Green Leases & Sustainable Capital Investment in Buildings: The Split Incentive Dilemma

What’s Namasté Solar’s interest in recommending commercial green leases to its Colorado clients? 

Eliot Abel: Let’s start with the importance of addressing the commercial sector when it comes to meeting climate change goals. Just in the city and county of Denver, 57 percent of greenhouse gas emissions are coming from commercial and multi-family buildings. Denver can’t meet its ambitious 80x50 Climate Action Plan (80% reduction in 2005 greenhouse gas emissions by 2050) without addressing the commercial sector and owners of those properties are a significant customer base for Namasté Solar. Candidly, commercial properties have historically been a tough sector to crack because there’s been a split incentive “problem”.

The most common commercial lease structure is a triple-net-lease where the tenants pay the utility bills, and the owner is responsible for making the significant capital improvements on the property. The owner is not financially incentivized, consequently, to make energy efficient capital improvements - like adding solar to the property - because a good portion of the benefit of the upfront investment in solar or energy efficiency comes in the form of the electricity savings. And, those savings go to the tenant because they’re the ones paying the bills.

For Namasté Solar to be successful in helping more commercial property owners add solar to their properties, we need to align the incentives for building owners and tenants, with owners, specifically, having a new mechanism to realize the economic benefits that are offered by onsite solar. With green leases, the tenant still gets to benefit—by saving some money on their electricity bill—and the owner has a way - through a modified lease structure that allows for cost recovery - to earn a return on investment for installing a long-term asset on their property that’s going to deliver positive cash flow for 25-plus years.

Sara, elaborate on why Kilroy Realty Corporation asks its tenants to sign Green Leases? 

Sara Neff: We want tenants to be happy to be in our buildings, because we believe firmly that there is value in that. We have made it clear to our tenants that a lower operating expense is something you can enjoy from a Kilroy building, because of our focus on energy efficiency.

If there’s no incentive whatsoever to improve the operating expenses of a building, then it’s going to be really hard to get those projects done. A classic example is LED lights. The traditional way that leases are written is for investments to be recouped over the lifetime of the equipment. If you install an LED light that’s going to last for 20 years, you can’t recoup that cost over 20 years. The light will be obsolete, and the tenant will have moved out. What green leases have allowed us to do is recover the capital investment over the payback period of the project. Everybody’s happy, and we have all the motivation in the world to keep making those investments because we’re not throwing money down the drain.

Green leases have also allowed us the broad ability to install solar. We have the ability to procure power, change who’s procuring the power, where the power comes from, and more. Tenants are not in the business of energy procurement; that’s my area. Our leases give me the broad ability, as long as we remain focused on reducing tenant operating expenses, to nimbly make these deals that will save our tenants a lot of money and help the earth at the same time. 

How is the Solar Industry currently grappling with how best to help clients realize the benefits of green leases and align the incentives of both tenant and commercial building owners in a way that leads to an increase in renewable energy being deployed in buildings?

Eliot Abel: We’re helping to educate our commercial developer/owner clients on green leases and best practices in deploying them. Sara Neff and Kilroy model how an owner – using a green lease – is able to earn a return on their solar investment, and the tenant saves on their electricity bills.

The challenge is figuring out how to guide those other commercial entities that don’t know about green leases to modify their existing lease structures in a way that can benefit both them and their tenants, and get solar on their rooftops.

Elaborate on how ULI promotes imbedding green leases into real estate transactions? 

Billy Grayson: Sara definitely hit on one of the important ways that we do it by convening often with the public and the private sector, but also just with ULI members. We have a program called the Tenant Energy Optimization program (TEOP)—a 10-step process to help tenants and owners execute a sustainable set up. We also have the Green Lease Leader program, where the green lease is one of the key parts to that 10-step process. When we’re doing trainings to get tenants and owners to work together on sustainability, green leases are front and center as part of that program.

