Money Growing: Third-Hand

Contrary to popular opinion, sub renting is not a "scheme" or in any way shady in terms of its legality as a way of conducting commercial activity. At least in most cases. Sub renting has similar commercial terms as standard renting. However, it also has a number of specific features.

I asked the city

The practice of sub renting in Moscow appeared in the 1990s. At the time the only large landlord in the “office” real estate market was the government of the city, and the first modern business centers were extremely rare in the capital and rented out basically to western companies. Then enterprising citizens led by officials of the department of property created the beginning of this market.

The business logic was simple. At that time in the capital there were a number of privileges for renting premises for various types of firms - from small businesses to companies working with disabled people. Depending on the part of the city and the type of business, companies renting premises "from the city," could expect certain factors to lower the rent. In the most outstanding cases the discount could be up to 80 per cent of the stated rental rate which was several times lower that the market rate. The most surprising thing is that companies that had the right to such privileges, as a rule, didn’t even know about them. But officials and owners of business structures close to them were perfectly informed on the system.

Naturally, the difference in prices and corruption created a scheme that would be favourable to everyone involved. Everything was done very simply: a company close to the authorities leased a large premises from the city at a minimum rate which decreased by means of the use of the complicated system of factors that allowed for it to be lowered, divided it into smaller parts and then sub rented the space to any interested party. Including those who would have the right to rent the premises directly from the government at a reduced price. The most dexterous managed to obtain premises at absolutely miniscule prices for lengthy periods.

And to this day the city or an investor can unexpectedly learn that in a building intended for demolition or reconstruction, there is a company that concluded a rental contract at a fixed price 25, or even 50 years ago. And in its place are scattered various subtenants.

This business was super profitable. "Previously sub renting was a widespread form of business relations as companies had the opportunity to lease inexpensive state property, and then re-rent it at a higher price," says Roman Sokov, director of the consulting department at Becar Commercial Property. "Sub renting is attractive in cases when rates are below market value. Only in this situation can the tenant make profit from sub renting the premises. Therefore there was active development of sub renting federal and municipal real estate," adds Butba, head of the commercial real estate department at Vesco Consulting.

Moscow’s authorities only started to fight against the system at the beginning of 2000 when officials understood that the budget was losing hundreds of millions of dollars. In 2005 the head of the property department of Moscow Vladimir Silkin stated that, for example, in 2004 the income of such companies from sub renting exceeded $100 million. The solution the Moscow authorities found was simple: from 2005 rental privileges in Moscow and the rates at which real estate had been rented out at were practically cancelled and brought closer to market figures. And the premises were rented out by open auctions. The standard tenancy agreements were also amended forbidding tenants from sub renting premises without the permission of the proprietor of the property, i.е. from the city authorities. "The city is starting a policy of aligning rental rates and raising them practically to market level," says Vladimir Zhuravlyov, sales manager at NAI Russia.

To some extent the measures taken have had the desired result, and a share of those who exploited this market has lost income. However, as general director of marketing group Besh Oksana Krymina notes, even in Moscow this shady scheme has not been completely eradicated and the practice is still not a rarity for the market. "Still now, periodically there are reports on illegal sub renting in Moscow office centers being uncovered. In many regions there were and still are many such cases," she says.

Necessity

Because of the numerous scandals at the beginning of the 2000s sub renting became almost a swear word for many developers and tenants of commercial real estate. Meanwhile in many cases, sub renting not only does no harm, but also benefits all those participating. "The practice of sub renting office areas is quite widespread both in Moscow and in the regions,” considers Ashot Barsegyan, head of commercial real estate at MIAN. “From our experience it is possible to say that more than half of contracts concluded are sub rent." And according to Aydar Galeyev, the director of the consulting department at Miel Commercial Real Estate, sub renting makes up 20-25 per cent of the total amount of offers of office premises in the market.

And these are all absolutely legal contracts. Experts note that the practice of sub renting is most widespread in low class premises. "Sub renting is characteristic in class B+, B- and C premises. As a rule they are office buildings, private residences, and ground floors of apartment buildings. Premises in class A business centers are rarely sub rented," Zhuravlyov confirms. "Sub renting, as a rule, is come across in low quality premises as frequently they act as way of minimizing tax payments, and large capital developers who are engaged in the realization of class A and B business centers do not abuse the scheme," Galeyev adds.

Small and average sized companies, as a rule, act as subtenants. "Sub rented offices are in demand mainly by small companies that are only just entering a market and need time to develop. For such companies it is unprofitable to rent a large office based on forecasted development and decorate, furnish and fully equip it themselves," says Yury Yudakov, head of the office real estate department at Praedium. Galeyev explains the prevalence of small companies concluding sub rental contracts, as a rule, for short periods: "It is fraught with additional risks, therefore more solvent companies which pay a lot of attention to estimating risks prefer to rent directly."

However, there are exceptions. According to Dmitry Kuznetsov, director of the office real estate department at Colliers International mainly small offices measuring 100-250 sq.m are sub rented: "But subtenants are mainly representatives of foreign and Russian companies that are just starting new activities in a new region. As soon as the prospects for the business are clear, they start to look for a permanent office and employ additional personnel."

