Green lease agreements: Navigating uncharted waters

Tenants seeking to negotiate a green lease should follow the adage “buyer beware.”

While an increasing number of landlords are building out space to meet the U.S. Green Building Council’s Leadership in Energy and Environmental (LEED) standards, the marketplace is still sorting out what constitutes a green lease [see “BOMA ‘greens’ lease guidelines,” SI "2008 Green Real Estate Guide"].

Under current market conditions, tenants and building owners must address several issues when drafting a green lease:

• Rent structure and operating expenses
• Energy use by tenant
• Operational performance
• Hazardous materials
• Green cleaning
• Recycling
• Build out of tenant spaces

Virtually every commercial lease executed in the last 30 years contains a rent escalation clause. The intent is to protect the landlord’s investment from the ravages of inflation. The trend led landlords to draft leases where the tenant pays rent plus reimbursement for operating costs, such as energy, water, janitorial, insurance and taxes.

Real estate professionals call this a “net lease.” In effect, it transfers operating risks from the landlord to the tenant. Doing so reduces the landlord’s incentive to apply efficient management or sustainable principles to cut operating costs, since these costs are now excluded from calculating a building’s net operating income (NOI); this is the basis for calculating a building’s economic value.

For tenants, especially in multi-tenant buildings, there is a downside to using the net lease. For years, the operating expense and tax clause, or common area maintenance (CAM) clause, that requires tenants pay for any increase in the building’s operating expenses, has been a secret profit-center for landlords.

Following is a list of the eight most-common overcharges:

• Capital costs incorrectly allocated as repairs
  
• Parking garage expenses not offset by the parking revenue
• Costs specifically excluded in the lease are lumped into “miscellaneous” expenses
• Tax abatements, rebates, or refunds not passed through or credited to tenants
• Double billings for utility service paid by an individual tenant but also included in a general utilities category
• Accountants’ fees for preparing the landlord’s tax returns
• Failure to pass through expense reductions as credits
• Build-out expenses for a specific tenant

Overcharging by landlords by either error or intent is common. Yet, it is difficult for tenants to detect when they’ve been overcharged. In some cases, the statement shows only a single payment due. In other cases, the statement includes a breakdown by major expense categories (such as utilities, maintenance, management fees, taxes, and the infamous black hole “other”) and the tenant’s pro rata share. Rarely can tenants tell if the charges comply with the lease agreement they negotiated.

In general, the net lease structure used in most multi-tenant buildings encourages financial abuse and discourages the building’s landlord and its tenants from working together to operate a sustainable building. A green lease should provide a financial incentive for landlords to build and manage sustainable buildings without sacrificing tenants’ comfort or service.

From the tenant’s standpoint, a green lease ensures the full use of a healthy and productive work environment over the lease term at a competitive price. To meet both parties’ objectives, a green lease should include the following essential elements.

Rent structure and operating costs
A green lease should reward the landlord for reducing energy use and operating an efficient and sustainable office building. This can be done two ways: 

Modified gross lease (which includes all operating costs, such as utilities) with both an expense stop clause and appropriate escalation clause.

• An expense stop is the point where the tenant agrees to pay for additional costs. It should be all-inclusive, based on 100 percent building occupancy, and be stated in dollars per rentable square foot. (Note that a base year is not the same as an expense stop.)
• A comprehensive and equitable definition of operating costs is needed to protect the interest of both the landlord and tenant.
• The lease should allow the landlord to reasonably amortize the cost of projects that will reduce operating costs and treat that amortization as an operating cost—as long as the amortization does not exceed the savings.
• A “Right to Audit” clause is needed to protect the tenant from overcharges and define a reasonable audit process that protects the landlord from frivolous audits.
• The escalation clause should exclude the portion of the rent covered by the expense stop to avoid double dipping.

Full service gross lease that increases the rent by a fixed amount each year, or the percentage increase in either the consumer price index (CPI) or another inflationary index. The advantage of this format is simplicity: no argument over what is a legitimate operating cost, no operating expense statements and no audits. For landlords that have very efficient operations this is the best way to go, since a well-run green building costs far less to operate. This structure increases the building’s value with the same level of rental income.

Energy use by tenant
To account for after-hours use or prevent excess energy consumption by any tenant, the lease should state an energy allowance (in kilowatt-hours per square foot per year) and provide for the sub-metering of each tenant’s energy use. While most office buildings are designed for a load of 8 watts per square foot, usage in a typical office building runs 2.3 to 2.75 watts per-square foot.

Operational performance, materials and cleaning
After rental rates, comfortable temperatures and indoor air quality are the second- and third-most important issues for tenants, according to the Building Owners and Managers Association (BOMA). Yet both comfort and air quality are most often the greatest source of tenant dissatisfaction.

Therefore, the lease should state that the building’s HVAC system will be operated in compliance with ANSI/ASHRAE Standard 55-2004, Thermal Environmental Conditions for Human Occupancy and ANSI/ASHRAE Standard 62.1-2004, Ventilation for Acceptable Indoor Air Quality.

A lease clause should also define hazardous materials and require that neither the landlord nor any tenant violate any federal, state or local laws or regulations regarding the presence, disposal, storage, generation or release of hazardous materials.

Green cleaning can be addressed as a lease exhibit. The exhibit, will define the materials, procedures and protocols for cleaning the building in a sustainable manner.

Building rules and regulations
This boilerplate lease exhibit should stipulate a building-wide recycling program. Specific operational issues can be detailed in a “Recycling Program Guide” cited in the Rules and Regulations.

Tenant construction agreement
This lease exhibit should contain language that includes sustainable product requirements and construction practices for all tenant improvements.

Tenant manual and development guidelines

To ensure high building performance, landlords should develop a guide that explains—in non-technical terms—the building’s sustainable features, benefits, procedures and operating parameters. The development guidelines should give the tenant insights into how to maximize the building’s design features and systems to create a high-performance, sustainable workplace.

Get it in writing
A lease is a complex legal document. Yet it is also a tool that can be used to define parameters for sustainable operations. This is critical for tenants interested in occupying a green building as the ownership of the building and its operating managers can change several times over the course of a tenant’s lease term.

Alan Whitson, RPA, a nationally recognized speaker, author and seminar leader, is president of the Corporate Realty, Design & Management Institute (www.squarefootage.net). Contact Alan at 503-274-7162 or awhitson@squarefootage.net.

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This article appeared as part of the "2008 Green Real Estate Guide," a digital supplement to the April 2008 issue of the magazine. Download Sustainable Industries "2008 Green Real Estate Guide" for more information about green leasing, as well as complete listings of LEED-certified commercial and retail spaces on the West Coast.