We also recently worked with a number of our members involved in buying and selling buildings on an 11-tip process on how to embed sustainability in the real estate transaction life cycle, and again one of the key steps was negotiating a green lease.

In previous lives, I was a green lease leader at Liberty Property Trust for commercial office buildings. In 2017, we launched a solar ready leasing guide about how to make lease revisions and include components in new leases to make solar attractive to both the owner and the tenant.

Are retrofits of older buildings more challenging than new construction re: aligning owner/tenant interests around the signing of green leases?  

Sara Neff: We’re a real estate investment trust, and we’ve executed a lot of acquisitions over the 9 years I’ve been at Kilroy. I’m very familiar with older and existing buildings, and I think those are the ones where it’s most critical. Most of the built environment already exists, a little under 90 percent of the buildings that will exist by 2050 are already up and running.

There are major opportunities to save on operating expenses. Study after study has shown that tenants prefer LEED and EnergyStar buildings, and our leases allow us to make the building efficient to get those certifications.

It’s easy to build a new building, but to get an existing building there takes more effort, but there’s a lot of reward there. Everybody uses the example of the Empire State Building, which was a Class C building but became Class A through a very major renovation they were able to do. I think there’s a huge opportunity for existing buildings if your leases allow you to do it. 

From your experience, are public entities, themselves, utilizing green leases?

Sara Neff: Yes. One of the major drivers of green leases is GSA (General Services Administration). They have the highest green leasing requirements I have seen. For example, they don’t want to leave space in the building that’s not EnergyStar. They will give you a certain amount of time to get there, and if you don’t, you are paying a penalty. GSA has the biggest footprint in the country, and we want to be able to provide the building that they want.

Are new public regulations/incentives driving an uptick in the greater use of green leases?

Eliot Abel: We’re seeing the ‘stick’ side of the equation with new building codes that require greater levels of energy efficiency or solar on the rooftop of every new building being built. The Denver Green Buildings Ordinance that is currently in effect is an example of this. Every new commercial building that’s over 25,000 sq. ft needs to have a green vegetative roof, a higher level of energy efficiency, rooftop solar, or some combination thereof. The ‘stick’ is in place and it’s expanding; more counties and states are requiring this, and more tenants are demanding it from properties.

The missing piece that a green lease tries to address is the ‘carrot.’ Yes, a building owner may be compelled to go solar to meet sustainability goals, or their tenant may demand it, but there should be a mechanism for them to earn a return on their investment as well. When it’s structured the right way, the tenant and the owner are both better off with a green lease. We see this playing out in the data that shows having solar on your property helps attract and retain better tenants.

How do Colorado and California learn from each other on green leases—state-to-state, property-to-property, and lease-to-lease?

Eliot Abel: Colorado is looking to be a leader in this area. Denver has launched a smart leasing program to help educate landlords and tenants. That being said, Colorado, like many other states, often looks to California to see what moves have already been made to encourage more renewable energy within the state and help meet our climate goals. We’re trying to take best practices and lessons learned in California and incorporate them here. As a purple state, we can’t do everything that California has done; there are certain things that fly there that wouldn’t fly here. But, we’ve been able to incorporate and tweak current regulations and plans moving forward based on some of the policies that have worked in California. 

Sara Neff: As Eliot has referenced, the city of Denver has launched the first city green leasing program that I know of. It’s not an ordinance, and there’s no monetary fine if you don’t do it, but Denver recognizes the importance of the green lease. I know the city of Los Angeles is looking at that program and its success, so we really salute Colorado for doing that. 

How does Kilroy -recognized by the Institute for Market Transformation as a Green Leader, LEAD re: green leases? 

Sara Neff: I once had a very sustainability-focused tenant tell me that ours was the first green lease they’d ever signed. They had very strong environmental programs, but clearly the legal side wasn’t really aligned at the time. They had to have a lot of internal conversations, and now they’re on board, and now it’s something they’re disseminating across all of their leases, which will make a really big impact.

