More on green lease clauses: Out with the bad, in with the good

Today’s post shares details about that “bad” green lease featured last Friday. Also I’m sharing a few green lease tips from BEPN that talk about ways green lease language can help support value creation in environmentally certified buildings.

The “bad” green clause’s web of risk

Several folks pointed out that LEED-EBOM certification can be achieved without any cooperation from the tenants. Unfortunately, our “uniquely negotiated” lease contained other typical provisions, which, when combined with the green clause in question, made the green business case uncertain, in the eyes of the buyer.

The lease in question was that of a major tenant - and major tenants are often able to negotiate special terms many other areas of the lease, with a deep focus on the expenses that can be passed through via common area maintenance and capital expenditures.

The major tenant lease was no different.  Lease language required the Landlord to obtain the major tenant’s permission in advance of passing through any expenditures, which were outside of a stipulated list. On top of that, the pro rata formula for calculating the tenant’s share of base building common area included an alternative common area square footage.  The formula denominator was a negotiated larger number, so the major tenant would pay less than its full share of common area expenses.

All of the above moves are typical, and limit the major tenant’s exposure to unforeseen or undesirable cost increases over the lease term.  In exchange for this, the Landlord gets a great tenant on a long term, which greatly enhances the building’s image and value.

The limiting of expenses (which is typical) plus the questionable “green” clause, created a situation for the investors where, a) much of the CAM and capital expenditure repayments were “locked in” by the prior owner over a very long time, limiting the new landlord’s flexibility, and  b) if any type of CAM or cap-ex charges were related to “green features” over the major tenant’s lease term, they couldn’t recoup those charges from the major or any other tenant either.

These investors’ business plan is to hold assets for a long term and realize an explicit increase to NOI from operating them as certified green buildings. So they were very focused on lease language not limiting their ability to execute that strategy. Losing part of the CAM recovery via the negotiations might be typical, but being further prevented from recovering costs from any tenant for any sustainable features over a long term put the lease contract into their “risky” column.

BEPN: “Green leases essential for achieving landlord’s environmental goals”

Check out this article from BEPN titled “Green Leases are Coming” (subscription might be required). It lays out a few issues that green leases address, all aimed to make sure that tenants and landlords are aligned with the environmental goals set for a project.

Essentially, the article talks about the kinds of lease provisions that can be negotiated with tenants so that it is easier for the landlord to achieve environmental objectives for a building.

The only part of the article that I would question is the assertion that most leases in the United States are triple net. During my tenure on the San Francisco Mayor’s Task Force, we talked about this point at great length. Large owners and property managers on the task force indicated that most office buildings are leased with gross leases. Of course, retail and industrial properties are nearly always triple net leased.

In any event, the main point here is to make sure you do not exhaust yourself trying to develop or retrofit green, then negotiate the “same old same old” in your leases. If you do, you are passing up a great opportunity to maintain and enhance the value of your environmentally certified building.

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.

Green Leases Add Value to Sustainable Real Estate

When it comes to quantifying the value green strategies bring to an asset, green leases are a fundamental component of the green real estate investing underwriting process. Yet we see that many property investors and real estate lawyers are reluctant to embrace this extremely important tool for clarifying and preserving the hard cash benefits confirmed by their terms.

Need a primer on green leases? We’re reprinting an excerpt of a post written recently on Sustainablog:

In order for a commercial office building to achieve the most in terms of sustainability, the landlord and its tenants must partner in working toward that goal. In the case of the landlord and tenant relationship, the governing document is the lease. If the landlord and the tenant agree that the property subject to the lease should be constructed, operated and occupied in a sustainable fashion, that should be reflected in the lease.

What Should a Green Lease Cover?

