The little clause that killed a green building sale

 

Here’s a live action green building underwriting story.

Basically, it underscores the need for property owners and lenders to make sure their underwriting processes are tailored to certified green and/or Energy Star qualified buildings.

Tonight I received a note from a rather overworked, but sharp-eyed investment analyst, under the gun to underwrite his firm’s purchase of an office building under a very tough deadline.

He was not only frazzled, but also frustrated — prompting his note. You see, earlier in the deal, he had been excited about helping his firm to buy a LEED-certified building. Working on this acquisition gave him the hands-on chance to participate in directing more environmentally responsible investment choices — what he really wants to do more of in his career.

The excitement turned to frustration, however, as he came across the following phrase in the anchor tenant’s lease:

“Landlord shall not be required to impose on Tenant or any other tenant of the Building, requirements for Tenant or other tenants to comply with any certification requirements under the USGBC’s Green Building Rating System or other green or sustainable design elements.”

Long story short: his firm interprets this clause to mean that the landlord is blocked from employing any O&M practices, which would help the building to perform to the level expected from it’s LEED certification. To them, the language allows the tenant to object to any measures employed by the landlord that can potentially affect their costs in any way, no matter if those measures even benefit them down the road.

The building is LEED-NC certified and now the property buyer is faced with the reality that — if they wanted to get a LEED-EBOM certification or even just an Energy Star qualification — which, in their view, helps preserve value over the holding period, absolutely every tenant in the building is explicitly not obligated to cooperate with any measures the Landlord would introduce to achieve those certifications.

Moreover, they also worry that investing in the asset marketed as LEED-certified, with the full knowledge that achieving environmental performance is effectively impossible, leaves them open to being thought of as greenwashers.

As a result, our colleague and now his superiors have adopted the opinion that the LEED certification on this building is essentially worthless. Moreover, they don’t see any way to proceed with the acquisition because they will have to wait nearly ten years until the anchor tenant’s lease expires in order to change this clause, which prevents them from working with every single tenant in the building on this matter.

The investment is fundamentally flawed, doomed to a lifetime of discounted rents and sales prices any time other tenants and future buyers figure this out — or until that lease clause is changed. It could be completely non-competitive on energy performance within its submarket by then as all the other landlords will have been able to easily write leases which assure the landlord the ability to institute O&M expected of green buildings, making this asset the market laggard and — relatively devalued at disposition.

Ironically, any appraiser would typically ignore this in their valuation of the project since absolutely none of these issues would hit their traditional underwriting radar. They would have to be sensitized to the connections between sustainable design, O&M, building performance and related contractual lease obligations to figure out the true negative impact of this clause.

So the seller, after spending so much time marketing the building as a high quality, LEED-certified asset now must move on and find a buyer, who is not as sensitized to the de facto devaluation of the building, and willing to pay his sales price.

Kudos to this investment analyst and his firm for doing the right thing, both financially and environmentally. Green buildings made brown by bad lease language shouldn’t be rewarded with top dollar purchase prices.

In the meantime, please take this as a cautionary story about actual underwriting issues that can come up with green building investments in today’s market.