The Net Lease and the “Split Incentive”

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 (dale.burket@lowndes-law.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.

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Dale Burket is a partner in the Real Estate Transactions, Development and Finance Commercial Leasing, and Environmental Law practices. With over 29 years of experience, Dale focuses his real estate legal practice on multi-site, multi-jurisdictional real estate acquisitions, dispositions, leasing and financing and large, multi-site and multi-state real estate transactions. His hospitality practice concentrates on restaurant leases and financing arrangements. Dale has also represented Real Estate Investment Trusts (REITs) in connections with mergers, securitizations, purchase of income producing properties, and sales of properties by taxable REIT subsidiaries. Dale is Board Certified in Real Estate Law by the Florida Bar Board of Legal Specialization and Education. He has represented local, regional, and national clients in commercial real estate transactions, including CNL Financial Group, Inc., JDS Holdings, LLC., and Northland, A Church Distributed Inc. Dale has also handled purchase and sale transactions in excess of $100 Million, handled real estate aspects of a corporate merger involving more than 2,000 properties, and closed senior credit facilities on behalf of the borrower in excess of $50 Million.

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