As the dust settles in Australia (at least, economically) following the COVID-19 pandemic, businesses small-to-large, are undoubtedly re-evaluating how and, importantly, where they operate.
One anticipated shift (and a persistent concern for landlord and tenant businesses) stems from the up-take of flexible and remote work arrangements, which over the medium term is expected to decentralise business hubs and reduce the need for floor space. While the extent and permanency of this shift is yet to be seen, landlords fear increased vacancy rates and conversely, tenants are anxious they may no longer need (or be able to afford) all of their leased space.
Given the ongoing market shake up and the scaling back of rent relief and other government stimulus measures, there is no better time to re-evaluate your lease arrangement. Whether or not the underlying motivation is pandemic-related, there are, in many cases, efficiency, cost or operational benefits in doing so.
One common option for tenants is subleasing.
In this three-part series, Partner, Ivan Orola and Senior Associate, Chris Cullendiscuss the concept of subleasing and the relevant legal and practical considerations for landlords, tenants and sublessees when entering into sublease arrangements.
What is subleasing?
At its most basic level, a sublease is an arrangement where a tenant of a lease (tenant) grants to another party (sublessee) the right to lease the same (or part of the) premises for a term which is less than the original lease (headlease). In this situation, the headlease is unaffected by the creation of the sublease and each continues to run concurrently.
Once a valid sublease is on foot, the sublessee is given a right to exclusive possession of the whole or a specific part of the property – that is, the general right to exclude others (including the tenant) in respect of the sublease area.
So why sublease? Subleasing can be an attractive proposal for many reasons, including:
- for tenants, they are relieved of potential financial pressure as sublessees provide rental income and therefore reduce some or all of the burden to pay rent or outgoings. Subleases also allow lessees to monetise unused space within their tenancy;
- for landlords, by allowing a tenant to sublease the premises, a landlord may secure a further party to underpin rental income for the particular asset (especially where rent redirections apply); and
- for sublessees, the rent and fit-out costs may be less than a direct lease and make good obligations may not be as onerous especially where the premises is being occupied immediately prior to the sublease being granted and expires well before the expiry of the headlease.
Considerations for tenants
Just like any legal arrangement, there are several important factors which tenants should consider before entering into a sublease.
Does the lease permit subleasing?
The first step from a legal perspective is to review the terms of the headlease to determine if it permits the tenant to sublease the premises (or part of it). While it is common that leases permit tenants to sublease (ordinarily subject to the landlord’s prior written consent), some leases expressly prohibit this.
The headlease prohibits subleasing – what do I do?
If the headlease prohibits subleasing, this does not mean that it is game over. A tenant can always approach its landlord to seek the landlord’s agreement to sublease the premises, and typically, where there are commercial benefits for a landlord, the landlord may be willing to allow the lessee to do so.
The headlease permits subleasing, but only with the landlord’s consent
Where subletting is permitted and the landlord’s consent to the sublease is required, the Property Law Act 1974 (Qld) (PLA) provides that the landlord’s consent cannot be unreasonably withheld. If it appears the landlord’s consent has been unreasonably withheld, the tenant may elect to either proceed to sublease (and defend any attempt by the landlord to forfeit the lease for failing to obtain consent) or seek a declaration from the court that such refusal was unreasonable. However, either action should only be taken after obtaining appropriate legal advice and in any event, may be a costly exercise to pursue.
There are often additional requirements that must be complied with before the landlord’s consent will be given to ensure that the sublessee poses no additional risk to the landlord. These requirements may include providing relevant information to the landlord regarding the proposed sublessee (e.g. financials, proof of capacity and experience) preparing and executing documents required by the landlord (for example, a deed of covenant). Other common requirements include that the sublease must be for the same permitted use as the headlease and that the sublease rent must not be greater than the headlease rent .
What happens if I ignore the headlease or don’t obtain consent?
