Discounted Sublease Rates Pressuring Landlords

A: This is part of the deflationary pressures that I discuss here often, all part of the healing process. Its painful, but it's healthy and corrective.

Half off sales, foreclosure sales, Bulk REO deals all lead to new owners with a more efficient operating environment with less debt overhang with which to manage the properties. This allows the investor/purchaser to offer lower rates to consumers; assuming an income producing property of course. This in turn pressures existing inventory. The deflationary cycle is a cycle like any other, feeding on itself until the excess is purged.

Add in the sublease element and the companies that are tied in to longer term leases but are no longer using the space, and you get one more pressure. The chart below for 2009 Manhattan Office Market Vacancies is from OptimalSpaces.com.

The NY Times reports, "Bargains Abound in New York’s Sublease Market":

Financial companies are trying to sublet space that they are no longer using in some of the most desirable office buildings in Midtown Manhattan, and the rents they are asking are heavily discounted compared with what landlords are seeking for similar space across the street — or even in the same buildings.

Many large financial companies dumped hundreds of thousands of square feet on the sublet market, with much of that space in prime Midtown locales near Grand Central Terminal, Rockefeller Center and the Plaza Hotel. Now, the sublet space that is still on the market is being offered at rents much lower than rents for space that can be leased directly from landlords in the same submarkets.

“This is going to have an impact on the rest of the market” for office space in New York, said Joseph Harbert, the chief operating officer of the New York metropolitan region for Cushman & Wakefield, a provider of commercial real estate services. “If I am a tenant, and I can get sublet space on Park Avenue at a discount, why would I go elsewhere and pay more?”

He said that the gap between the asking rents for direct space and sublet space in the most desirable Midtown office buildings — what brokers generally refer to as Class A space — was the largest he could remember.

On average, the owners of Class A buildings in Midtown Manhattan are now asking $72.03 a square foot, compared with $55.68 for comparable sublet space, according to Cushman & Wakefield. So tenants willing to sublet can get a 22.7 percent discount in Midtown. The discount was 12.6 percent a year ago.

A 22.7% discount between sublease space and Class A space from landlords? Ouch. That is a bargain worth discussing and one that should spark the attention of would be tenants. Now, the only concern is whether the current distress in the sublease market is a true indicator of the actual marketplace for Class A space. While sublease rates are a good measure as to where the real market is, we do not know the terms of the sublease or the desperation of the corporation that is seeking to re-rent out their space; perhaps at a loss.

Enter Robert Knakal, Chairman & Founding Partner of Massey Knakal, who writes on NYC's investment markets in his StreetWise blog:

"Sublease space is very indicative of what the real market is, because the sub lessor is willing to get whatever the market will currently bear. They do not have artificial constraints on what the lender is requiring or what the debt service payments require rent levels to be. The key area is the term of the sublease. In order for the sublet rent to have integrity as an indicator though, the sublease term has to be substantial enough to be a truer indicator of the market. A minimum of five years and ideally as close to ten years as possible would help gain credibility as a true indicator of the market. Clearly short term sublets for 3 years or less are not indicative of what market rents are."

Mr. Knakal makes a very solid point. What are the terms of the subleases that are being signed at a 23% discount to comparable Class A office space in the same area? If its very short term, it loses some luster as a true indicator of where the office market seems to be. So lets just use a bit of caution and try to dig up more details about the sublease market before coming to any concrete conclusions on how off the Class A market may be from its ultimate bottom and if it really is following the sublease path.

One thing is certain, the phenomenon is a deflationary one.

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