Respectable companies are even often forced to sub rent. "Large companies, having concluded a direct long-term rental contract with a proprietor, are often compelled to rent more space than is really necessary for them at the present time (the proprietor will only rent floors or big blocks but at a good rate). Having received consent from the proprietor they sub rent the premises, sometimes dividing the space into small blocks and to business partners or foreign companies," says Barsegyan.

"For large companies moving involves very large expenses on furnishing new offices and the infrastructure of the building. Such companies rent larger offices than they need at that time, which guarantees them the opportunity to expand within the limits of the existing business center over a certain period of time. Surpluses are sub rented for periods of one to three years," adds Kuznetsov. "Such tenants will search for a subtenant with a reliable reputation, ready to conclude a long-term rental contract of 2-3 years," says Polina Makarenko, head of the office real estate department at Knight Frank.

In some cases, Krymina says, companies sub rent part of the premises to business partners or affiliated structures. It can be more favourable when conducting successful business for a company’s partners to be located in the same office complex. Another reason to sub rent space is named by Sokov: "It may happen that a company, for some reason, may move out of an office but the contract of rent has been concluded for several years. As a rule, such companies sub rent the office." Otherwise the tenant would have to pay the proprietor huge amounts of compensation for cancelling the rental contract early.

A most unpleasant situation is when a company needs to sub rent space as their business is going downhill, and therefore need to get rid of some employees and reduce costs as soon as possible.

Sub renting conceals within itself a number of risks. "Such a contract is more risky for the subtenant as it has no mutual relations directly with the proprietor,” explains Makarenko. “There is a danger that if the proprietor wants to terminate the main rental contract with the direct tenant, the subtenant will automatically be in the same situation even if it did not break any clauses in its contract." However, Zhuravlyov adds, an exception can be in the event of if in the subtenant’s contract it separately states that the proprietor should renew the contract of direct rent with the subtenant if the contract with the direct tenant is broken early.

According to Krymina, proprietors try to register the main rental contract with permission for the tenant to sub rent the areas: "This is done not to transform the office center into a double-exited courtyard where the tenants are diverse and may even not suit the general image of the premises." "Landlords have the right to refuse this or that tenant if, for example, the status of the company of the subtenant does not match the general concept of the office center," confirms Barsegyan. "High-quality premises require a certain level of tenants and the right to sub rent does not allow for the prediction of your future neighbours," Galeyev summarizes.

Business

However, in the Moscow market there are companies that have managed to transform sub renting into a profitable and, most importantly, completely legal business. Here we are talking about Regus, M-style, Dayev Plaza, Millenium House. The largest player in this market is Regus, which already is already sub renting premises in Smolensky Passazh, Kapital Plaza, and the Avrora Business Center. Such companies of course have no connection with space belonging to the city or privileges provided by it. These companies have simply able to build a business, renting the areas at market prices and sub renting them at rates above market value. According to Olga Shirokova, head of the analytics department at Blackwood, rental rates under sub rental contracts are on average 15-20 per cent higher than average rental rates.

However, Regus type companies not only earn money from the simple difference in rates, but also by investing additional funds in providing additional services in the rented premises. As a rule, such companies rent the premises as whole floors at a discount, then divide the premises into smaller blocks and sub rent the areas at much higher prices. "They don’t just sub rent the premises with profit,” says Butba. “As a rule, they remove poor quality premises, renovate them and then sub rent them profitably."

The calculation of the cost of premises sub rented is not made by square meters, but by workplaces. If you counted the cost of sub renting per square meter the price would seem 2-3 times more than average rates. "A feature of the given format is that small, completely furnished and equipped offices are rented out, not by square meters as is accepted in the market, but by workplaces,” Shirokova says.

"The completed infrastructure that exists in such business centers allows the tenant to start work immediately with minimal initial capital investments,” says Yudakov. “Each office has furniture and office equipment, high speed connection to the Internet and modern telecommunications. Another advantage of such offices is that the rental contract can be concluded for several months, which is convenient for small companies or foreign representatives."

It seems wonderful. But not for those who want to rent areas in these premises. In the same business centers of company Regus, tenants frequently impose a number of absolutely unnecessary services which according to contractual obligations are impossible to refuse. Vedomosti has been informed that some subtenants of Regus, in these business centers, may appear to even have to pay to use a kettle. Good job it’s not a toilet! The cost of additional services is high. Bu the advantages for many companies still outweigh the high expenses. Not without reason vacant premises in Regus business centers rarely appear on the market.

Analysts believe that sub renting in the office real estate market in these or other forms will always exist - both as a business, and as "a realized necessity." "Sub renting is a normal commercial practice permitted by the law and the customs of business. Now it occupies a certain niche in the real estate rental market, and therefore a significant reduction in such relations, in my opinion, will not occur, although a growth in their number should also not be expected," says Galeyev. "The practice of sub renting will not go anywhere as in the Central Administrative District construction of business centers and offices is almost forbidden and this means that demand for these premises will not fall much. Representative offices in the center of Moscow will always be needed," Zhuravlyov concludes.