Monday, February 9, 2009

"Green" Leases Growing

As we all know, during the last 30-plus years, there has been a steady shift in the marketplace from the all-inclusive gross lease to the net lease. Gross leases, although they commonly contained rent escalation clauses, for example, to cover inflation, are not very protective when building operating costs, such as energy costs or property taxes, increase faster than the inflation rate. The advantage of the net lease is that it effectively transfers all risks for building operating costs to the tenants. So it is easy to understand why the majority of the leases today are net leases.

The downside of the net lease, however, is that the landlord gets none of the benefits from reducing operating costs, since this has no impact on the building’s NOI, and as we all know, it is the NOI that impacts the building’s value. Net leases also create an unnecessary hurdle for green buildings, particularly with respect to investment for energy savings projects.

The complicating issue is who pays for an energy savings project and who benefits. In the ideal case, he who pays should benefit. Under the triple net lease, the tenant pays rent plus a pro-rated share of taxes, utilities, maintenance and insurance. Since electricity cost is a pass-through directly to tenants, there’s little financial incentive for building owners to invest in technologies to reduce electricity costs. In fact, until tenants complain about high energy costs and threaten to move to more energy efficient space, building owners do not have much incentive to act. This makes little sense in today’s world.

Also interesting today is that there is little incentive for tenants to implement energy conservation measures. In most existing commercial buildings, a single meter measures the power fed to the entire building and the building pays for it at a bulk rate. The electricity cost is then included in the monthly maintenance or common charges, in the same proportion that other costs are allocated, typically on the basis of a tenant's square footage. Hence, tenants don’t pay for the electricity they use individually. And it is not unusual to find that some tenants can be subsidizing other tenants who are wasting electricity. This way of doing business provides no great incentive for the tenant to reduce energy consumption. Clearly, this also does not make sense.

The fundamental problem is getting the benefits of an energy savings investment into the hands of those who paid for it, or the benefits of energy conservation measures into the hands of those who implemented them. This is where the “green” lease comes into play. In a “green” lease, both the tenants and landlord can benefit.

While green leases are relatively new on the landscape, they generally are a form of modified gross lease. Yes, so it entails going back to gross leases. The “green lease” or modified gross lease, with the appropriate language, transfers the fiscal responsibility for controlling operating costs back to the landlords, who are far more qualified to control operating costs than the tenants. The leases allow the landlord to reasonably amortize the cost of energy savings projects that will reduce operating costs and treat that amortization as an operating cost – as long as the amortization does not exceed the savings. To account for after-hours use or prevent excess energy consumption by any tenant, the lease provides for the sub-metering of each tenant’s energy use. Green leases may also address a building-wide recycling program and sustainable product purchase requirements.

Because of the many complexities of preparing a “green lease,” last year BOMA released its Green Lease Guide, for writing "green language" into a commercial real estate lease. Terms of the lease incentivize tenants to reduce energy consumption, water use, produce less waste, recycle as much as possible, and choose environmentally-friendly products, furnishings and office equipment. The language included in the document gives owners the right as standard procedure to pass thru to tenants any capital costs that result in lower total operating costs. The lease guide can be purchased on BOMA’s web site, at http://shop.boma.org.