Overcoming the Split Incentive Barrier – Triple Net Lease

Building Energy PerformanceThe most fundamental economic question that must be addressed before any energy efficient retrofit is undertaken is “Who benefits?”. While leases vary widely in their treatment of energy costs, most can be categorized as either gross, net, or fixed-base leases. Each takes a different approach in allocating utility costs — and potential savings — among owners and tenants. A review of the leasing arrangement is discussed during our Initial Assessment and forms part of the Recommendations and Proposal, where the potential constraints of the current lease are defined and possible solutions provided. This can included a renegotiated lease, or more commonly, an amendment designed to more equitably distribute the savings from an energy efficiency upgrade.

The three categories of lease allocate expenses between building owners and tenants in following ways:
  • Net lease: the tenant pays for all expenses
  • Gross lease: the building owner pays for all expenses
  • Fixed-base lease: the building owner pays a certain amount of expenses

With a thorough understanding of these allocations and a concerted effort to align lease terms with high-performance objectives, building owners can pursue energy targets profitably in virtually any leasing environment.

Gross Lease
A gross lease is where the building owner is responsible for all operating expenses, which means that the building owner can invest in an energy efficiency retrofit and receive the full benefit of any savings. Because the owner is fully responsible for operating expenses, reductions in those expenses will not be diluted between owners and tenants. Any reduction in the owner’s share of operating expenses raises the property’s Net Operating Income, improves the building’s profitability, and supports higher appraised value.

In this situation, the tenant has no financial incentive to limit energy use, so any energy efficiency retrofit should focus on automated interventions, such as occupancy sensors, and avoid relying on behavior change to drive savings.

Net Lease
A net lease is where the responsibility for operating expenses are assigned to the tenant, which means that all utility expenses – and any increases or decreases to those expenses – will be absorbed by the tenant. Because the tenant is responsible for for the utility bill, they will benefit from any savings leaving little incentive for the building owner to invest in an energy efficiency retrofit.

However, a building owner might consider an energy efficiency capital project that would reduce their tenant’s utility bill, if that reduction enabled higher rent prices.

Providing that the tenant’s occupancy cost did not increase, money the tenant would have spent on energy could be redirected to an increase in rent. The real advantage of this approach to the building owner is an increase in Net Operating Income resulting in a higher property value.

It may even be possible to pass through some or all of the capital costs to the tenant. Typically, leases modeled on the BOMA standard have a clause to prevent building owners passing through capital expenditure. However, there are usually 3 exceptions to this clause:

  1. Government regulatory costs
  2. Safety
  3. Reducing the operational expenses for all tenants (and this includes energy efficiency retrofits)

Lastly, if a building owner were approaching the end of a lease, an energy efficiency upgrade may prove profitable to lower the utility bills for future tenants so that a new higher rent can be achieved.

However, capital cost recovery through a lease assessment clause to pay for an energy efficiency retrofit will reduce or remove the ability to capitalize the energy savings and create property value. It is usually better to raise the tenants’ rent to offset the tenants’ energy savings than require the tenant to reimburse the owner for the cost of equipment because it provides a longer-term and sustainable increase in cash flow, Net Operating Income, and property value.

Fixed-Base Lease
A fixed-base lease is a gross lease with an upper limit on the building owner’s responsibility for operating expenses, usually set by the base year and called an expense stop.

Assessing the value of an energy efficiency retrofit in this environment is complicated and requires expert modeling, a detailed understanding of how different operating expenses are treated under the lease, and some predictions about future costs.

However, to simplify the assessment, if operating expenses were higher than the current expense stop, the tenant would already be paying for a portion of the energy cost. Reductions in energy usage would first financially benefit the tenant. If the potential savings were large enough to reduce the operating expenses to a point below the expense stop, the owner would benefit as well.

Green Lease – Negotiating a split incentive
Traditional commercial leases in the U.S. are considered a “zero-sum” game — meaning that one party’s gains are considered as loses by the other. These are a result of complex, often long negotiations between tenants and owners, where each side seeks to promote its own interests. This is primarily caused by incentive misalignment between tenants and landlords, which effectively prohibit them from joining forces to save energy.

Green leases aim to split costs and benefits between the parties in such a way that both parties can benefit from an energy retrofit. To distribute costs and benefits with respect to utilities in a lease requires addressing questions of who assumes the costs and risks. However, a green lease is often not a practical option for an existing tenant, even at the time of lease renewal. This is because landlords and tenants are often reluctant to enter into a new lease agreement, as it is often a very lengthy and arduous process. Frequently, the only components of the lease that are renegotiated are the term and rate.

The solution to this barrier — and a way to facilitate an energy efficiency retrofit — is a letter agreement typically used by a building owner to gain the tenants’ buy-in, or renegotiate some of the terms of the lease, to more equitably share the costs and the savings of the proposed retrofit without reopening any of the other terms of the lease contract.