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”.
Post Tagged with: "commercial"
Many professionals tout sustainability and “green” practices as being here and now. LEED building certifications seem to gain a lot of press these days, and architects and engineers line up to become LEED-certified professionals. Webinars, seminars, publications abound with the latest information about green lease provisions, green construction terms, etc. This author receives, almost daily, emails and flyers with notifications of upcoming events and publications which feature green topics. But in reality, the number of green/sustainable buildings is relatively very small and not growing at a significant rate. The U.S. Green Building Council (www.usgbc.org) estimates that 2% of all new building construction projects receive LEED certification. While there are many good reasons to go green, in the real world – the one in which we all live – there are significant practical reasons why building sustainability is stalling.
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.
A growing number of cities are passing ordinances which require green or sustainable building practices. Cities such as San Francisco have passed comprehensive standards new-build and renovation projects must meet, while Atlanta and Miami are in the early stages for such requirements.
But what if your city doesn’t pass these kinds of ordinances? Are green building practices and incentives going to matter? Despite the current economic climate, developers, economists and industry-leaders are in agreement that green leases will be a part of the new commercial and residential developing market. “In today’s ‘red’ economy, some may argue that green real estate is just a passing fad. However, all signs indicate just the opposite—that green is the future standard in the real estate industry.” (Diana M. Ducharme, “Green Leasing in a Red Economy,” Hinckley Allen Snyder, LLP Client Update, December 2009). The green building market, including residential and commercial projects, is expected to more than double from today’s $36-$49 billion to $96-$140 billion by the year 2013 (U.S. Green Building Council, “Green Building By the Numbers,” April 2009).
Even though new commercial construction starts are at a record low, some developers are seeing an increase in their sales due to their widespread marketing and publicity of their green-built projects. For example, Dockside Green, a new 1.3 million square foot commercial, industrial and residential development in Victoria, British Columbia has actually seen an increase in sales with the promotion of the ‘green-ness’ its units. Developer Joe Van Belleghem said, “What we’ve tried to train our people [to do] is really make sure the customer knows what they’re getting. Because if you’re saving a lot of energy and water and sewage and you start to look over time how much that will save you over a 20-year period, it’s phenomenal how much dollars you’re saving.” (“Dockside Green defies market slump,” Times Colonist, November 2009 – article no longer available).
Due to an influx in available commercial and residential space, perhaps there is even more of a need for building green and then heavily promoting the sustainability of properties, as well as providing incentives in green leases for both landlords and tenants. “Now, [the landlord controlled commercial real estate lease negotiation] relationship is inverted with landlords wooing prospective and existing tenants like never before. With landlords worried about a shortage of creditworthy tenants, and tenants worried about deteriorating economic fundamentals . . . mutual commitment to a green office environment may be [an opportunity to create a balanced win-win-relationship]” (Barry LePatner, “Green leases add value for landlords and tenants,” Real Estate Weekly, July 22, 2009). By providing a green space and a green lease and marketing it as such, developers and commercial real estate owners could have the opportunity to put a little more ‘green’ in their pockets. “On the bright side for owners, it’s a great opportunity for improved performance and repositioning of a building. Re-branding is hard to do, and this is a great way to do it. You can buy an older building, retrofit it and make it a LEED EB building.” (Matt Hudgins, “Green Leases: A Matter for Debate,” National Real Estate Investor Online, May 5, 2008, quoting Mark Pillsbury).
There is no industry standard definition of what constitutes a green lease. Simply, a green lease should “ensure that both landlords and tenants reach mutually agreed upon objectives regarding sustainability.” (Susan Coleman, “Negotiating Commercial Leases: How Owners & Corporate Occupants Can Avoid Costly Errors,” PLI Order No. 18155, May 18-19, 2009).
It seems obvious that there cannot be a “one size fits all” model for green leases. Green leases must differ based on the types of space being used, whether the space is new or existing, the location of the building, the amount of space a tenant will occupy, how many tenants will occupy the building, and what kind of green technology is being utilized in the building. (Ronald B. Grais and Kristen M. Boike, “Jenner & Block: Green Leasing—The Changing Environment of Leasing,” Emerging Issues Commentary, June 2008).
In addition to the complexity of drafting based on the green-centric specifics of each lease, there are several additional problems which result from altering a typical commercial real estate lease structure. Though most tenants and landlords understand the benefits to constructing and occupying buildings which were designed with sustainability in mind, there are incentive problems. For example, a standard gross lease doesn’t offer tenants incentives to act in a green manner. “In a gross lease, it is the owner’s incentive to take action to reduce the carbon footprint for the building and preserve resources, because any savings which flow from those decisions will benefit the owner and not the tenants, whose monthly rent usually goes up each year.” (Jeffrey Swenarton, “Get ready—green leases are coming,” Business Review, December 10, 2009). According to Karen Penafield, vice president of advocacy for the Building Owners and Managers Association (BOMA), “You can upgrade all your systems and achieve a lot of energy efficiency that way, but if the tenants use more and more energy, you’re not really doing anything on the conservation side.” (Kevin Borgia, “A model lease agreement,” Sustainable Industries, December 4, 2007).
Landlords who improve on energy efficiency in their buildings may not be able to recapture the costs of green building from tenants. “Landlords have little incentive to improve the building’s energy performance since the tenant pays its own utility bills.” (Barry LePatner, “Green leases add value for landlords and tenants,” Real Estate Weekly, July 22, 2009). A net lease, on the other hand, would require that a tenant would pay its own utility bills, and therefore, give it the incentives to act in a green manner.
Due to the need to revolutionize current lease structures in order to incentivize behaviors on both the landlord and tenant sides, law firms, business organizations, and other companies are starting to create green lease sample forms. Organizations like BOMA and Square Footage are selling their versions of green leases which they claim account for landlord and tenant cost and benefits in a green building. CB Richard Ellis assists clients with adding green standards to traditional leases, instead of drafting an entirely new environmentally friendly lease. “That can be included in the lease as an exhibit just as you would include an exhibit for how a building will be cleaned every night.” (Matt Hudgins, “Green Leases: A Matter for Debate,” National Real Estate Investor Online, May 5, 2008). Looking forward, law firms and their clients will need to come up with solutions to site-specific lease negotiations, perhaps incorporating ideas from model lease ideas.
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.