by James Kidston
Environmental sustainability is a hot topic these days, and the real estate industry is no exception. The total market for “green” buildings currently exceeds $30 billion, and is expected to more than double within the next five years. The trend reflects not only an increasing desire to minimize the impact we have on our environment, but also the lower cost of operating a well-designed and managed green building.
As more of these projects are completed, more businesses of all types sign leases on the space. But as landlords, tenants, and their lawyers have found, green buildings create unique issues traditional leases do not adequately address.
What Is A Green Lease?
While there is no widely-accepted definition, a good green lease aligns the incentives of the parties toward conservation of resources and efficient operation while helping maintain a healthy, productive interior environment. Beyond that, the devil is in the details.
Model green leases developed by BOMA International, the Corporate Realty Design and Management Institute, and Canada’s REALpac have recently arrived on the scene, and represent the most comprehensive attempts yet at tackling the problem. Most of the issues are far from settled, however, and landlords and tenants still face a challenge in creating effective green leases.
Gross vs. Net
The basic structure of the lease, and the incentives thereby created, is especially critical. Triple net leases, where the tenant pays its proportionate share of the property taxes, building insurance, and maintenance costs in addition to the rent, have become the predominant type of lease in commercial real estate over the past several decades. In the green building context, however, a triple net lease can discourage investment in green design by passing most of the benefits to the tenant in the form of lower maintenance and operations costs. The landlord, the party best positioned to undertake the green construction, does not get to share in the resulting savings. The landlord will likely be able to charge a higher rent for space in their more efficient building, but that increase may not generate a return sufficient to justify the investment.
Using a form of gross lease instead – where the landlord pays some or all of the costs that are passed through in the triple net lease – creates better incentives. The landlord can recoup its investment through lower operating costs, and can improve its return through continued high efficiency. The tenant in a gross lease may have less reason to operate efficiently, however, and a landlord should ensure the tenant also has a financial incentive not to undermine the building’s green character. This can be accomplished in a number of ways, for example by modifying the gross lease to pass through certain costs or portions of costs, or drafting efficiency incentives into the rent escalation clause or the calculation of additional rent.
Following the LEED
Another consideration in a green lease is the growing influence of third-party environmental rating schemes, which is increasingly leading to their incorporation into the lease itself. The US Green Building Council’s Leadership in Energy and Environmental Design (LEED) system is the most prominent of several, and together these rating systems are taking on greater importance for green buildings and their leases.
Tenants of all sizes are increasingly likely to demand a certain level of LEED or other certification as a condition of leasing the space. State and local governments have enacted rules requiring similar certification for all buildings meeting certain size or location criteria. Numerous federal government agencies, including the Department of Energy and the General Services Administration, have begun requiring LEED or equivalent certification for all buildings in which they lease space. Other cities, including Las Vegas, have created financial or tax incentives for projects meeting applicable LEED classifications. This trend represents opportunity, but also a growing source of potential liability for landlords.
Tenants may be inclined to seek a representation that the building will continue to maintain a certain certification. Such guarantees are problematic for the landlord because the criteria underlying LEED certification are centered on the siting, design and construction phases of a project. Once the building is in operation, any certification issues may be costly and difficult, if not impossible, for the landlord to address. Though the building’s architect seems best positioned to warrant certification, architects are unwilling to make such warranties because they generally fall outside the bounds of their professional liability policies and LEED-specific coverage does not yet exist.
In order to make certification clauses more palatable for landlords, the parties should consider treating certification-related breaches differently than others. For example, a green lease could treat a loss of certification as a non-material breach and set out specific, limited remedies such as a period of free or abated rent. Both parties would likely prefer such a remedy to termination of the lease, though if a tenant is obligated to seek new space in the event of decertification, the landlord should obtain a right to cure, and attempt to define the events giving rise to termination as narrowly as possible.
Tenant behavior is often the cause of subpar efficiency in a green building. Landlords obviously must address that issue in a green lease, not only due to the various certification issues but also to protect its ROI. One option is to require the tenant to maintain an environmental certification of its own, such as LEED for Commercial Interiors. Tenants, like their landlords, should be very aware of exactly how they are bound by such obligations and of the consequences for breaching them. Landlords should require that tenants participate in recycling programs, conform to minimum requirements regarding tenant improvements and disposal of waste, and use certain efficient equipment such as fluorescent light bulbs, motion sensing light timers, low-flow toilets, or Energy Star rated appliances.
The parties to a green lease can also benefit from taking a new look at some familiar old terms. For example, the landlord will want to include language in the assignment and sublet provision allowing it to withhold consent where the prospective assignee’s operations may compromise the building’s efficiency targets. The tenant will want to limit any landlord’s relocation rights to new premises meeting the same or higher environmental or efficiency standards. Both landlord and tenant might consider negotiating for the right to audit the energy efficiency data of the other.
With demand for environmentally-friendly buildings growing fast, green design is here to stay and the unique legal challenges spawned by these new kinds of buildings will continue to require careful attention. The landlord-tenant relationship is evolving in response, and it’s clear the traditional lease is undergoing a much-needed green renovation of its own.