Sustainability Initiatives Changing How Landlords Approach NNN Leases
Building owners across the country are increasingly subject to state and local regulations that require them to improve the sustainability of their properties or face sometimes hefty fines. But when it comes to paying for those improvements, especially in offices with elevated vacancy rates stemming from reduced tenant usage, the question of who pays what can get sticky.
After all, tenants are the ones who control energy usage and are likely to reap the savings from green upgrades, at least under a common triple-net lease structure. But it’s landlords that front the cost of the improvements.
“Traditional leases have what we call a split-incentive challenge,” said Stephanie Greene, CBRE managing director of sustainability solutions. “So they don’t usually address sustainability or zero-carbon measures like energy-efficiency in the lease, and then what that means is that neither the tenant nor the landlord are really incentivized to implement sustainability improvements in the building.”
Split incentives arise when one party, usually the tenant, benefits from another party, usually the building owner, making upgrades to a building and reducing utility costs. The Consortium for Building Energy Innovation describes this phenomenon as “a major barrier to improvements in the energy efficiency sector.”
Greene and others say one way to solve the problem is by implementing green leases, a type of commercial lease that establishes the tenant-landlord relationship with an eye toward improving sustainability.
“I’d say that green leases are really just essential as part of energy transition and sustainability transition in commercial property,” Greene told Bisnow in an interview.
Green leases can create frameworks for owners and tenants to decide who pays for what and who benefits from any cost savings.
“Green leases also provide a mechanism for these parties to agree on cost-sharing structures so that the financial burden doesn’t solely land on the building owner, especially if the tenants will be benefiting from lower operational expenses through gains in energy efficiency,” JLL ESG Research Manager Paulina Torres told Bisnow via email.
Cities ranging from New York City to Chicago and Denver have adopted new building codes that require existing building owners to drastically reduce their carbon emissions with renewable energy, like adding solar panels or heat pumps. Some of these codes also carry significant penalties that go into effect next year, which could leave building owners on the hook for billions in fines if they don’t meet the benchmarks.
New York City’s Local Law 97 is one of the most well-known examples of this kind of regulation. The law established protocols for assessing building carbon usage and set the goal of reducing overall building emissions by 40% by 2030. Buildings that don’t meet these standards can be fined $268 for every ton of carbon dioxide emitted beyond a building’s target rate. An analysis by The Wall Street Journal found that 128 buildings in the city could face upward of $50M in fines during the first five-year enforcement period, which begins in early 2024.
The Energize Denver program requires commercial and multifamily property owners to reduce their carbon emissions by 80% from 2005 levels by 2040. It also carries fines of 30 cents per thousand British thermal units, or kBtu, of energy over the benchmark. Those fines will increase to 50 cents per kBtu by December 2024. And those penalties can add up quickly. Denver estimates that a 150K SF office building that doesn’t lower its energy usage requirements could pay upward of $2.8M in fines between 2024 and 2040.
Other cities like Chicago, Salt Lake City and San Jose, California, have similar electrification requirements on their books. To Greene, this means commercial property owners potentially face billions in fines if they don’t add renewable energy sources.
Green leases also have the capacity to help building owners better understand their energy usage and how to improve it, according to Torres.
“Green lease terms can secure data sharing practices around energy usage to inform decarbonization strategies and timelines, especially in NNN leases where the tenant controls the utilities,” Torres wrote. “Data sharing can also help drive behavioral change in the operation and use of a building.”
But there are a few big hurdles that need to be cleared before green leasing can become mainstream.
Avison Young Head of U.S. Net Lease Group Jonathan Hipp told Bisnow he is skeptical that green leases could help overcome the split-incentive structure in traditional leases because they aren't mainstream enough yet.
“There’s a number of people in the world that just aren’t going to [use green leases] until it becomes mainstream,” Hipp said.
One way to make green leasing more mainstream is to improve the financial incentives attached to it, according to Hipp. He said many landlords and building owners he works with have a hard time calculating the financial implications of green leasing. If building owners and landlords were offered tax credits like they can receive for adding electric vehicle charging ports, then green leasing may become more popular, Hipp added.
Some state and local governments are trying to set up incentive programs to help offer building owners a proverbial carrot in addition to the stick posed by fines.
Colorado Gov. Jared Polis in June signed House Bill 23-1005, which created a statewide energy improvement grant program for commercial building owners. Washington state and New York have similar grant programs available.
Nationwide efforts like the Department of Energy’s Property Assessed Clean Energy program can be used to further offset the costs of making clean upgrades.
“All of these are tools that can make it easier to implement and execute on your energy reduction goals — and avoid those fees in the process,” Greene said.