Green / Leasing / Sustainability / Tips

Lease Structure Key to Energy Savings

When office tenants pay only for their actual energy consumption, they inherently use less of it. Unfortunately, most tenants in “Class A” buildings have a lease structure called “fully-serviced” which does not account for how much energy each individual tenant uses, and therefore doesn’t motivate them to reduce their energy consumption because there’s no economic incentive.

submeter

Leasehold structures can generally fall into one of three categories:

• Triple Net (NNN):  In addition to paying Base Rent, the tenant is billed separately for property taxes, insurance, maintenance charges, utilities and janitorial services.

• Industrial Gross (IG):  All of the above expenses are included in the rental rate, with the exception of utilities and janitorial, which are paid separately by the tenant. This can also be called “Manufacturer’s Gross” (MG) or “Net of Utilities and Janitorial” (NUJ).

• Full-Service (FS):  In this lease structure, the tenant’s rental rate covers all of the above expenses, and is also sometimes referred to as a “Gross Lease”.  Any increases in Operating Expenses “OpEx” are passed through to the tenant as “Additional Rent”.  So for example, if the utility company decides to hike up the cost of their electricity, the tenants get stuck with the bill and pay according to their pro-rata percentage share of how much space they occupy in the building.

Turn off the lights behind you.  One day when you’re paying the bill you won’t forget! – Mom

So here’s the problem.  In a Full-Service lease, the landlord is not incentivized to implement energy-saving measures since they’re passing all increases through to the tenant.  And the tenant has no reason to try and save energy because doing so won’t reduce their monthly rent.

The logical solution is to sub-meter the tenant’s space so that they’re only paying for what they actually consume, and will realize the economic benefit from conserving energy.  This is much easier said than done, however.  Most Class A buildings simply aren’t designed to sub-meter individual tenant spaces, and most tenants do not have the necessary leverage to get the landlord to agree to pull them off the Full-Service lease.

Commercial real estate firm CB Richard Ellis found that separately metered buildings where tenants pay for what they consume, lower their energy costs on average by 21%.

So what do we do in the meantime while we wait for new buildings to be designed that can address this concern and take advantage of the huge opportunity for mass energy reduction in the workplace?  One option is to seek out buildings that already offer leaseholds on an Industrial Gross basis.  Typically you’ll see this in smaller, older buildings with a lower tenant density.  Or, if you are in an office tower and occupy several floors, you may have the necessary leverage to negotiate a lease that’s net of electric and get the landlord to agree to sub-meter your space.

As a broker, I always give preference to buildings that have leases structured as Industrial Gross.  In addition to the obvious benefit of saving money, I think employees appreciate being engaged and knowing that their energy-reducing actions have a positive impact and benefit.

21 thoughts on “Lease Structure Key to Energy Savings

  1. Nice post Benjamin – here in Seattle, much like you described, size matters. A 5,000 sf tenant in a 900,000 sf hi-rise has absolutely no leverage to submeter their premises or greatly modify the lease. Most would classify San Francisco and Seattle as progressive business environments and yet what we typically see is “business as usual.” Advocates like you, educating tenants on practical sustainability issues will help change this. Keep up the good work. Cheers!

    • Hi Gil,

      Thanks for taking the time to read my blog and comment! This split incentive is certainly the “rub” of our generation of brokers. Small tenants have absolutely NO leverage in submetering their suite, as in your example, and if a landlord can simply pass through energy costs, why would they ever be motivated to conserve it?

      Consider this. Here in the Bay Area we use a general rule of thumb for energy costs of $3.00/SF/annually. However, one of my clients monitored their energy use for a year (they’re in that business, actually), and found that they only spent $0.90/SF over the course of the year!

      Now imagine if Class A building owners began submetering, and marketing their office towers as Industrial Gross, informing tenants that they could realize cost savings of approximately $2.00/SF/annually just by moving into their building and controlling their energy costs.

      I think landlords will become further incentivized to reduce energy as measures such as California’s AB1103 is rolled out, which requires mandatory benchmarking, and San Francisco’s more stringent ordinance that requires commercial owners to conduct an energy audit every 5 years, in addition to benchmarking and reporting.

