'Green' Leases Support 'Green' Buildings

Large institutions find that development and occupancy of green buildings achieve many widely accepted corporate goals, including adoption of socially responsible practices promoted by corporate stakeholders and employees; attraction of younger workers, particularly in the knowledge industries; and the projection of a socially responsible image. Institutional owners and tenants recognize that the American public embraces green goals and the companies that adopt these goals as their own. Green buildings also yield considerable efficiencies in terms of energy savings and worker productivity.

New Standards

The green movement has been advanced by new rating standards and benchmarks for the efficacy of green building design and development. These include the Leadership in Energy and Environmental Design (LEED) and Energy Star standards promulgated by the U.S. Environmental Protection Agency, Building Research Establishment and Environmental Assessment Method (BREEAM) in the UK, Green Star in Australia, Comprehensive Assessment System for Building Environment Efficiency (CASBEE) in Japan and others.

LEED

LEED is a third-party certification program promulgated by the nonprofit U.S. Green Building Council (USGBC), whose mission is to promote sustainable design, development and operation of buildings. Now the predominant certification benchmark in the U.S. sustainable building market, LEED has surged from its inception in the late 1990s to cover more than 29,000 registered projects. LEED is intended to be a transparent, uniform, publically reviewable, points-based system in which design and development projects can accumulate LEED points if they conform to certain adopted green building design elements and criteria. The point system synthesizes a detailed scoring system based on scientific criteria consisting of prerequisites and credits applicable to a number of major categories, including sustainability of the site, efficiency of water utilization, energy and atmosphere, materials and resources used, and indoor environmental quality.

Many alternative versions of the LEED rating system have been developed for specific types of projects and lifecycle junctures, including new construction, existing construction, core and shell, commercial interiors, homes, schools, retail and health care, and the Neighborhood Development pilot program.

LEED certification has a number of significant advantages, including validation of a building's green design and development achievement by third parties that conduct thorough, transparent reviews of the building's design and construction, thereby permitting the marketing of the project with the LEED imprimatur to governmental and high-quality institutional tenants. LEED certification also permits a project to qualify for federal, state and local governmental incentives that are awarded based on LEED scores.

Green Building Economics

Although there is insufficient data at this time to support the blanket proposition that green buildings have relatively higher operational performance levels, it is generally accepted that the benefits of developing, owning or leasing in a green building are considerable.

According to CoStar, buildings with LEED or energy efficiency certification have a higher occupancy rate and lease for more rentable dollars per square foot than peer buildings. Green buildings achieve considerable operational efficiencies that reduce lifecycle operating costs and raise return on investment. For example:

• Expansion of daylight use reduces heat emission and the need for electric lights, resulting in a reduction in cooling requirements.
• Use of salvaged, recycled or new green materials results in many savings.
• Use of high-efficiency HVAC with optimized control systems, as well as Energy Star appliances and office equipment results in considerable heat load savings.
• Collection and reuse of water for nondrinking and cleaning purposes and, in suburban and exurban settings, use of vegetation for filtration reduces water costs.
• Green buildings promote employee productivity gains and lower health care and related insurance costs due to fewer allergies and other sicknesses.
• Other green human resources innovations, such as telecommuting alternatives and company-sponsored transit, reduce overall carbon emissions,
  generate increased productivity, lower real estate costs and raise morale of employees who can spend more time with their families.

Of course, there are many in the private sector who are skeptical of the financial benefit of investing in green buildings, and it is true that some elements of green building construction are more susceptible than others to a return on investment analysis (generally those involving energy, ventilation and lighting). It is also true, however, that most benefits are achieved over a relatively long life cycle, which is why many of the most sustainable buildings are those of public entities at the federal, state and municipal levels, which benefit from low-cost government financing in which benefits are realized over a lengthy period.

Lease Terms to Match

Once parties have agreed to embrace green principles in development and construction or retrofit of a commercial building, they must execute agreements to carry out these sustainability goals ' the “green lease” in the landlord-tenant context. Essentially, a green lease is the lease of a green building or conventional building that will be retrofitted.

