Will Tech End The “Split Incentive”?

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.

Add these facts to the “Split Incentive” problem: Many commercial buildings (especially high rise office buildings) don’t have separate electric metering for each space – remember there is no need to do this if the energy costs are simply split based on rentable space. And the vast majority of net leases in the marketplace don’t address any mechanism for correcting the split in motivations between landlords and tenants. Although I’ve attended a number of seminars where “green lease provisions” are discussed, the conclusion at the end of most of these is that green lease provisions are relatively non-existent in the marketplace. Having prepared, reviewed and negotiated literally thousands of leases, I have concluded that lease forms look surprisingly similar other across the country, and address most of the same issues in similar ways. As attorneys and other real estate professionals, we tend to borrow from each other’s documents where something strikes our fancy, and this process of perpetual cross-pollination has resulted in surprising uniformity.

In my opinion, technology is about to change all of this, making it possible for energy (or water or gas) use to be measured for any tenant space (even if without a separate meter). As a consequence, a tenant could be motivated to make certain “green improvements” which would reduce its own operational cost, if the lease were to provide for an allocable cost based on actual use, as opposed to proportionate share of rentable square footage.

The technology at play here is called submetering, and it involves the installation of a device say, on a tenant floor, which measures electricity usage flowing through the tenant’s electrical system and records/transmits data for future use. Submeters installed for each tenant space could more precisely measure each tenant’s energy usage, and dividing the total energy cost for the building based on actual energy use would, in and of itself, provide the appropriate incentives to the tenant to reduce its overall energy use, either through installing energy efficient upgrades for its space, or paying the landlord to do the same. The submetering business is set to explode in the commercial real estate context: some researchers think it will be a $1.5B market in 2020.

So what does this mean for commercial real estate professionals who prepare and negotiate leases on a regular basis? I think it means we must revisit our lease provisions, especially those which divide building expenses based on square footage of rentable area, and provide a mechanism to divide certain expenses based upon actual use, or if actual use is not readily available, then based on square footage. This relatively straightforward (and innocuous) change could be incorporated into all new leases and in all lease renewals, so that eventually all of the leases in a building would have the desired terms. It won’t be an overnight change, but it is a step in the right direction. And it will help place the motivations to conserve and to operate sustainably in the right place, even in the net lease context. So let’s stop bemoaning the “Split Incentive” and get our leases ready to catch up with the present technology.

Dale A. Burket 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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