  2. Thanks for a good post. However there’s another conflict to consider related to lease structures:

    If a tenant pays utility bills then yes they have an incentive to turn off lights and relax temperature setpoints when they’re not needed. However the landlord has no incentive to replace inefficient central equipment or operate equipment in an efficient manner or provide low-energy designs for new construction/remodeling.

    If the landlord pays utility bills then they can implement all the efficiency measures they want, but the end user has no incentive to limit their use.

    The preferred approach from my perspective is a different type of lease where the the total utility bill is paid by the building owner, but submeters are provided for tenants. A portion of a tenant’s lease (say $1.50PSF, should be roughly equal to the average of the building) is devoted to utilities and is individually metered and anything used above an allowance is billed to the tenant by the landlord. From the landlord’s side, they are encouraged to provide efficient systems to reduce the “average” utility bill since it’s money in the bank for them. That way both parties are invested in energy conservation.

    • Hi David, typically the tenant receives a credit when operating expenses are reconciled by the building. Are you proposing that the tenant would waive their ability to benefit from a decrease in OpEx while allowing a landlord to passthrough overages? I think that might be challenging.

      I think having readily available and reliable ROI data is very important in these types of situations. For example, let’s say the landlord in agrees to a tenant improvement allowance of $15.00/SF, however the tenant wants to upgrade the lighting and controls to increase efficiency, resulting in an additional $1.00/SF above what the landlord has agreed to commit to. The lease is structured net of electric, so the tenant is incentivized to reduce energy consumption, however the landlord does not benefit by paying for the upgrade.

      One solution could be to amortize the cost of the upgrade into the tenant’s base rent, should the cost savings in reduced energy use over the life of the lease eclipse the cost of the upgrade. I think that’s why it’s important to have solid ROI numbers so models like this can be supported.

  3. David actually there is an incentive for Landlords to upgrade to more energy efficient measures like Lighting, HVAC systems, and Building envelope (cooling roofing, windows, etc), the EPAct 179D energy efficient tax deduction does exactly what you are suggesting.

    By implementing energy efficiency in these areas the owner can get up to $1.80 per sf deduction to help offset the cost of those upgrades and considering those types of upgrades are normally part of the a 39 depreciation schedule, but are often replaced in 5-15 year increments it actually makes a huge difference in their bottom line and many times they see increased satisfaction from tenants as well.

    For buildings that as Benjamin stated are not “designed” to sub meter this can be a win/win for both landlord and tenant alike because they both benefit from these upgrades.

    • Thanks for pointing that out, Todd. I wasn’t aware that these upgrades were depreciated over 39 years and not the useful life; good to know. For our readers, here’s an excerpt from the deduction:

      Maximum Deduction:

      $1.80 per square foot equals a 50% reduction in total annual energy and power costs (compared to a reference building meeting minimum requirements of ASHRAE Standard 90.1-2001); not to exceed the amount equal to the cost of energy efficient commercial building property placed in service during the taxable year.

      Partial Deduction:

      $.60 per square foot = 16 2/3% reduction for lighting, HVAC (including water systems) and building envelope (roof, insulation, windows).

      Partial Deduction (Interim Lighting):

      $.30 – $.60 per square foot = 25 – 40% reduction in lighting power density (50% in case of warehouse).

  4. Benjamin actually that is slighting out dated qualifying percentages, even though the building owner really should not care because they typically have no way of calculating those numbers themselves.

    Here are the updated reduction percentages:

    Building Envelope: Save $0.60 per square foot for a 10% reduction.
    HVAC: Save $0.60 per square foot for a 15% reduction.
    Lighting: Save $0.60 per square foot for a 25% reduction.

    Partial credit: 30-60 cents for a 25-40% reduction in lighting power density
    Receive $1.20 or $1.80 for meeting requirements in multiple categories.

    But the key for building owners to focus on (which many of them do not understand) is when calculated these percentages- we do not compare where the building is before those upgrades compared to where it stands after the upgrades. It’s where it stands after the upgrades compared to a similar building built to ASHRAE 2001 standards. You stated that above; however when I talk to building owners and efficiency designers/installers that is one of the most misunderstood pieces of EPAct 179D and think their building will never qualify. Typically that statement really clarifies it for the owner.

    Additionally most states have adopted ASHRAE 90.1 2007/09 standards, so most anything built 2007+ can do smaller upgrades and qualify for 179D due to increased efficiencies in the 2007/09 standards.

