is another key factor that landlords must consider. In the previous case, there is little to no risk involved. Large companies like Google will sometimes lease more space than they need at the time in order to extract maximum concessions from the landlord, take advantage of economies of scale, and ensure room for future growth. In such cases, companies may choose to sublet their space until they need it. Conversely, many (if not most) requests to sublease or assign the lease are the result of lost contracts, decreased revenue, declining profits, etc. and can foreshadow default. If market rents are higher than the contract rent in such cases the landlord should choose to recapture the space.

The opportunity cost associated with recapturing/releasing the space takes into account the previous two considerations and the difference between the contract rent and market rents, as well as market concessions. Depending on the condition of the space, the tenant’s proposed improvements and the associated costs, and current market tenant improvement allowances, the landlord may choose to simply take 50% of the net profits from the sublease/assignment.

Another closely related and crucial element is the time remaining on the lease term and whether the tenant is seeking to sublease or assign the lease. If there is not much time left on the lease, i.e. less than one year, the landlord may choose to recapture the space to secure a long(er)-term tenant when market rents exceed the contract rent. In the case of a sublease for a portion of the space for a portion of the lease term, the landlord may choose to simply share in the profits under the presumption that the original tenant will reoccupy the subleased space within the lease term. If a tenant is requesting to assign the lease the landlord will carefully consider the reason behind the request when making its decision.

The guiding principle for landlords/owners is to maintain control over their property by providing themselves with the most options/rights to manage changes in the market or their tenant’s financial condition. A property’s net operating income (NOI) sets the benchmark upon which it will be valued, but the risk associated with that income determines the capitalization rate to be applied, which ultimately establishes the property’s market value. The higher the NOI  and the lower the risk/cap rate the greater the value.

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