For purposes of this post, let’s accept the notion that an office tenant should pay to the landlord a share (usually one-half) of the net profits on any sublease. Typically the negotiation of this provision centers around what costs should be deducted in computing net profits, and most landlord forms limit this to the tenant-sublandlord’s construction, brokerage and legal expenses relating to the sublease.
A tenant-sublandlord ought also to be entitled to recover the rent it pays on the space during the following periods:
- while the space sits empty and is listed with a broker for sublease,
- while the space is being built out for the subtenant, and
- while the subtenant is enjoying free rent.
These are all fair costs and are the type of costs a landlord incurs when marketing space itself.
Some tenant-sublandlords also seek to be entitled to deduct the construction costs they incurred in preparing the premises for their own occupancy. Since these are sunk costs, not costs of subletting, I think the landlord is justified in resisting this, especially since, if the tenant moved out, the landlord would recover the space with all the improvements made by the tenant.
Most landlord forms provide that the tenant-sublandlord’s costs will be amortized and deducted over the term of the sublease. This should be strenuously resisted by the tenant and is very unfair because (a) the subtenant might default, and (b) even in the case of a super strong subtenant, the tenant should not have to provide unreimbursed financing (and be cash negative) for an extended period.
Instead the profit sharing calculation should work like this:
- A cumulative account of the tenant-sublandlord’s costs should be kept, starting when the space is empty and listed with a broker for sublease. This includes all rent paid to the landlord and all of the standard costs (brokerage, construction and legal related to the sublease). Call these the “debits”.
- A cumulative account of the tenant-sublandlord’s receipts should be kept, starting when the first dollar is received from the subtenant. Call these the “credits”.
- Each month (or quarter) the tenant should pay to the landlord, as profit sharing, one-half of the excess, if any, of the total credits (cumulative back to the first credit) over the total debits (cumulative back to the first debit), minus all prior payments of profit-sharing by tenant to landlord.
Of course during the early months (or even early years) of the sublease term there is likely to be no excess and thus no profit-sharing payments, but that is exactly the point of the structure: the risk to the tenant of a subtenant default is minimized as is the unreimbursed financing being provided by the tenant.
One additional feature of this structure is that it handles correctly a sublease under which during one part of the term the face sublease rent is less than the face lease rent and during another part of the term the face sublease rent exceeds the face lease rent.
A tenant who prevails on the issues described above has secured a fair profit-sharing provision.
Commercial Tenant Notes 