There are many variations, but green leases have certain common characteristics. These include fostering landlord-tenant collaboration on the integrated design of a building or its space, establishing joint benchmarks according to a readily ascertainable standard such as LEED certification, and providing economic incentives to allocate and control the green operation and building maintenance properly by managing operating expense-related provisions. Green leases also incorporate provisions that relate to the ongoing operation and maintenance of the building, as well as closely tailored green operational and maintenance requirements that are often included in a tenant handbook or operations manual for the building.

Because green buildings are rated, and ratings are incorporated into financing assumptions and requirements for major leases, it is important that the landlord establish a legal framework that will prevent rating slippage. From a purely financial perspective, a key element of green leases is the treatment of green practices cost-sharing by tenants through provisions relating to operating expense pass-throughs. Equally important is promoting efficient use of energy through direct metering or sub-metering, which places the full onus of saving energy within tenant space (i.e., the vast bulk of energy building costs) on the tenant.

Other resource conservation should also be effected, such as installation of water use-reduction equipment in lavatories and kitchens, and mandated caps on, or percentage reductions to, use of resources such as water, expressed in gallons or liters of water per square foot annually, and electricity, expressed in kilowatts per square foot annually. Highly technical green leases should be drafted in concert with consultants, including electrical engineers, mechanical engineers and architects.

Highlighted below are green provisions in contemporary leases, in the order in which they are usually included.

Operating Expenses

Debate over the green lease's economic structure pits “gross” against “net” leases. In a gross lease, the landlord pays for operating expenses and real property taxes incurred during a “base” year, and the tenant pays for increases in operating expenses and real property taxes over those incurred during the base year.

Some argue the gross lease can better achieve green incentives because it encourages the landlord to minimize expenses. As a result, the tenant is responsible only for expense increases. Others assert the net lease is better because the tenant absorbs operating expenses from the outset, providing incentives to reduce energy consumption and persuade the landlord to minimize expenses.

In our opinion, the optimal structure is a gross lease in which the landlord, who can best evaluate baseline building costs, establishes a base operating expense framework that recovers capital costs incurred to achieve green ratings and requires tenant payment for increases in those expenses. It may be refined to establish a “green pass-throughs” category, just as gross leases may incorporate several types of escalations for energy costs, insurance and the like. In all cases, operating expense pass-through clauses should generally permit recovery of annual amortization of green building capital expenditures and repairs up to savings achieved, as well as recovery of the landlord's costs of maintaining, managing and repairing the building in accordance with LEED or Green Globes (including costs to achieve and maintain sustainability standards, including applications, reporting and commissioning).

If the building will be greened during the term of the lease, the operating expense pass-through clause should permit a reduction in base year operating expenses to recapture savings achieved from the greening of systems, particularly with respect to energy efficiencies.

Finally, the parties should consider whether tenants might be offered incentives to help achieve green rating targets. For example, tenants could receive operating expense (or rent) reductions if they achieve a certain percentage of waste recycled or a reduction in energy consumption. Conversely, it could be agreed there should be an increase in rent or additional rental charges if tenants fail to achieve rating targets.

Insurance

Most major insurance carriers now have green building insurance or an endorsement that covers costs to reconstruct a building to a specified sustainability standard following a casualty. A variation of the “laws and ordinances” endorsement, it covers the cost to comply with current code requirements applicable to a reconstruction.

Insurance may cover construction features, high-efficiency systems, equipment and appliances, and soft costs to achieve green status, such as application and commissioning costs. A green lease may provide for green insurance coverage and inclusion in pass-through expenses.

Utilities

All utilities should be sub- or directly metered whenever possible to encourage conservation and promote accountability. Tenants should be required to submit copies of utility bills to the landlord to benchmark energy consumption patterns against a baseline, provide transparent reporting of the building's energy performance and monitor tenant compliance with established energy reduction goals. Utilities should not be shared or charged on a floor area proportion of costs aggregated for the building.

Uses

The use section should provide that the tenant will not operate the premises so as to cause the building to fail to conform to green rating standards adopted in the lease, or fail the building or premises certification for the green standard. This section should also require the tenant (and sublessees or licensees of the premises) to abide by any state or local environmental laws.

