The pros and cons of sub-leasing

When a franchisee signs up to a lease, there are two options: signing on as the leaseholder, or becoming a sub-lessee.

A sub-lease is a contract between the lessee, (the retailer that has the lease with the landlord) and a third party. Within franchising this arrangement means the franchisor holds the lease (often referred to as the head lease), while the franchisee then becomes the sub-lessee beholden to the franchisor as its landlord. The terms and conditions of the head lease are usually the same, so it follows that the rent for the franchisor and franchisee should be the same.

In technical terms a sub-lease is as follows:

  • A sublease is the lease of all or a portion of premises by a tenant who has leased the premises from the owner. In legal terms, the landlord is the lessor, the tenant is the lessee, and the sublessee is renting from the lessee.
  • A sub lessee has no contractual obligations to the (head) lessor as its agreement is with the lessee (franchisor).
  • A franchisee should have a written lease agreement, to protect themselves from any problems or legal actions. An oral agreement is not enough and is always subject to misunderstanding and challenges in court.
  • In a sublease, the franchisee will still be responsible for paying rent.

Subleases are generally simpler, and more straightforward than other complicated types of retail leases. However, subleases are still binding legal documents and are also contingent on the original lease. You should give strong consideration to having a solicitor or retail tenancy expert view the sub lessor’s lease, as well as the sublease before signing anything.

Pros of being a sub-lessee as a franchisee

1. Most franchisors will have established leases at company level prior to franchising (and other units depending on their level of development) therefore the most crucial areas of the lease – therent and incentives – will already be in the lease and should be passed down within the sub-lease.

2. In essence a franchisor should be providing the benefit of their experience and resources through the sub-lease. When it comes to negotiating with landlords, the franchisor’s collective bargaining power is one of the attractions to franchisees; it should be an advantage to the sub-lessee not only with the initial lease agreement but when it’s time to renew the lease as well. The burden of negotiating a renewal on equitable terms falls upon the franchisor.

3. In theory if the sub lease is not favourable the sub lessee can walk away from liability. I say in theory because often there is a great deal of investment and good will tied up in retail franchise sites which makes it very hard to walk away from a lease that may become a burden.

4. Hidden traps such as Category 1 costs, for instance modifications to air-conditioning systems, fire sprinkler modifications, and power upgrades, are items that the sub lessee should not be burdened with because they would have been dealt with at lessee or franchisor level. These costs – and the savings to franchisees – can often amount to tens of thousands of dollars.

5. Guarantee provisions in terms of a security deposit will be required by the sub-lessee to an amount the franchisor has negotiated in their lease and this is often reduced when it is a multi-site operator. As a sub lessee, a franchisee’s personal guarantees (which can be an enormous liability) are usually given to the franchisor, not the landlord or shopping centre directly.

This is an advantage because the franchisee is transacting directly with the franchisor who will be personally liable for anything that goes wrong with the lease.

Cons of being a sub lessee

Of course there are disadvantages to this leasing option.

1. The value of any retail business is directly linked to the lease, and as a sub-lessee you technically have two landlords, your franchisor and the landlord above them. This can be burdensome at times and when selling a business both must approve the party wishing to purchase.

2. As a sub lessee all control of the site rests with the lessee or franchisor. If anything unfavourable happens to the lessee (such as bankruptcy), this has an automatic effect on the sub lessee without any legal comeback. There have been cases over the last few years in which administrators have been appointed to a franchised business and the level of input and direct control a sub lessee has is lost – it’s a frustrating situation for the sub lessees.

3. If there are day to day disputes to do with a building issue or shopping centre issue as a sub lessee you haveno legal right to communicate directly with the landlord. This can often frustrate an operator on the ground as landlords are happy to collect rent direct from a sub lessee but distance themselves from communication when push comes to shove. The sub lessee is required to communicate through the lessee/franchisor which can be time consuming and frustrating.

However many of the larger franchises have developed systems and good communication to alleviate these problems.  While a leasing incentive or cash contribution to establish a business may exist between the landlord and lessee (franchisor), this doesn’t always get passed onto the sub lessee.

In summary there are pros and cons to choosing a sub lessee rental agreement. However in my opinion the pros outweigh the cons when dealing with reputable established franchisors that employ best practices. Getting advice from your lawyers or leasing advisor is always recommended before signing any lease agreement.