Last year, a joint group which included the Real Estate Board of New York, US Green Building Council, the Natural Resources Defense Council, the Environmental Defense Fund, and HR&A Advisors endorsed a Model Energy Aligned Lease Provision, which purports to remove the “split incentive” problem which can exist with respect to commercial “gross” leases. In a nutshell, the split incentive problem occurs in the gross lease context, where all utility costs are typically passed through to tenants on a square footage ratio, so the landlord is not motivated to retrofit their buildings with energy and other resource-saving improvements for which they will never recover the cost. For background on the split incentive issue, see my prior post, “The Net Lease and the Split Incentive”.
Archive for category: Leases
The “Split Incentive”, or as I have also heard it called, the “Split Incentive Disincentive”, is going to go away, and commercial real estate professionals had better be prepared for it. Here’s the “Split Incentive” problem in a nutshell: Building owners construct or buy a commercial building which they net lease to tenants, who pay the operating expenses, maintenance, insurance, etc., or in the context of a multiple tenant building, pay a proportionate share of such costs, typically based on rentable square footage. By paying only a proportionate share of, say, energy costs not based on actual use, the tenant has no incentive to save on energy costs by installing more energy efficient lighting and equipment. And, if the owner decides to incur the expense of upgrading its building by adding “green” improvements, it can’t recover that expense from its tenants, even if the “green” improvements result in energy savings to all the tenants (for more on the “Split Incentive”, check out my past article.
It is widely accepted that a significant part of the waste generated by a typical office – paper, packaging, cardboard, etc. – can be recycled if it is properly segregated from other waste which is not easily recycled, such as food waste. In the large commercial office building or development with multiple tenants, this means that literally tons of waste from a single project can be diverted each year from landfills and repurposed for use as recycled copy paper and envelopes, cardboard packaging, etc. Why, then, is there no widespread activity in the commercial lease context to recycle everything that can be recycled? There are multiple explanations for this lack of effort, including these:
I recently ordered, paid for (ugh!) and received a copy of the “Model Green Lease” offered by the Corporate Realty, Design & Management Institute (www.squarefootage.net). Of course, I read it with great interest, looking both at the suggested terms and the overall philosophy of the document. I’m sure that a lot of thought, debate and editing went into the creation of this lease, as it has for the several “green” leases which are available, either free or for a fee.
I’ll save a discussion of the merits of particular provisions of the Model Green Lease for a later date. The matter I want to comment upon is the concept of the “split incentive” contained in the Reference Guide to the Model Green Lease, which was prepared by B. Alan Whitson. His point, if I read correctly, is that although the market seems to favor net leases for many commercial building types, the net lease does not provide a suitable framework to properly incentivize the landlord and tenant to either build or operate in a “green” manner. Whitson ends the Reference Guide with a sort of “call to arms” for the commercial world to ditch net leases in favor of the gross lease. In so doing, he ignores the economic desires of a very large segment of commercial landlords and tenants, all of whom have built their businesses around a net lease structure.
Whitson’s argument goes something like this: significant reductions in energy cost, particularly in an office building, directly and materially increase a building’s value, while the same reductions in energy cost by a tenant result in only a small savings in the tenant’s overall operational cost (including rent, tenant improvements, furniture, technology, salary and benefits). Because of this division in the motivations between the landlord and tenant to adopt energy saving alternatives (the so-called “split incentive”), Whitson believes that the landlord is in the best position to reap the benefits of “going green”, and therefore only the gross lease will properly align and environmentally motivate both parties.
While I agree that certain commercial properties that already work well with gross leases, such as high-rise office buildings, could be designed, built and operated with green features, I disagree that the remainder of the commercial world should (or even could) throw away the financial and tax structure of the net lease in order to become green. The net lease structure provides a division of the ownership “bundle of sticks” which allows the landlord to invest in real property without having to be present to fix the roof, while at the same time allowing the tenant to deduct rent as an operating expense and to make repairs to the property that it notices. Many REITS with properties spread out across the country have thrived over the years with this structure since they are by nature “passive” landlords, and their tenants are free to focus on their core business, rather than also carrying the burden of owning properties.
If “green leases” are going to become commonplace, chances are it will not be because net leases have been shelved in favor of gross leases. Rather, it will more likely be so because the sum total of economic, tax and other motivations of the parties, as well as mandated governmental requirements, will lead landlords and tenants to adopt green alternatives in whatever lease structure matches the entire balance of their needs.
If you have any thoughts on this particular (and far from settled) topic, I invite your comments. There will have to be a lot of debate before we’ll ever get to workable answers.
Dale A. Burket (email@example.com) is a Florida attorney who is Board Certified in Real Estate by The Florida Bar. He is a partner with Lowndes Drosdick Doster Kantor & Reed, P.A. (www.lowndes-law.com) in Orlando, Florida.