Reporting

A green lease should provide for periodic environmental performance reporting, from landlord or tenant, to measure achievement of goals and benchmarks. For example, it may contain resource-reduction targets such as not exceeding a specified amount of: 1) kilowatt hours of electricity per square foot; 2) cubic meters of natural gas consumption per square foot; 3) liters of water consumption per square foot; 4) waste diversion rate per annum; or 5) parts per million of indoor carbon dioxide levels compared with outdoor levels, typically per American Society of Heating, Refrigerating and Air Conditioning Engineers (ASHRAE) standards.

Green Building Standard

A green lease should expressly adopt a green rating standard, such as LEED or Green Globes, and the tenant conduct provisions of the lease should track the relevant rating requirements to provide a single reference point and conform to the green rating requirements adopted in relevant financing and equity documents.

The tenant should be required to use proven energy and carbon reduction measures, including energy efficient bulbs and task lighting, lighting controls to avoid over-lighting interior spaces, closed shades on the south side of the building to avoid overheating, the purchase of Energy Star-qualified equipment and water-saving and related equipment, and be required to comply with recycling covenants, including the sorting and separation of trash.

Maintenance and Repair

The maintenance and repair section should provide that the tenant comply with the landlord's sustainability practices (or, in large leases, vice versa), which may change. Provisions should also require reporting of environmentally sensitive tenant purchases, audit of same by the landlord, and vice versa. The landlord should be permitted to install energy-saving equipment and use portions within walls and above hung ceilings to accomplish this.

For performance of maintenance and repair functions, the lease should mandate adherence to green construction rules and regulations by building construction contractors, including with respect to construction and the review of all work projects for potential impact on reduction targets and environmental programs. A LEED- or Green Globes-certified consultant may be retained at the landlord's or tenant's expense to evaluate tenant compliance.

Alterations

The alterations section should specify use of green materials for all alterations, including recycled materials, green products such as Energy Star-rated appliances and equipment, lighting sensors, floor finishings and coverings, paints, sealants, adhesives and bathroom fixtures such as waterless urinals and water-efficient toilets. The tenant should not be permitted to make alterations that may adversely affect the building's LEED rating or environmental performance, and work practices should specify sustainable practices, including rating systems. The lease may require that the tenant agree to maintain LEED for Commercial Interiors certification.

If alterations are permitted or required to be removed at the end of the term, the lease should provide that the tenant will dispose of them in a sustainable manner. Alterations to be demolished should be recycled whenever possible.

Cleaning

Cleaning should be performed in accordance with sustainability practices, which may require that it be performed during office hours using environmentally acceptable materials.

Building/Construction Rules And Regulations

As with maintenance and repairs, building and construction rules and regulations should require that the tenant and its contractors adhere to sustainability guidelines, including use of environmentally acceptable materials and adherence to recycling guidelines.

Carbon Offset Credits

A truly green lease may provide that, if the tenant is unable to achieve certain energy-saving measures, it will be required to purchase carbon offset credits to offset that failure. Similarly, provision for carbon taxes incurred by the landlord should also be considered for inclusion under operating expenses. Leases can be “greened” in older buildings by introducing green provisions as they are amended and rolled over. Alternatively, the landlord can gradually modify the lease by promulgating new building rules that cover green topics, many of which (e.g., recycling) are covered by contemporary leases.

Conclusion

Green buildings have reached a tipping point and will constitute more than a market niche, thanks to prodding by governmental mandates and incentives, as well the goals of corporate institutional users and developers of space. Green buildings and leases will become the market standard. Buildings that do not fit the green framework will be disadvantaged just as “smart” buildings vanquished older properties. Use of the green lease to achieve sustainable building goals will grow in importance and sophistication; in fact, green leases will drive a societal shift to green buildings.

Mario J. Suarez is a partner, and Marisa Zavarella an associate, in the New York office of Thompson Hine LLP. This article also appeared in the New York Law Journal, an ALM sister publication of this newsletter.

Sustainable or “green” buildings offer healthy workplaces and reduce the costs of energy, water, waste and building operation and maintenance throughout a property's life cycle. They contribute to environmental stewardship and lower landlord and tenant expenses. The interplay between a green building and the traditional legal relationships covered by commercial real property leases forms the nexus of this article.

