Leasing Green building

Affordable Green Leasing

Sustainable upgrades aren’t just for institutional landlords.

The article “Not Easy Leasing Green” (CIRE, September/October 2012, p.36) told an unpopular truth. It tallied a long list of hurdles confronting tenants and landlords who pursue Leadership in Energy and Environmental Design certification. This situation helps explain why California municipalities, New York City, and Canadian jurisdictions have enacted laws mandating environmentally responsible leases.

In fact, outside of large institutional landlords and mandated jurisdictions, green leases are rare — and for good reason. Complex leasing provisions often require ongoing monitoring, reporting, consulting, and benchmarking responsibilities that typically involve engineering and computer systems specialists, facilities and asset managers, LEED-certified examiners, cost auditors, accounting specialists — and, of course, specialized lawyers.

Because environmentally responsible leasing is costly, time-consuming, and unfamiliar, many landlords and their leasing agents often dismiss it without even investigating the possibility. Fear of the complexity and cost means the environment suffers, since heating, cooling, and lighting commercial buildings generates a large portion of greenhouse gases.

But in truth, many of the heating, ventilation, air conditioning, and lighting efficiencies that have the most impact per dollar invested can be attained with very simple paperwork and within the typical landlord-tenant relationship. Small, non-institutional landlords can take advantage of many profitable environmental leasing opportunities that are easy to access.

Keep It Simple

As owners of industrial, office, retail, and multifamily properties for more than 38 years, we have found that many environmentally responsible changes can be made with a few simple steps that will not delay or complicate the leasing process, nor significantly increase expenses.

The key is to write leases empowering the landlord to make energy-saving equipment purchase decisions unilaterally — without having to involve the tenant and third-party environmental professionals in the process. A lease clause permitting the landlord to decide when and how to make building system upgrades and committing tenants to cooperate gives unilateral power to the landlord.

For example, this simple lease provision states that operating charges include:

the cost, amortized over its useful life, of the purchase and installation of any device including the maintenance and repair of such device, to improve the operating efficiency of any system in the building or reduce the cost of insurance and thereby reduce operating expenses.

Under this clause, the tenant pays the amortized cost without the need for an engineering study supporting a tenant savings in excess of the amortized cost. However, in the interest of good tenant relations, our practice has been to exclude interest and do a simple payback period calculation.

For big-ticket items we recommend getting an engineer’s opinion letter stating that the savings to the tenants exceed the amortized cost. Tenants are protected by having an engineer benchmark the existing consumption with the proviso that the total operating costs paid by tenant will not increase when the cost of the improvement is charged to the tenant.

Another reimbursement method is New York City’s Energy Aligned Clause that states:

(1) tenant shall reimburse landlord 80 percent of the yearly amortized cost of the upgrade; and

(2) the reimbursement period shall be lengthened to 125 percent of the actual years used in the amortization calculation, enabling landlord to recoup 100 percent of its outlay (80 percent of yearly amount mulitplied by 1.25, the length of the payback period);

(3) no interest is added in amortizing as a means of approximating the additional benefit to landlord of having newer equipment without having had to pay all of the replacement costs due to eventual failure of the existing equipment.

If the landlord wishes to be more aggressive it can seek a quicker payback period and a higher annual recovery rate than 80 percent of the projected cost savings.

The EAC may be more effective than a simple payback at 100 percent amortization for capital investments that may produce savings that are difficult for the engineer to quantify. Although the EAC lengthens the reimbursement time by 25 percent (the tenant pays back at the rate of 80 percent of the yearly amount due), this clause is more evenhanded when there is any significant uncertainty about the utility savings. [See “Resources” for more information.]

How Does It Work?

The following examples illustrate how landlords can make environmentally responsible upgrades to their buildings under different lease types.

Triple Net Leases . In some NNN leases, energy efficient upgrades present disincentives to building owners because the tenant benefits and the landlord pays. For example, why should a landlord replace eight functioning, circa 1975 natural gas-fired boilers that are 65 percent efficient with newer boilers that are 94 percent efficient when the tenant’s gas bill will be reduced but the landlord will pay all of the capital cost?

But if the landlord looks at the larger picture, the 94 percent boilers, plus the associated engineering costs of $200,000, have an operational life of 25 years, and an amortizable life under asset depreciation standards of 10 years. They produce a savings in reduced natural gas consumption and maintenance of $30,000 per year. So over the long term there is an incentive to replace the boilers.

Using the EAC method, the tenant saves $30,000 in yearly fuel and operating costs and pays the landlord amortization of $16,000 per year — a net gain of $14,000 per year. The landlord recoups all of its costs in 12.5 years and owns a system that’s still got about the same length of life remaining. Furthermore, after the tenant vacates, the building’s inclusive costs of occupancy have gone down, making it a more attractive rental.

CAM Expenses Charged to Tenants . Numerous commercial leases require tenants to reimburse the landlord for common area maintenance costs, which could include environmental upgrades. For example, replacing obsolete T-12 fluorescent tubes with T-8 lamps can provide 40-watt illumination with 22 watts, a savings of 45 percentof the electrical cost with some additional savings in air conditioning since less heat is produced.

