Now Subletters Are Subleasing Their Spaces As 'Magnitudes Of Risk Compound'

A second wave of sublease space has hit the market in Dallas-Fort Worth, a phenomenon poised to create a logistical nightmare for landlords and put imperiled properties at greater risk.

Over the past three to four months, a handful of companies that took space from another tenant have put their space back on the sublease market. Such situations have historically been rare given the risks that come with layered tenancy, but as building owners grapple with the potential consequences of lost revenue and weakened occupancy, some are beginning to bend in unexpected ways.

“Subleasing is difficult in general because you have to get signoff from multiple people, and it’s not always in their incentive to do that,” said Steve Triolet, senior vice president of research and market forecasting for Partners Real Estate.

“With a sublease of a sublease, now you’re talking about three entities, and you have to jump through a lot of hoops.”

Sublease availability in North Texas hit a new peak in the second quarter of this year, ticking up by 2.1% to more than 10M SF, according to CBRE. About 60% of the sublease market is vacant and ready for immediate occupancy.

Second-generation space is materializing across a range of urban and suburban properties, though submarkets like Far North Dallas and Las Colinas that have seen the bulk of sublease activity thus far are more vulnerable, Triolet said.

Among the companies looking to offload subleased space are Conti Capital, which listed 21.8K SF in Preston Center; nThrive, which is looking to sublease 51K SF at One Legacy West in Plano; and Omni Logistics, which is hoping to get rid of 41K SF in Cypress Waters.

Competition with market-rate direct space is one reason why landlords tend to shy away from allowing a chain of subletters. Rental rates for subleases are typically discounted by about 25%, but in extreme cases, tenants are accepting cuts of up to 50%, Triolet said. To sweeten the deal, some are throwing in free furniture and money for tenant improvements.

“They want to get rid of it, and they’re basically eating half the costs,” he said. 

Advantis Medical took over Ansira’s 44K SF lease in Far North Dallas in September 2022. The company returned the space to the market in late August at $18.50 per SF triple net, significantly below the $33 triple-net rent for direct space in the building, according to data from Partners.

At top-tier properties, where sublease space is in higher demand and tenants don’t have to negotiate on price to find a creditworthy subletter, competition is also an issue, said Marijke Lantz Flowers, senior vice president of investments and build-to-suits at Billingsley Co. 

Landlords would rather those tenants take direct space in the building and continue to improve occupancy than take over an existing tenant’s lease. 

“If you are a Class-A building that everybody wants to go to, you’re not seeing the discount, so therefore the chances of it being in direct competition are much higher,” Flowers said. “In a building that somebody doesn’t necessarily want to be in and there’s not as much demand, that’s where you see the discounts.”

The original tenant is on the hook with the landlord regardless of whether they are occupying the space or if their subletter is paying rent. Consequences of a default can reverberate up the chain, putting not only the original tenant in jeopardy but the landlord as well.

“The magnitudes of risk compound with every sublease,” said Justin Smith, founding partner of TXRE Properties, a company that owns multitenant, Class-B office buildings in suburban markets. “Landlords really don't want a sublease, let alone two subleases.”

If there are concerns about the primary tenant’s ability to pay rent, some landlords may feel inclined to bend the rules. In most cases, though, building owners aren’t keen on allowing a subletter who wouldn’t otherwise be able to afford space in the building, Smith said.

“Landlords already have the credit of the original tenant and the sublease tenant, so we’re really secure in our position, so why take the additional risk and headache?” he said. “The chances of that tenant, upon expiration, coming and paying market rent are almost zero, so we’re really disincentivized to do that, unless you’re worried about keeping the lights on.” 

A chain of subleases is risky for tenants, too. If the subletter stops paying rent after the company above it has already wiped the rent obligation from its balance sheet, it could find itself in a compromised financial position.

“If it pops back up, that’s a really big problem,” Smith said. “That money has been put somewhere else.” 

All landlords strive for healthy, vibrant buildings, so it is often beneficial for landlords to improve occupancy through subleases, said Noreen Mehdi Weathers, a vice president with CBRE’s occupier group. Most tenants would prefer to stay in their office space long-term and have budgeted for market rent in the event of a renewal.

“The heartburn for any landlord, whether they’re Class-A to Class-C, is that they don’t have a direct relationship with the subtenant — all they did was sign a consent form,” she said. “It would behoove landlords to get to know their subtenants, because that’s low-hanging fruit for long-term tenants.”

The pandemic changed the way lenders scrutinize a building’s performance, and a glut of sublease space can hinder an owner’s ability to refinance their loan, Flowers said. A building that is mostly leased but only partially occupied can raise concerns over a borrower’s ability to pay.

“Everybody in the capital stack is looking at occupancy, use and vacancy, whereas before, it was, ‘What’s your vacancy? How leased up are you?’” she said.

Nearly 19% of North Texas office buildings comprising more than 52M SF have debt coming due in the next two years, according to Yardi Systems data reported by the Dallas Morning News.

Sublease space impacts the value of office buildings because lenders will only underwrite income from tenants who are physically occupying the space, said Russell Ingrum, vice chairman and senior partner on the CBRE Texas Capital Markets Institutional Properties team.

"If 25% of your space is dark and available for sublease, your underwritten [net operating income] is 25% less and thus, the value is less," Ingrum said in an email. "Equity investors are not as punitive, but it does have an impact."

Whether or not owners with looming maturities are able to refinance will come down to a number of factors, but a persistent sublease trend could compound other concerns.

“It’s definitely going to raise some eyebrows,” Smith said.

UPDATE, SEPT. 18, 11:37 A.M. CT: This story has been updated to include more information about the impact of subleases on building values.