The Market, the Standards

Green building design and development has gained acceptance in the last decade, with the trend accelerating in the last five to eight years. The green building market is driven by a number of factors, the most prominent of which is the demand for green building design by corporate, governmental and nonprofit tenants.

Large institutions find that development and occupancy of green buildings achieve many widely accepted corporate goals, including adoption of socially responsible practices promoted by corporate stakeholders and employees; attraction of younger workers, particularly in the knowledge industries; and the projection of a socially responsible image. Institutional owners and tenants recognize that the American public embraces green goals and the companies that adopt these goals as their own. Green buildings also yield considerable efficiencies in terms of energy savings and worker productivity.

New Standards

The green movement has been advanced by new rating standards and benchmarks for the efficacy of green building design and development. These include the Leadership in Energy and Environmental Design (LEED) and Energy Star standards promulgated by the U.S. Environmental Protection Agency, Building Research Establishment and Environmental Assessment Method (BREEAM) in the UK, Green Star in Australia, Comprehensive Assessment System for Building Environment Efficiency (CASBEE) in Japan and others.

LEED

LEED is a third-party certification program promulgated by the nonprofit U.S. Green Building Council (USGBC), whose mission is to promote sustainable design, development and operation of buildings. Now the predominant certification benchmark in the U.S. sustainable building market, LEED has surged from its inception in the late 1990s to cover more than 29,000 registered projects. LEED is intended to be a transparent, uniform, publically reviewable, points-based system in which design and development projects can accumulate LEED points if they conform to certain adopted green building design elements and criteria. The point system synthesizes a detailed scoring system based on scientific criteria consisting of prerequisites and credits applicable to a number of major categories, including sustainability of the site, efficiency of water utilization, energy and atmosphere, materials and resources used, and indoor environmental quality.

Many alternative versions of the LEED rating system have been developed for specific types of projects and lifecycle junctures, including new construction, existing construction, core and shell, commercial interiors, homes, schools, retail and health care, and the Neighborhood Development pilot program.

LEED certification has a number of significant advantages, including validation of a building's green design and development achievement by third parties that conduct thorough, transparent reviews of the building's design and construction, thereby permitting the marketing of the project with the LEED imprimatur to governmental and high-quality institutional tenants. LEED certification also permits a project to qualify for federal, state and local governmental incentives that are awarded based on LEED scores.

Green Building Economics

Although there is insufficient data at this time to support the blanket proposition that green buildings have relatively higher operational performance levels, it is generally accepted that the benefits of developing, owning or leasing in a green building are considerable.

According to CoStar, buildings with LEED or energy efficiency certification have a higher occupancy rate and lease for more rentable dollars per square foot than peer buildings. Green buildings achieve considerable operational efficiencies that reduce lifecycle operating costs and raise return on investment. For example:

• Expansion of daylight use reduces heat emission and the need for electric lights, resulting in a reduction in cooling requirements.
• Use of salvaged, recycled or new green materials results in many savings.
• Use of high-efficiency HVAC with optimized control systems, as well as Energy Star appliances and office equipment results in considerable heat load savings.
• Collection and reuse of water for nondrinking and cleaning purposes and, in suburban and exurban settings, use of vegetation for filtration reduces water costs.
• Green buildings promote employee productivity gains and lower health care and related insurance costs due to fewer allergies and other sicknesses.
• Other green human resources innovations, such as telecommuting alternatives and company-sponsored transit, reduce overall carbon emissions,
  generate increased productivity, lower real estate costs and raise morale of employees who can spend more time with their families.

Of course, there are many in the private sector who are skeptical of the financial benefit of investing in green buildings, and it is true that some elements of green building construction are more susceptible than others to a return on investment analysis (generally those involving energy, ventilation and lighting). It is also true, however, that most benefits are achieved over a relatively long life cycle, which is why many of the most sustainable buildings are those of public entities at the federal, state and municipal levels, which benefit from low-cost government financing in which benefits are realized over a lengthy period.

