By: Kyle Cianchetta
As fears rise over climate change, environmentally friendly building is transitioning from a novel idea to a preferred building method. Environmental consciousness coupled with hefty tax deductions has caused the number of commercial green buildings to skyrocket – approximately 40 percent of commercial buildings in the United States’ 30 largest markets are certified by government or private green-building standards.
However, issues of green building do not stop at substantial completion of a structure and its components. Buildings consume approximately 70 percent of the electricity in the United States – mostly from heating, cooling, and lighting. If a landlord or tenant wants to improve their energy efficiency or pursue Leadership in Energy and Environmental Design (LEED) certification (an independent certification system), their current lease may not allow them to reap those rewards. It is therefore necessary to incorporate green provisions into commercial leases, so the landlord, tenant, or both, can benefit from their investment.
Incorporating green provisions into a lease is necessary because common commercial lease types (triple net lease or unmodified gross lease) create what is known as the split incentive. In a triple net lease, the tenant pays the utility bill. Thus, landlords have no incentive to make energy efficiency improvements; landlords would spend capital but not reap the rewards. In an unmodified gross lease, the landlord pays the utility bill. Since tenants do not see utilities as a separate expense, they have little incentive to improve their energy efficiency.
Green Lease Clauses: Pass Through And Submetering
One way to address this split incentive is to include a pass through clause in the commercial lease. A pass through clause allows landlords to recover the costs associated with energy efficiency upgrades: solar systems, building recommissioning, and energy-efficient renovations. The cost of the upgrade is incorporated into the lease as part of the operating costs paid by the tenant. Typically, a pass through clause can be justified if the capital cost investment actually reduces operating expenses. A pass through clause can look something like this:
“Cost of any capital improvement to the Building that reduces Building Operating Costs, the costs of such improvements to be amortized over the minimum period acceptable for federal income tax purposes, and only the yearly amortized portion thereof shall be treated as a Building Operating Costs. In no event shall this charge for yearly amortization be more than the actual reduction in the Building Operating Costs.”
Another way to address the split incentive is to include a submetering clause. Submeters monitor electricity, natural gas, and HVAC use in a tenant’s space. The data can be used to bill tenants by their actual use rather than per square foot, which may lead to more environmentally conscious behavior.
Submeters are also important for benchmarking agreements between the landlord and tenant. Benchmarking agreements are typically used when a landlord is pursuing green-building certification through the EPA or LEED, and reporting the building’s consumption on a periodic basis is required. A submetering clause may include an affirmative covenant, like this:
“Tenant covenants to cooperate with Landlord in connection with satisfying Landlord’s compliance requirements with respect to any sustainability measures implemented by Landlord, including, but not limited to, providing Landlord with monitoring data and reporting duties related to the Premises.”
The Future Market For Green Leases
Structuring a green lease typically benefits the landlord by allowing them to claim tax deductions and zoning exceptions. Although a tenant can lower their utility costs through submetering, there is not a comparable federal program for tenants like there is for landlords.
However, in June 2018, the EPA wrapped up a tenant pilot program that recognized commercial office tenants (LinkedIn, JPMorgan Chase, Cushman & Wakefield, et al.), who met energy-efficient criteria. The tenant program was introduced in the Energy Efficiency Improvement Act of 2015. The EPA is currently reviewing results of the pilot program and retooling requirements for market-scale recognition for tenants.
Given that the EPA has economic incentives for owners who construct energy-efficient buildings, this pilot program may be a step in the direction of providing economic incentives to energy-efficient tenants. If that is the case, tenants may demand not only a green building, but a green lease as well.