ULI has a city summit where representatives from the sustainability teams of many cities and developers come together to share practices, work on publications, and workshop solutions to shared problems, and we discussed green leases at the most recent summit. There’s also a Green Lease Leader Library to look at sample language, and the fact that it’s public helps disseminate the program. When we started, we were green leaders in the inaugural class and it really made waves in the media. It didn’t seem possible to have a lease that could get over the split-incentive, but now it really is. 

What are the real obstacles your ULI members—who are some of the most experienced developers in the world—face when negotiating green leases?

Billy Grayson: Bigger, more sophisticated tenants come in with a lot of bargaining power, and many have their own corporate lease or standard RFP that they expect landlords to agree to, and many of them are not very aware of the green lease program.

It’s also a challenge when you have multi-tenant buildings—whether that’s office or industrial—to figure out how to get all tenants on similar leases, so that you can manage common areas in the building according to similar provisions. Usually you get Triple Net or Fully Serviced across all of your tenants, but there are often provisions about cost recovery that end up being different if they were signed at different times or with tenants with different negotiating power.

Tenants are often not interested in signing key provisions about how they operate their space—that should be their prerogative, even when that strategy may help to achieve or maintain a green building certification. Even if they are going to do the right thing, they want to keep the flexibility. I have had tenants who are always going to recycle and compost, but if you put that in the lease provision as part of the building operating rules they would ask you to strike it. Even if they were going to do it, they did not want to be forced to do it or feel like they might end up being in violation of the lease if they don’t. 

Sara Neff: The thing that I got the most pushback about was utility disclosure. Now, people have dealt with me for long enough that they know that language is in everything. We require our tenants—if they procure their own energy, water, or have their own waste services—to give us that data when asked within a reasonable time frame, and that’s the thing that was difficult.

It’s all well and good for the sustainability people to be talking to each other, but those aren’t the people in the room doing the leasing transaction. There’s a lot of great broker engagement programs, but there’s still a lot of education that still needs to happen with the broker community. For example, we work with the same brokers year after year, and they understand what we’re doing and why we’re doing it, so I don’t even worry at this point.

The other really good thing about green leases is that there is one definition of a green lease, and it’s the Institute for Market Transformation definition. Everybody just agreed on the same framework, which has made it so much easier in the market to change. 

What’s the economic opportunity presented by the Green Lease”? 

Eliot Abel: The opportunity is huge. We are barely scratching the surface of deploying solar and energy efficiency across the commercial, industrial, and multi-family sector. Especially when it comes to the existing building stock—that market is enormous.

Billy Grayson: I’ve seen a lot of other solar companies flame out when they’re working on commercial rooftop solar. People get into it because the market size is gigantic, especially in the states and cities that have the right mix of incentives. As with energy efficiency, there are a lot of challenges and most of them have to do with your investment cycle and the split incentive between owners and tenants. A green lease can play a major role in opening up much larger segments of the market to solar.

Sara Neff: I would say the top potential is half of all of the building energy consumption in the US, so were talking about 20 percent of US carbon emissions theoretically ameliorated by green leases. Tenants are really important, and unless you can get the finances aligned, there’s going to be a lot of energy savings opportunities left on the table.

If we are able a year from now to address with each of you the subject of green leases, what if anything in the marketplace will have changed?

Billy Grayson: Smart grids, storage, health and wellness, life cycle of carbon, embodied carbon in buildings, resilience, and social equity—These will all be things that sustainability experts are starting to tackle and will probably have to start addressing in green leases for new green building certification standards

Sara Neff: I would agree with that. Another thing that I hope changes is this concept of being recoverable over a payback period. It’s very important and foundational, but also very limiting for the things Billy mentioned. Right now, it’s very hard for those who are stuck on the payback schedule because of a green lease to invest in great software that is more of a tool.

The Institute of Market Transformation is always evolving the Green Lease Leader program. This is the first year they had levels; there’s now a gold and silver level. They recently came up with a team transaction award to highlight the work of lawyers and brokers, who are key to getting green leases across the finish line.