Lease Terms to Match

Once parties have agreed to embrace green principles in development and construction or retrofit of a commercial building, they must execute agreements to carry out these sustainability goals ' the “green lease” in the landlord-tenant context. Essentially, a green lease is the lease of a green building or conventional building that will be retrofitted.

There are many variations, but green leases have certain common characteristics. These include fostering landlord-tenant collaboration on the integrated design of a building or its space, establishing joint benchmarks according to a readily ascertainable standard such as LEED certification, and providing economic incentives to allocate and control the green operation and building maintenance properly by managing operating expense-related provisions. Green leases also incorporate provisions that relate to the ongoing operation and maintenance of the building, as well as closely tailored green operational and maintenance requirements that are often included in a tenant handbook or operations manual for the building.

Because green buildings are rated, and ratings are incorporated into financing assumptions and requirements for major leases, it is important that the landlord establish a legal framework that will prevent rating slippage. From a purely financial perspective, a key element of green leases is the treatment of green practices cost-sharing by tenants through provisions relating to operating expense pass-throughs. Equally important is promoting efficient use of energy through direct metering or sub-metering, which places the full onus of saving energy within tenant space (i.e., the vast bulk of energy building costs) on the tenant.

Other resource conservation should also be effected, such as installation of water use-reduction equipment in lavatories and kitchens, and mandated caps on, or percentage reductions to, use of resources such as water, expressed in gallons or liters of water per square foot annually, and electricity, expressed in kilowatts per square foot annually. Highly technical green leases should be drafted in concert with consultants, including electrical engineers, mechanical engineers and architects.

Highlighted below are green provisions in contemporary leases, in the order in which they are usually included.

Operating Expenses

Debate over the green lease's economic structure pits “gross” against “net” leases. In a gross lease, the landlord pays for operating expenses and real property taxes incurred during a “base” year, and the tenant pays for increases in operating expenses and real property taxes over those incurred during the base year.

Some argue the gross lease can better achieve green incentives because it encourages the landlord to minimize expenses. As a result, the tenant is responsible only for expense increases. Others assert the net lease is better because the tenant absorbs operating expenses from the outset, providing incentives to reduce energy consumption and persuade the landlord to minimize expenses.

In our opinion, the optimal structure is a gross lease in which the landlord, who can best evaluate baseline building costs, establishes a base operating expense framework that recovers capital costs incurred to achieve green ratings and requires tenant payment for increases in those expenses. It may be refined to establish a “green pass-throughs” category, just as gross leases may incorporate several types of escalations for energy costs, insurance and the like. In all cases, operating expense pass-through clauses should generally permit recovery of annual amortization of green building capital expenditures and repairs up to savings achieved, as well as recovery of the landlord's costs of maintaining, managing and repairing the building in accordance with LEED or Green Globes (including costs to achieve and maintain sustainability standards, including applications, reporting and commissioning).

If the building will be greened during the term of the lease, the operating expense pass-through clause should permit a reduction in base year operating expenses to recapture savings achieved from the greening of systems, particularly with respect to energy efficiencies.

Finally, the parties should consider whether tenants might be offered incentives to help achieve green rating targets. For example, tenants could receive operating expense (or rent) reductions if they achieve a certain percentage of waste recycled or a reduction in energy consumption. Conversely, it could be agreed there should be an increase in rent or additional rental charges if tenants fail to achieve rating targets.

Insurance

Most major insurance carriers now have green building insurance or an endorsement that covers costs to reconstruct a building to a specified sustainability standard following a casualty. A variation of the “laws and ordinances” endorsement, it covers the cost to comply with current code requirements applicable to a reconstruction.

Insurance may cover construction features, high-efficiency systems, equipment and appliances, and soft costs to achieve green status, such as application and commissioning costs. A green lease may provide for green insurance coverage and inclusion in pass-through expenses.

Utilities

All utilities should be sub- or directly metered whenever possible to encourage conservation and promote accountability. Tenants should be required to submit copies of utility bills to the landlord to benchmark energy consumption patterns against a baseline, provide transparent reporting of the building's energy performance and monitor tenant compliance with established energy reduction goals. Utilities should not be shared or charged on a floor area proportion of costs aggregated for the building.

