Subleasing emerging as a key trend following COVID-19

Practical implications on leasing

The COVID-19 pandemic has caused significant disruption and uncertainty for both landlords and tenants to retail and commercial leases.  As a result, the Federal Government released a mandatory code of conduct for commercial leasing.  The code was adopted to varying degrees by each state and territory through its own legislation and regulations.

The legislation provides the processes for landlords and tenants to negotiate and enter into temporary rent relief arrangements.  A fundamental principle of the legislation is that parties will engage in rent relief negotiations in good faith.  Importantly, there are threshold requirements of a tenant before the legislation applies, these relate to the maximum annual turnover and minimum decrease in turnover of the tenant business (assessed at the store level for franchisees and at the group level for retail groups).

Using subleases to mitigate the impacts of COVID-19

Tenants have sought means beyond the legislation to mitigate the effects of COVID-19 on their businesses.  Subleasing has increasingly become a method tenants are turning to in order to achieve this.  In essence, subleasing is a tenant making an agreement with a third party to take on part of the tenant’s leased space.  This is appealing to many tenants who are reassessing how much floor space they will require going into the future and also to those tenants who are not eligible for mandatory rent relief under the legislation.

The increase in subleasing activity, in the context of COVID-19, has bought to light the practical limitations of current industry practice in drafting subleasing provisions in commercial lease agreements.  For example, it is standard to require that the landlord’s consent (not unreasonably withheld) is sought, and certain prescribed information is provided to them, before subleasing can take place.  From a tenant’s perspective, this may be regarded as unduly burdensome, costly and time consuming, particularly where they seek to enter subleases to offset some of their expenses.  Conversely, landlords are expressing concerns with subleasing as they are, to some extent, taking on an unseen risk associated with the viability of the sub-tenants in an increasingly difficult commercial environment.

The risks and challenges

Based on current drafting practices, tenants take a significant risk when they sublease their premises.  This is because they remain liable for all their obligations to the landlord under the headlease, including payment of rent.  In the COVID-19 context, this risk is magnified due to the increased possibility of business failure for both the tenant and subtenant.

Subleasing has also posed a particular challenge for the practical application of the legislation.  The legislation does not explicitly refer to subleases, but has been interpreted to apply to them.  However, issues can arise where rent relief has been granted to the subtenant where the subtenant is eligible for rent relief, but the tenant under the headlease remains liable to the head landlord for full rent because they do not qualify for the application of the legislation.

Commercially, where tenants are subleasing to reduce their expenses they should be mindful that many other tenants are experiencing similar financial pressures.  An increase in the appetite to sublease means there will be an abundance of stock of subleases floor space hitting the market which will likely result in downward pressure on the price per square meter of subleases.

Key considerations

Given these, some key considerations in the subtenancy space follow:

For tenants looking to grant a sublease:

a) consider the lease provisions in relation to subleasing and landlord’s consent;

b) engage as early as possible with the landlord, to ensure they understand and agree to the arrangement, and their requirements are understood by all parties;

c) ensure that subleasing (rather than an assignment, or partial surrender) is the best option;

d) ensure that you are satisfied with the subtenant’s financial capability, noting that you will remain liable under the lease if they fail to pay rent;

e) what security (including bank guarantee, cash security and/or personal guarantees) is the subtenant providing;

f) who is paying the landlord’s cost of consenting to the sublease (where required); and

g) how are other costs (including rent, outgoings, levies etc.) passed on. 

For subtenants looking to take a sublease:

a) ensure that the landlord’s consent is obtained (where required by the lease);

b) ensure that the sublease requires the tenant to pass on notices relating to the premises from the landlord and others, noting there is otherwise no direct connection; and

c) consider whether a direct relationship with the landlord is preferred, noting that subleases generally rely on the existence of the lease to survive.

For landlords being asked to consent to a tenant granting a sublease:

a) consider any requests promptly and ensure requirements for consent are clear from the outset, to avoid any delays or unnecessary costs;

b) ensure that the tenant remains liable under their lease; and

c) ensure that the sublease is not inconsistent with the terms of the lease (ideally, as far as possible it should pass on all obligations consistently).

It is recommended that landlords, tenants and subtenants seek legal advice to understand and negotiate these arrangements.

This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.