Granting a sublease where it is either prohibited under the headlease, or subject to the landlord’s consent (particularly if they have denied, or not given consent) may entitle the landlord to terminate the headlease. In those circumstances, the sublease will also automatically terminate which may, expose the tenant to a claim by the sublessee. This is because the tenant has promised to provide the sublessee a right of exclusive possession for a particular term and now cannot do so. Accordingly, it is paramount that the headlease process is complied with when granting a sublease.
Rent and other monies
Whilst subleasing is one way for tenants to reduce financial burden on their businesses, tenants cannot simply wash their hands of their financial obligations under the headlease. In addition to payment and other obligations in the headlease continuing, landlords ordinarily require that the tenant agrees to remain liable for all monies payable under the headlease. It is therefore important to choose a sublessee with the financial capacity to perform the sublease.
Careful consideration should also be given to the amount of rent to charge a sublessee, particularly if only a portion of the land is to be subleased. Tenants should factor in to this determination, amongst other things, the size of the area being leased by the sublessee (if only a portion of the property), whether rent under the headlease is charged on a net or gross basis, the rent review mechanisms (if any) in the headlease and how to best apportion operating costs with the sublessee.
Term of the sublease
There is a fine, but important, legal nuance that needs to be addressed in relation to the term of a sublease to ensure that it is not deemed to be an assignment. In short, an assignment is a transfer of the entire lease interest, whereas a sublease is the transfer of an interest that is less than the tenants interest (i.e. the term of the lease). In order to avoid an assignment of the lease, the expiry date for the sublease must be at least one day before the expiry date of the headlease. If the term of the sublease is equal to or greater than the term of the headlease, it will constitute an assignment and will not operate as a sublease. In this situation, the tenant will lose its interest in the lease and the sublessee will have a direct relationship with the landlord.
Why does this matter if a tenant’s intention is to sublease the premises for the balance of the term anyway? Amongst other things, it means that if the sublessee leaves the premises early, the tenant will not have an automatic right to resume possession. An assignment will also impact on the tenant’s ability to recover sublease rent from the sublessee and would likely be a breach of covenants given in favour of the tenant’s bank, especially where that bank has used the headlease as security for loan facilities.
Options
A difficult situation arises where the headlease and sublease both contain options to renew and the term of the sublease expires on the day before the term of the headlease. This is because the sublessee’s ability to extend the sublease is reliant on the tenant extending the headlease, because without it, there would be noting to sublet. In those circumstances the parties should consider how this can be addressed – either through tweaking the notice periods so that the sublessee can only exercise the option if the tenant has done so under the headlease or providing that the grant of the further sublease is conditional upon the tenant exercising the option under the headlease.
Service interruptions, closures and other COVID-19 considerations
Given the recent experience with COVID-19 related lockdowns and the risk of further interruptions to business as usual trading, it is prudent that tenants consider appropriate provisions in the sublease which anticipate and deal with interruptions to services, forced business closures or other matters (including rent relief measures, if applicable). Provisions of this nature need to be carefully drafted and have regard to any obligation under the headlease on the tenant to ensure that trade is maintained (which is a common requirement in many retail leases).
Make good obligations
Making good a premises can be a costly exercise at the end of a lease or sublease. This can become a cause for negotiation where the sublease expires close to the expiry date of the headlease. The headlease will have its own framework and make good requirements. Tenants should consider whether they intend to pass any or all of those make good requirements on to the sublessee under the sublease. The headlease may also contain provisions requiring the tenant to seek the landlord’s consent prior to making alterations or commencing make good works. In those circumstances, the sublease should contain a back-to-back obligation on the sublessee to do so as well to avoid the tenant being in breach of the headlease. In any event, regardless of what the sublease says, tenants should be wary that they will still be liable to perform the terms of the headlease regardless of whether the sublessee performs to terms of the sublease. Follow the link for more comprehensive information on make good obligations.
This only touches the surface in relation to legal and practical considerations when granting a sublease. Tenants should carefully consider the above issues along with appropriate legal advice to ensure that the sublease achieves its intended purpose.
Stay tuned for part 2 – Sublease considerations for landlords.
If you would like further information or assistance, please contact our Commercial Property team.