The Green Lease: Considerations for Existing Buildings

By Robert Smith
Partner, Holland & Knight LLP

According to an April 2009 report by the U.S. Green Building Council, (USGBC), commercial and residential buildings account for almost 40% of all energy consumed in the U.S. and a full 72% of the nation’s electrical use.

An increasing number of new buildings are being constructed with an eye towards sustainability, though the percentage is less than optimists had hoped for a decade ago. Approximately 4.9 million buildings in the U.S—totaling an area of more than 72 billion square feet—were built before sustainability became the concern that it is today. These numbers alone suggest that upgrading the efficiency of the stock of existing commercial buildings is essential to assuring a sustainable future. It was in recognition of this fact that the USGBC created LEED for Existing Buildings (LEED-EB) in 2004.

There are many ways the owner of a commercial building may upgrade the performance of the building, including the installation of more energy efficient chillers for the air conditioning system or motion detector controls for lighting, for instance. A building owner can replace older, inefficient lighting systems with T8 or T5 fluorescent lighting systems or existing bathroom fixtures with low-flush toilets and waterless urinals. Even the upgrading of elevator systems can save on utility costs, with components that improve passenger handling and energy-saving devices such as regenerative drives.

Long-term property owners such as universities, hospitals and government institutions can easily rationalize the financial benefits of funding these more efficient systems in their buildings. Unfortunately, the structure of many office leases in America tends to discourage an owner from similarly investing in such upgrades.

Approximately 58% of office rentals in America are effectively net leases, which pass all of the operating costs each year through to the buildings’ tenants. The economic proposition for constructing a new, green, income-producing building, where the leases are to be net leases, is dubious. A landlord does not directly enjoy the benefits of his or her investment in energy savings and other resource conserving measures, as he or she will be passing through all of the presumably reduced operating costs to the tenants.

The only way a landlord would be able to recoup the incremental costs of the sustainable building would be via higher base rents. However, operating expenses constitute too small a portion of the total cost of doing business to excite the average tenant from an economic perspective. And a landlord’s assurance that the sustainable features of the building will result in operating cost savings to the tenant in the future will likely seem a mere tease, in light of the actual higher base rent that the tenant would be asked to pay, with no real guaranty of tangible benefit over the term of the lease.

The economic proposition for making improvements to an existing building with a net lease environment—especially where there are existing leases—is all the more shaky, as the landlord will not be able to impose higher rents than the existing leases already call for. In the context of improvements to an existing leased building—as well as in the case of a new building—a gross lease structure affords the greatest incentive to a landlord, as it permits the landlord to reap the advantage of cost savings.

In a modified gross lease structure, the fixed minimum rent for the “base year” (typically the year in which the occupancy commences), incorporates the landlord’s estimate of operating expenses for that base year. The tenant is liable for his or her proportionate share of incremental increases in operating expenses in subsequent years over those for the base year. The hypothetical value proposition for a landlord of a sustainable building will be a gross lease under which the landlord will presumably be able to charge a rental rate no greater than that of comparable conventional buildings in the market. Because the fixed rent for the base year under a gross lease should effectively include a lower operating expense component, the landlord should enjoy the immediate benefit of lower operating expenses, compared to operating expenses in otherwise comparable conventional buildings with an equivalent rent structure. Let’s call this the “operating expense differential.” The landlord of a sustainable building would, of course, be motivated to perpetuate the operating expense differential. In other words, the landlord will want to wring the greatest possible advantage from the original operating expense differential in a sustainable building by insuring that the original green building elements and systems continue to function to their maximum efficiency.

The value proposition of the operating expense differential is applicable to the case of an existing building, as well. Just as a developer may be persuaded to develop a sustainable building in the first place on the basis of the prospective economic benefits over time, it follows that the landlord of an existing conventional building, leasing under a modified gross lease structure, should also be motivated to rehabilitate his or her building to capture potential operating expense savings.

In an existing building with existing leases in place, there are of course certain concerns that do not apply to a new building. First, existing gross leases have established operating expenses which incorporate the expense components of the base year. Secondly, existing leases naturally presuppose existing occupancy. In other words, tenants will be conducting business in the very premises that the landlord may wish to retrofit. The landlord of an existing building should anticipate that, over the term of the leases, he or she may want to entertain improvements. Accordingly, the landlord will want to incorporate in the leases a number of provisions to better facilitate the rehabilitation of the building.

For example, the landlord will want the right to adjust base year expenses down to the level those expenses would have been had the more efficient systems which the landlord intends to install been in place in the base year. The landlord will want the right to include operating expenses in the annual amount required to amortize the capital costs of more efficient systems. Though, as a quid pro quo, a sophisticated tenant will require that the annual amortized costs not exceed the annual savings in operating expenses. Finally, the landlord will want to be able to have reasonable access to the premises to install improvements, such as glazing, enhanced weather stripping, energy efficient lighting systems, day lighting, motion sensors and other conservation measures.

The improvement of existing buildings represents an enormous opportunity for conserving energy and other resources. It is critical that the leases in existing buildings be able to accommodate and encourage landlords to undertake those improvements. Two essential means to this end are a modified gross lease structure and leases that incorporate provisions that facilitate—and encourage—the possible future rehabilitation of the building.

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