    • So Todd, the baseline in determining the energy reduction percentage is not the actual building’s energy use before the upgrade, but a building built to ASHRAE 2001? Since a lot of buildings back then were still using MH and HPS lighting (even incandescent), it seems like these numbers could be easily achieved. Right?

  5. You got it. With that explanation you can typically see the light go on in the building owner’s head.

    However “easily” is not a word I would use because there are still other factors involved, but confident it would qualify if lighting controls were installed along with efficient lighting- Yes.

    And in some situations the lighting can be so efficient it can qualify the building for $1.20 or $1.80. Typically that is with controls and LEDs as an example.

  6. Yes
    Taking the learning from others, we too started the billing for indiviudual occupant for light & power and For AHU separately.
    This has resulted in reduced energy consumption. Encouraged by this we are now allowing occupants to monitor their energy consumption online and control the same.

  7. The mayor’s office in New York City developed an interesting approach to addressing the split incentive issue when it comes to energy efficiency retrofits to the base building systems called the Energy Aligned Clause. Along with a group of real estate professionals, they developed model lease language that creates a pass-through structure whereby the owner and tenants share in both the cost and the benefits by agreeing on a predicted amount of annual savings and having the tenant pay the owner recovery costs for the capital expenditure based on the predicted savings. A protective measure against underperforming retrofits, called a “performance buffer,” is put in place by setting annual payments at 80 percent and extending the payback period by 25 percent. This makes it easier for the tenant to pay back recovery costs by paying in smaller amounts over a longer period of time, as agreed upon by both parties.

    More info on the Energy Aligned Clause can be found on NYC’s Green Buildings & Energy Efficiency site here http://www.nyc.gov/html/gbee/html/initiatives/clause.shtml

    • Great reply, Izullo. Thank you! NYC’s EAC is definitely innovative and a huge step in the right direction. One of the major hurdles I see in its adoption, however, is that it’s simply not feasible for smaller users. A landlord will go through the time and effort to implement on a 285,000 SF user, but would that happen for a small, 10k SF user? Not likely. Regardless, it’s exciting to see a mayor get behind something so interesting and others would be wise to follow suit.

      Thank you again, Izullo.

      • In addition to developing the Energy Aligned Clause, New York City also passed an ordinance that requires the metering or sub-metering of all large non-residential tenants. As part of Local Law 88, passed in 2009, all non-residential tenant spaces that are larger than 10,000 sq. ft. will have to be sub-metered by 2025 and be provided with information each month detailing about how much electricity they used and how much they were charged for it. (The law did not go so far as to require that tenants be billed according to usage, since that goes beyond City jurisdictional powers. But the idea is that once sub-meters are installed, the tenants who are paying too much will demand to be billed by usage, and that will drive the change.)

        For more information go to: http://www.nyc.gov/html/gbee/html/plan/ll88.shtml

        Perhaps San Francisco will pass a similar ordinance!

        • And there you have it. Sub-metering links tenant cost with energy consumption in the tenant space (lighting, plug loads, data centers – thanks Laurie Kerr!), and the Energy Aligned Clause solves the split incentive problem for energy consumed by base building systems (thanks lzullo!) These two solutions provide financial incentives to conserve “both kinds” of energy in buildings.

          So there in an answer. Let’s steer these conversations to these solutions!

          • Agreed on all fronts! It’s a shame we have to wait until 2025 for this ordinance to be enforced. Perhaps a tiered rollout like San Francisco’s AB1103 could get the ball rolling faster. Something like, all tenant spaces 100k and larger need to comply by 2015, 50k and larger by 2017, etc.

  8. You actually make it seem so easy with your
    presentation but I find this topic to be actually something that I think I would never
    understand. It seems too complicated and very broad for me.
    I’m looking forward for your next post, I will try to get
    the hang of it!

  9. May I just say what a relief to find somebody that really knows what
    they are discussing on the web. You actually understand how to bring an issue to light and make it important.
    More and more people have to read this and understand this side of the story.

    I was surprised that you aren’t more popular since you most certainly possess the gift.

    • Thank you for the kind words; that was really thoughtful of you to take the time to write that.

      Feel free to pass this along and share the article, and let me know if I can answer any questions for you.

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