Same as in the triple net lease example above, the landlord can replace the old lighting when it chooses, as long as tenants are protected by an engineering opinion on cost recovery and the same simple payback formula.

As in the triple net example, the tenants’ day-to-day expenses are reduced or will not increase above what they would have otherwise paid. The landlord reaps the long-term benefits of newer equipment — delayed bulb changes and ballasts replacements and reduced air conditioning use.

Gross Leases. In gross leases without pass-through cost increases, the landlord pays all of the utilities, so it’s beneficial to replace equipment whenever there is a net savings of utilities over the amortized replacement costs. However, to calculate return on investment, the landlord must determine the current usage standards. For example, experts can install measuring devices over long periods of time to determine illumination needs during times of day and seasons, measure the workday air balances and air quality (volatile organics and CO2levels), air tempering, and shading needs from beginning to end of the work days and under various outside climate conditions.

But tenants may object to electrical engineers or HVAC technicians probing their ceilings during working hours. In fact, some tenants may object even to work done on weekends or evenings because it disrupts their business hours or is considered a security risk.

To solve this issue, leases should have a broad cooperation clause allowing reasonable access to landlord’s representatives and experts at any time during the term to analyze and upgrade and not just to repair systems. While all financial returns accrue to the landlord, tenants have reduced risk of equipment failure and enjoy modern advances in lighting or HVAC. Also, the carbon footprint, water consumption, or sewage burden is reduced.

Modified Gross Leases. With tenants paying increases in operating charges over a base year, it is always in the landlord’s interest to make capital improvements when reduced operating charges will exceed the investment.

For example, replacing working metal window blinds with insulating double-layered cloth blinds reduces natural gas used for heating and electricity used for cooling. The new shades have a 20-year life and cost $70,000. The mechanical engineer provides a detailed opinion that yearly costs for natural gas for heating and electricity for air conditioning will decline by about $6,000.

If savings from reduced heating and air-conditioning use are difficult to estimate with precision, use the EAC method here and do a payback schedule over the shortest time that would result in not charging more than 80 percent of the yearly savings.

With an amortized cost of $4,800 per year with a $6,000 utilities savings, a tenant’s portion of the passed-through increases are actually reduced by its share of the $1,200 annual savings. In those spaces where tenants are still below the base-year expense level or in vacant spaces, the landlord would reduce its expenses based upon the total building savings of $6,000 per year.

When the Lease Is Silent

Without permissive lease language, a landlord must obtain the tenant’s approval. Our practice has shown that this is best done through an assumptive close.

When sending the annual pass-through statement, attach a spreadsheet showing detailed operating costs in comparison to those of the base year and list the amortized amounts of capital investments that reduce those expenses. These expenses are footnoted for each item. The property manager also calls the tenants and explains the rationale and what they gain.

In multitenant buildings, a few holdout tenants should not scuttle your improvements since the reduced financial savings combined with the intangible benefits of newer equipment and higher tenant satisfaction from better HVAC or lighting could still justify upgrading.

For small, private investors competing against deep-pocket institutions, it’s hard to find attractive new properties at the right price. However, money invested in upgrading equipment in your existing buildings will often yield higher returns than new projects. An environmentally responsible property is more competitive and more attractive to tenants both new and old. And, it’s just the right thing to do.

Miles Schlosberg, based in Anchorage, Alaska, is involved in commercial real estate development, construction, and investment in Alaska, Florida, and Washington state. Contact him at m.s.schlosberg@comcast.net. Carl D. Kuhn, CCIM, is a broker with Jack White Commercial in Anchorage. Contact him at cdk@gci.net. The authors thank Gordon Timmerman; John T. Moore; Brian Player, PE; Mark Miller; and Brian Schmid, PE, for their assistance.

Miles S. Schlosberg and Carl D. Kuhn, CCIM

Resources • New York City’s Model Energy Aligned Clause is explained in detail at www.nyc.gov/eac. • Building Owners and Managers Association International’s Guide to Writing a Commercial Real Estate Lease, Including Green Lease Language is a helpful discussion of some of the pitfalls involved in charging tenants for capital improvements that reduce operating expenses. Go to store.boma.org and click on “Sustainability.”

Recommended

Commitment: The Cornerstone of Net Lease

Summer 2021

One of the most appealing aspects of net lease is its focus on the long term. Since net leases are traditionally longer, investors can rely on stable continuous income, and tenants can count on predictable leasing costs. 

Read More

Surviving Volatility

Spring 2021

The coronavirus pandemic turned the world upside down, so CRE professionals will need creative options when it comes to renegotiating leases.

Read More

Preparing for the Storm

July.Aug.19

Last year, the United States incurred $91 billion in costs from weather- and climate-related disasters, making it the fourth most expensive year since 1980, with the top three years all occurring in the past decade. Government action on infrastructure development and energy efficiency can help the industry prepare for an uncertain future. 

Read More

Fitting Plans for the Future

May.June.19

Three new FASB accounting standards with wide-ranging consequences are taking effect: revenue from contracts with customers, lease accounting, and current expected credit losses. An they may require substantial implementation efforts from corporate accounting and finance departments.

Read More