Court to Decide What Happens to a Tenant When Its Coworking Firm Doesn't Pay Rent | Market Commentary by Jennifer Frisk
JUUL Seeks to Untangle Itself From Hudson Pacific Properties, Knotel Lease
The question of what happens to a tenant when its flexible office space provider stops paying rent to the landlord may soon find an answer in a San Francisco courtroom.
E-cigarette maker JUUL has filed a suit in San Francisco Superior Court this month against flexible office operator Knotel to try to untangle itself from a legal dispute over unpaid rent for a downtown San Francisco building between the sublandlord and the building's owner.
At the heart of the matter is the relationship between a coworking company like Knotel that leases office space, renovates it then subleases to a client. The responsibilities of an entire real estate industry sector that is an intermediary is being examined in this case.
"It's a concern right now because it won't be an isolated incident," Jennifer Frisk, a senior managing director for brokerage Newmark Knight Frank in Los Angeles, said of issues emerging between coworking operators or sublandlords and their tenants. "There will someday be a version 3.0 of coworking that is offered directly by landlords or operators, but for now, that doesn't exist. For now, we have to make sure we build in some sort of assurance or protection in case the middle man stops paying rent to the landlord."
JUUL has a deal with Knotel to occupy a total of 56,721 square feet at 625 Second St., a property Knotel leases from building owner real estate investment trust Hudson Pacific Properties.
According to the lawsuit, Knotel has defaulted on its rent for the Second Street space to Hudson Pacific, which sent a letter to JUUL asking the e-cigarette marker to pay Hudson directly for the space it was occupying in the building. Hudson also filed its own lawsuit against Knotel for the missed rent payments.
Now, JUUL, which moved out of the building in June after it said it learned of Knotel's rent default, argues the flexible office provider breached its part of their deal, putting its office space and ability to do business there at risk through the default. Knotel argues JUUL is on the hook for the length of its agreement.
JUUL, Knotel and Hudson Pacific Properties did not respond to CoStar News' requests for comment. The companies' lawyers also did not return requests for comment.
Legal Ambiguity
In all, the lawsuits and disagreements shine a spotlight on the legal ambiguity facing the flexible office and coworking industry, which has been one of the fastest growing types of office tenants in the nation in recent years but has been financially strained by the pressure of the coronavirus pandemic.
It provides one of the first glimpses into what may be facing tenants of flexible office spaces as their sublandlords struggle to pay rent to building owners and keep their doors open. Many of their tenants, or members, have stopped using the spaces and paying fees since the virus hit and social distancing requirements forced most office workers to stay home. Firms, including Knotel, have been forced to close locations, layoff staff or stop paying rent to try to shore up their finances.
JUUL alleges in the lawsuit it first heard of its sublandlord's potential default on its lease when it received a letter on April 24 from Hudson Pacific demanding payments.
"JUUL cannot effectively operate its business facing such a legal threat," Danna McKay, JUUL's corporate general manager, wrote to Knotel account executive Ryan Sakowski on June 10, according to the lawsuit. "In addition, JUUL has been subject to competing demands for rent payment at 625 Second St. because, as Knotel is aware, Hudson itself has made demand upon JUUL for direct payment of sublease rent."
The lawsuits are proof that the challenges facing the coworking industry are beginning to affect landlords and tenants, something that coworking critics have raised questions about since the industry began expanding at a rapid pace.
Many of Knotel's landlords, from New York to San Francisco, have sued the coworking space operator for unpaid rent. In San Francisco, Hudson Pacific filed a lawsuit the day before JUUL's lawsuit alleging Knotel owes nearly $394,000 in past due and unpaid rent for the space it leased at 625 Second St.
Despite JUUL's argument that it shouldn't be held liable for Knotel's defaulted lease agreement with Hudson Pacific, real estate attorney Tony Natsis with Los Angeles-based law firm Allen Matkins said it could be a losing battle.
"The general rule for subleasing is that the primary tenant is responsible for paying the landlord, but if you do your documentation correctly, the landlord can compel a subtenant to pay any amount the subtenant was paying to the primary tenant," Natsis said. "When they consented to the subleasing agreement, a subtenant also agrees to the original lease agreement, that's the almost-always rule. "It can force a subtenant to become a direct tenant by paying the landlord while the primary tenant is in default."
Subleasing Fallout
As the economic fallout of the city's months-long shelter-in-place order continues to hammer the commercial real estate market, San Francisco's subleasing availability has become one of the highest in the country.
Companies as large as Twitter, Uber and Airbnb have contributed to the flood of available space. While most sublandlords have been able to make their normal rent payments, as the number of subleasing agreements climbs, there is an increasing danger of lawsuits similar to the one in which JUUL, Knotel and Hudson Pacific are currently tangled.
"It's a question and issue that hasn't previously been in the market," Frisk said of sublandlords defaulting on their master lease agreements. "We've started asking sublandlords to provide financials and, if there's a concern, we have considered asking landlords to recognize the subtenant as the master tenant in case the sublandlord stops paying their rent. Obviously it's a case-by-case basis, but it's something that's definitely part of the conversation now that wasn't before."
According to the lawsuit, JUUL then looked to Knotel to confirm the status of the sublandlord's own tenancy in the building. However, after weeks of communication, Knotel told JUUL the coworking provider's lease at 625 Second St. was in default, and would remain as such for "many months."
After giving notice to Knotel of its termination of the sublease arrangement, JUUL officially moved out of the space June 11. By Sept. 9, Knotel's lawyers demanded JUUL to pay more than $3.7 million through the remainder of its sublease term, a request the e-cigarette maker is arguing as invalid given the terms of its agreement.
"JUUL is taking this step because of the imminent, and from JUUL's perspective, entirely unpredictable and unmanageable threat of substantial interference with JUUL's beneficial use of its demised premises at 625 Second St. that is now posed by the specter of an ongoing and protracted default by Knotel," Danna McKay, JUUL's corporate general manager, wrote to Knotel account executive Ryan Sakowski June 10.
"Such actual and threatened interference with JUUL's beneficial use of the premises relieves JUUL of its remaining obligations under the Knotel sublease at 625 Second St."
JUUL is asking to be absolved of any accusations it violated its sublease agreement, in addition to any legal expenses related to the suit and whatever else the judge feels "is just and proper."
According to the lawsuit, JUUL is arguing that because of Knotel's general lease terms and as detailed in its own lease agreement JUUL is not liable for any conflict Knotel may be in with the property owner.
For its part, Knotel argues in a letter included in the JUUL lawsuit that JUUL is trying to use the rent default as an excuse to exit the sublease as it faces financial trouble and layoffs of its own.
JUUL has long been trying to vacate its space in San Francisco, including the building it purchased last year for way above market rate. It has had trouble landing a buyer for it, and this lawsuit with Knotel is only adding to its challenges and expenses.
As the fight between JUUL and Knotel simmers, the case with landlord Hudson Pacific Properties is also a drain on the workspace provider's increasingly limited resources.
In its lawsuit, also filed in the San Francisco Superior Court, Hudson is asking for all attorney fees and expenses, all past-due and late rent charges, and any charges that moving forward through the lease expiration in April 2027, all including interest.