Subletting is the only option for office tenants looking to downsize

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Millicent Wong
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  1. property
  2. commercial real estate

Downtown office occupancy is still less than half what it was before the pandemic

Office buildings in downtown Toronto. Office buildings in downtown Toronto. Photo by Veronica Henri/Toronto Sun/Postmedia Network Files

As office tower owners continue to grapple with the uncertainty caused by the COVID-19 pandemic, their tenants face some tough decisions.

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For many, the shift to working from home and various hybrid arrangements have changed how space is calculated, leading to a surge in square footage in the subletting market.

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A report conducted by Avison Young on the Greater Toronto Area office market showed that subletting activity increased 26 percent in the fourth quarter of 2022 compared to the same period last year, with inventory now at record levels.

“The amount of available subleasable space continued to grow, increasing by 566,000 square feet to 7.7 million square feet (msf) in the fourth quarter — an increase of 1.6 msf year-on-year and surpassing the previous peak of 7.4 msf set in April 2021 was recorded,” the report said.

In comparison, the CIBC Square complex under construction in Toronto’s Financial District will total 3 msf over two towers once completed.

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Avison Young said there is still a great deal of uncertainty among tenants about their office space needs and that many are therefore deferring their decisions to sign leases whenever possible and hedging their bets with shorter terms to maintain flexibility.

Joe Almeida, managing director at Avison Young in Toronto, said that for those who have ultimately decided it’s not worth keeping the premises, terminating a lease is rarely an option, as neither party can do it alone , unless a specific clause in the contract allows it.

“It’s very difficult to terminate a lease because both the landlord and the tenant have to agree on terms that they would find mutually acceptable,” Almeida said in an interview. “You can’t cancel a lease the way people think about terminating an apartment lease.”

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Almeida said that tenants who want to evict often quickly realize that their only option is to offer the space on the sublease market.

The most prominent example was e-commerce firm Shopify, which signed on as the anchor tenant of The Well, a large mixed-use gated community in downtown Toronto that was being built by real estate investment firms RioCan and Allied Properties, but was announced in mid-November. December that she would no longer occupy the office.

The entrance to Shopify Inc.'s Toronto headquarters. The entrance to Shopify Inc.’s Toronto headquarters. Photo by Van Paassen/Bloomberg Files

The 15-year lease meant Shopify likely had a legal obligation to continue paying rent until the lease expired, and thus would have faced a lawsuit for breach of terms if it stopped making payments.

Shopify’s 348,103-square-foot space — which spans seven stories — entered the subletting market in January, so it’s not included in Avison Young’s fourth-quarter numbers.

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According to Almeida, Shopify hasn’t disclosed the rent it’s asking for, a practice he says is “common in these situations.”

In some cases, Almeida said, subletting can offer a financial benefit, but there’s also no guarantee of getting the full rent back, especially in the current environment.

“If you look at the industrial market, maybe someone who rented space five years ago is paying $8 net. Today they could go out and sublet the space for $18 net,” he said. “In the office market we haven’t seen that kind of growth in the last five years, so they would bring it into the market and try to get the best possible recovery, but in some cases that could fall short that is their obligation under the lease.”

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Many leases also contain clauses that limit the profit a tenant can make from subletting.

“Some landlords will say that the tenant has to share any profits with the landlord 50/50, others remain silent,” Almeida said. “You really have to understand the rights and obligations that are in the lease. Then you want to make sure you have professionals to advise you like your real estate agent and your solicitor.”

In the final quarter of the year, layoffs in the tech sector and external economic concerns, along with ongoing remote and hybrid work strategies, have impacted office market performance.

Those factors have compounded downtown Toronto’s slow recovery from the pandemic. The Strategic Regional Research Alliance, a consulting firm, found that office occupancy in downtown Toronto was just 42 percent of pre-pandemic levels in mid-January, down from 38 percent in December.

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“In downtown Toronto, availability and vacancy recorded a notable increase of 140 basis points and 80 basis points, respectively, to year-end 16.1 percent and 10 percent in the fourth quarter,” the Avison Young report reads. In contrast, the office vacancy rate in the city center was 2.1 percent in the first quarter of 2020.

While the market has seen positive absorption – meaning more space has been let than is vacant – Avison Young noted that this is a lagging indicator and could reverse as the stock of new space becomes available.

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Toronto isn’t the only market with an active subletting market.

According to another report by Avison Young, Metro Vancouver sublease vacancies rose to 581,669 square feet at the end of 2022, up from 476,105 square feet in 2021. The increase represented the largest annual increase between 2017 and 2022.

In downtown Calgary, on the other hand, the sublease market remains awash with inventory despite a downturn in 2022. At the end of the fourth quarter, 2,559,773 square feet of office space was available in the sublease market, up from 3,136,056 square feet a year ago.

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