A “green” commercial office lease should incorporate the agreed upon sustainability goals for the building and the rights and responsibilities of each party necessary in order to achieve those goals.  Typically, sustainability goals for a commercial office building would include one or more of the following:

- Goals for reduced consumption of energy, water, and other natural resources;

- Goals for minimizing waste and diverting both construction and operational waste from landfill – in other words, recycling goals;

- Goals for creation and facilitation of superior indoor and exterior environmental quality; and

- Data collection, sharing and use as between landlord and tenant.

After these goals have been agreed to, the lease should be clear about the level of commitment on the part of the parties to achieve them.  One suggestion is that landlord and tenant agree in the lease to make good faith, reasonable efforts to achieve the stated sustainability goals and to reevaluate each of the goals periodically during the lease term.

Reduced Energy and Water Consumption

In order to make the goals of reduced energy and water consumption realistic and achievable, the parties must be able to measure their consumption.  After all, if you can’t measure it, you can’t fix it.  Thus, the green lease should provide for metering or submetering the tenant’s consumption of energy and water in its premises and should address the cost and responsibility of installing and periodically reading the meters.  The party responsible for reading the meters periodically should also be responsible for promptly communicating the information gleaned from the meter readings to the other party to the lease.

Equally important in a green office lease, the economic costs and benefits of reduced resource consumption should be allocated between landlord and tenant in a manner that both facilitates the goal of reduced consumption and compensates the appropriate party(s) for the cost(s) (if any) incurred to get to that goal.  Thus the traditional office lease arrangement whereby the cost of the energy and water consumed by the tenant in its premises is included in the base rent, with the tenant possibly paying its share of building wide cost increases over base year costs, needs to be examined and modified.  In the traditional scenario, the tenant typically has no knowledge of what it is consuming and it has no economic incentive to minimize that consumption.

Finally, the green office lease should set forth milestone dates around which the parties agree to discuss how actual consumption compares to the sustainability goals set forth in the lease and to use reasonable efforts to correct any discrepancies.

Tangible Integrity: Why Google Leases Green Office Space

I went to a local ULI Green Trends Program last night. Kacey Clagett, of Field Paoli, moderated a panel consisting of David Radcliffe, Sustainability Director for Google, David Johnson, West Coast Director for William McDonough & Partners and Richard Springwater, Head of The Prado Group, the developer who built Foundry Square.  Great discussion overall on why going green makes sense from the perspective of a tenant, architect and developer.

David Radcliffe’s comments on why Google leases green space stood out. Not only is leasing green space consistent with the general corporate philosophy, but he took the time to detail Google’s thinking process about green space. You can imagine that Google can throw a great deal of brain power at anything they want to study. It is safe to say that a couple of those brains went into overdrive deconstructing their “green space = value” proposition. Here’s a short summary on their perspective:

When Google evaluates space decisions, they look at their total cost of occupancy, which is made of:

• Base Rent
• Additional Rent – operating expense reimbursements
• Workplace Services, overhead
• Other related costs

Google studied their total costs of occupancy for leasing green space and figured out that they were paying a higher Base Rent compared to non-green space. However, since Base Rent was only 34% of their total costs of occupancy, the increase in rent for the green space increased their total occupancy costs by only 1.7%. So, the additional cost of green space is negligible in their view.

They also looked at one of their most important activities, attracting talent. They ran various tests attempting to isolate what mattered most to employees and linked it to sustainability initiatives, including occupying green space.

You gotta keep Google’s hiring scale in mind as you read this: Radcliffe pointed out that Google is hiring on a scale of 200 employees per week (!!). The right or wrong hiring equation has massive business implications for them, so they spend lots of energy learning and making sure they are delivering on what the right talent cares about.

They isolated several key variables of what their employees and talent care about the most. Tests revealed that a company’s integrity is THE most important variable to the employees and recruits. Integrity trumped pay, career development and every other traditional measure of employer relevance to Google employees. And the employees and recruits interpret green working facilities along with other green initiatives as being visible evidence of Google’s integrity.

So, for Google, leasing green space provides huge upsidewith very little or no downside. Not a bad deal at all.

Photo Credit: Flickr/Keso - Google logo