Question

According to an article in the Wall Street Journal, in 2007 the insurance company AXA Equitable signed a long-term lease on 2 million square feet of office space in a skyscraper on Sixth Avenue in Manhattan in New York City. In $2013,$ AXA decided that it needed only 1.7 million square feet of office space, so it subleased 300,000 square feet of space to several other firms. Although AXA is paying a rent of $\mathrm{\$}88$ per square foot on all 2 million square feet it is leasing, it is only receiving $\mathrm{\$}40$ per square foot from the firms to which it is subleasing the 300,000 square feet. Briefly explain why AXA's actions might make economic sense in the short run. Would these actions make sense in the long run? Briefly explain.

Short answer

In the short-term, it makes economic sense for AXA to sublet the surplus space, as they are able to recover some part of the rent that would be wasted otherwise. In the long term, this situation is not financially favorable as they continuously lose on rent for unused space.

Step-by-step solution

Understand AXA's Situation

AXA is paying $88 per square foot for 2 million square feet, totalling to $176 million, but only needs 1.7 million square feet for its operations. The remaining 0.3 million square feet, which costs them $26.4 million, is sublet at $40 per square foot, making them $12 million.

Short Term Economic Sense

In the short term, it makes economic sense for AXA to sublet the surplus space. Even though it is sublet for less than half the price per square foot, it allows them to recoup some cost that would otherwise be wasted. Instead of losing the entire $26.4 million on the unused space, they are able to regain $12 million, thus minimising their loss to $14.4 million.

Long Term Economic Sense

In the long term, however, this is not a sustainable financial decision. The company will be continuously losing $14.4 million every year if the rent rates and the space requirements remain the same. Unless the rents reduce or the company's space requirements increase, this would lead to financial loss. AXA will need to find ways to fully utilise the rented space or negotiate a reduction in their rent or lease agreement.

Key concepts

Cost Minimization Strategy

In business, a cost minimization strategy is often employed to reduce expenditures and increase efficiency. This concept is particularly relevant when a company finds itself paying for resources it is not fully utilizing. For AXA Equitable, the insurance company faced a situation where they had excess office space, leading to potential financial inefficiency.

By subleasing 300,000 square feet of unused space, AXA employed a cost minimization strategy. They could either bear the cost of $26.4millionfortheunusedspaceortrytorecoupsomeofthatexpense.Throughsubleasing,theyelectedtomitigatetheirfinancialloss,recovering$12 million from the sublessees. Although the sublease price was significantly lower than their cost, this approach reduced their overall loss from the surplus space to $14.4 million, exemplifying a pragmatic use of cost minimization in the short term.

Reducing Waste through Subleasing

The decision to sublease also reflects a principle of reducing waste. By subletting the space they could not use, AXA turned a completely sunk cost into a partially recovered one. Subleasing, in this sense, is a means to minimize the waste of existing resources, aligning the company’s expenses more closely with its actual needs and usage.

Short Term vs Long Term Economics

The economic rationale behind a decision often shifts when considering the short term versus the long term. AXA's decision to sublease its surplus office space is economically sensible in the short term as it provides immediate at least partial relief from the expenses associated with excess capacity.

In the short run, subleasing allows companies to quickly adapt to changes in their resource needs, such as shifts in staffing levels or operational restructurings without drastically altering their long-term commitments or incurring hefty penalties from breaking leases.

Long-Term Considerations

Long-term decision-making would require a deeper analysis of trends, such as market rental rates and the company's growth projections. If the market rental values were to increase, or if AXA forecasted a future expansion requiring more space, the strategic value of their leased space might change favorably. Conversely, if the preferred solution is cost-cutting through downsizing, then continually subleasing at a loss does not make sense. In the long term, AXA could consider negotiating a smaller lease or relocating to a better-fitting space to align more closely with their needs.

Office Space Utilization

Office space utilization is a critical metric in assessing how effectively a company manages its physical resources. Underutilized office space represents a significant opportunity cost for businesses.

AXA’s decision to sublease part of its office space was an attempt to improve its utilization rates. By doing so, AXA turned unusable space into a somewhat productive asset, a tactic which is generally better than allowing the space to remain vacant.

Optimization of Space

The optimization of space can involve creative solutions like subleasing, redesigning office layouts to fit more employees, or using the space for different purposes to support the company's operations. Regularly reviewing the utilization of office space helps in understanding current and anticipating future needs, enabling better strategic planning around leasing decisions and the management of real estate assets. The exercise of subleasing reflects not just an immediate financial tactic but also a broader approach towards efficient resource management.