Global warming, Miami’s proximity to the sea, and its average 6-foot above sea level elevation have provided the impetus for the adoption of MiPlan, a bold climate action intiative which identifies the current problems associated with greenhouse gases, the output of greenhouse gases in the city, and establishes a plan to reduce those greenhouse gases.
MiPlan inventoried current greenhouse gas emissions in Miami. The plan’s data suggests, surprisingly to me, that the Miami-Fort Lauderdale-Miami Beach area has the lowest per capita emission rate as compared to other Florida metropolitan areas (such as Tampa, Orlando and Jacksonville) and a lower per capita emission rate than the United States average. Approximately 54% of the city’s greenhouse gas emissions come from emissions associated with electricity. (MiPlan, page 8).
Commercial sector buildings contain approximately 35% of Miami’s built square feet, but consume 60% of the city’s electricity. MiPlan contends that because of the age of these buildings (80% of all Miami buildings are more than 20 years old), upgrades to assist with energy efficiency should have a great impact on the city’s overall energy consumption and greenhouse gas emissions. (MiPlan, page 10).
As a result of these findings, the City of Miami created (in 2008) a goal of reducing its greenhouse gas emissions by 25% by the year 2020. In order to accomplish this goal, the city concludes that emissions must be cut by addressing energy efficiency in new and existing buildings. (MiPlan, page 20). Of course, this means that the bulk of the financial burden in addressing the city’s goals will fall on the commercial sector.
MiPlan lays out seven actions to improve energy efficiency in buildings and decrease greenhouse gas emission from buildings. They include: forming alliances with other government and non-profit organizations to address energy efficiency; reducing energy consumption in existing government buildings by retrofitting, commissioning, and auditing; reducing energy consumption in existing private buildings by mandating energy improvements during major renovations and/or points of sale and developing financial incentives for improvements; reducing energy consumption in all new construction by developing mandates and incentives for green building efforts, such as requiring all city government buildings over 5,000 square feet to be built to minimum LEED silver certification and all buildings over 50,000 square feet to be built to LEED silver requirements; reducing the “heat island effect”, educating the business sector and the public on energy efficiency, and reviewing progress on increasing energy efficiency in buildings. (MiPlan, pages 20-24).
Since the city adopted MiPlan in 2008, several ordinances have been passed in order to begin to accomplish the goals set out in the ambitious plan. Ordinance 09-0095327 adds a new section entitled “Heat Island Effect-Roof” which provides for the construction of roofs (other than R1 and R2 residential zoning improvements) to reflect the sun’s heat. This ordinance pertains to new construction or the repair/replacement of a roof area greater than 50% of the existing roof. The city also passed Ordinance 09-0094921 which creates landscaping standards that prevent the destruction of the city’s tree canopy and encourages landscape design that promotes the channeling of breezes and air purification.
Despite the findings in MiPlan, there are those who feel that the benefits associated with having more energy efficiency aren’t matched by the cost of implementing these projects. One of the problems is that even estimating cost savings is difficult. How much can be saved by adding ‘green features’ or meeting a LEED certification? “None of us have hard data. . . .This whole movement came out of the academic and government worlds, and those two universes aren’t concerned about cost containment,” said Jack Lowell, managing director of Flagler Real Estate Services Oncor International in Miami (quoted in “Special Report: Going Green,” Daily Business Review, August 25, 2008).
Even if Miami begins to mandate particular building standards that new construction or renovation projects will have to meet such as LEED certification, there is no guarantee that projected greenhouse gas emission declines will occur or that estimated cost-savings will transpire. “The real [green] footprint of a building lies in the maintenance and operations,” said Brendan Owens, vice president of LEED technical development for the U.S. Green Building Council (quoted in “Special Report: Going Green,” Daily Business Review, August 25, 2008). This concern seems self-obvious, with maintenance and monitoring of existing buildings being a subject that has not received the attention and development it will obviously need for true energy and costs savings to landlords and tenants.
Even if energy savings are realized through green building and renovation standards, there remains the debate over who receives the benefit. “There could be an argument made if landlords said their energy costs are 20 percent less so they can charge 20 percent less in market rates, but it never works that way,” said Barbara Liberatore Black, principal and vice chairman of CresaPartner, Florida (quoted in “Special Report: Going Green,” Daily Business Review, August 25, 2008).
So, while the debate over “green buildings” and energy savings continues, Miami has nevertheless forged ahead with its own bold plan to reduce greenhouse gases. But until energy efficiency and measurement tools are commercially available and in use, and until the economics to justify “going green” are understood, we can expect slow going.
Dale A. Burket (firstname.lastname@example.org) is a Florida attorney who is Board Certified in Real Estate by The Florida Bar. He is a partner with Lowndes Drosdick Doster Kantor & Reed, P.A. (www.lowndes-law.com) in Orlando, Florida. The author gratefully acknowledges the contributions of associate attorney Laura M. Walda (email@example.com) to this article.