Uses

The use section should provide that the tenant will not operate the premises so as to cause the building to fail to conform to green rating standards adopted in the lease, or fail the building or premises certification for the green standard. This section should also require the tenant (and sublessees or licensees of the premises) to abide by any state or local environmental laws.

Reporting

A green lease should provide for periodic environmental performance reporting, from landlord or tenant, to measure achievement of goals and benchmarks. For example, it may contain resource-reduction targets such as not exceeding a specified amount of: 1) kilowatt hours of electricity per square foot; 2) cubic meters of natural gas consumption per square foot; 3) liters of water consumption per square foot; 4) waste diversion rate per annum; or 5) parts per million of indoor carbon dioxide levels compared with outdoor levels, typically per American Society of Heating, Refrigerating and Air Conditioning Engineers (ASHRAE) standards.

Green Building Standard

A green lease should expressly adopt a green rating standard, such as LEED or Green Globes, and the tenant conduct provisions of the lease should track the relevant rating requirements to provide a single reference point and conform to the green rating requirements adopted in relevant financing and equity documents.

The tenant should be required to use proven energy and carbon reduction measures, including energy efficient bulbs and task lighting, lighting controls to avoid over-lighting interior spaces, closed shades on the south side of the building to avoid overheating, the purchase of Energy Star-qualified equipment and water-saving and related equipment, and be required to comply with recycling covenants, including the sorting and separation of trash.

Maintenance and Repair

The maintenance and repair section should provide that the tenant comply with the landlord's sustainability practices (or, in large leases, vice versa), which may change. Provisions should also require reporting of environmentally sensitive tenant purchases, audit of same by the landlord, and vice versa. The landlord should be permitted to install energy-saving equipment and use portions within walls and above hung ceilings to accomplish this.

For performance of maintenance and repair functions, the lease should mandate adherence to green construction rules and regulations by building construction contractors, including with respect to construction and the review of all work projects for potential impact on reduction targets and environmental programs. A LEED- or Green Globes-certified consultant may be retained at the landlord's or tenant's expense to evaluate tenant compliance.

Alterations

The alterations section should specify use of green materials for all alterations, including recycled materials, green products such as Energy Star-rated appliances and equipment, lighting sensors, floor finishings and coverings, paints, sealants, adhesives and bathroom fixtures such as waterless urinals and water-efficient toilets. The tenant should not be permitted to make alterations that may adversely affect the building's LEED rating or environmental performance, and work practices should specify sustainable practices, including rating systems. The lease may require that the tenant agree to maintain LEED for Commercial Interiors certification.

If alterations are permitted or required to be removed at the end of the term, the lease should provide that the tenant will dispose of them in a sustainable manner. Alterations to be demolished should be recycled whenever possible.

Cleaning

Cleaning should be performed in accordance with sustainability practices, which may require that it be performed during office hours using environmentally acceptable materials.

Building/Construction Rules And Regulations

As with maintenance and repairs, building and construction rules and regulations should require that the tenant and its contractors adhere to sustainability guidelines, including use of environmentally acceptable materials and adherence to recycling guidelines.

Carbon Offset Credits

A truly green lease may provide that, if the tenant is unable to achieve certain energy-saving measures, it will be required to purchase carbon offset credits to offset that failure. Similarly, provision for carbon taxes incurred by the landlord should also be considered for inclusion under operating expenses. Leases can be “greened” in older buildings by introducing green provisions as they are amended and rolled over. Alternatively, the landlord can gradually modify the lease by promulgating new building rules that cover green topics, many of which (e.g., recycling) are covered by contemporary leases.

Conclusion

Green buildings have reached a tipping point and will constitute more than a market niche, thanks to prodding by governmental mandates and incentives, as well the goals of corporate institutional users and developers of space. Green buildings and leases will become the market standard. Buildings that do not fit the green framework will be disadvantaged just as “smart” buildings vanquished older properties. Use of the green lease to achieve sustainable building goals will grow in importance and sophistication; in fact, green leases will drive a societal shift to green buildings.

Mario J. Suarez is a partner, and Marisa Zavarella an associate, in the New York office of Thompson Hine LLP. This article also appeared in the New York Law Journal, an ALM sister publication of this newsletter.