"Green" Leasing: Landlord and Tenant Perspectives

The result of these trends is an increasing interest in incorporating "green" lease provisions into commercial leases, and a need for building owners and their tenants to understand the impact of such provisions. This article discusses a few of the more common "green" lease provisions, such as those related to operating expenses, negative and affirmative covenants, and assignment and subletting, and some attendant issues to consider when negotiating a commercial lease, whether as a landlord or as a tenant.

Operating Expenses
Operating expenses are often one of the most negotiated issues in commercial leases. Commercial landlords desire to pass through to tenants as much of the operating expenses of the property as possible, and tenants desire to limit exposure to unanticipated or unwarranted operating costs of the landlord. As a result, certainty in what types of "green" costs may be passed through to tenants, or must be absorbed by the landlord, is important to both parties.

Many standard operating expenses charged to tenants on a pass-through basis already include aspects of "green" compliance, such as use of fluorescent light fixtures and recycling of office trash. However, given the likelihood of new environmentally friendly technologies, practices and regulations, a landlord may wish to broaden the range of environmental standard compliance costs that constitute operating expenses to include the costs of seeking or maintaining a certain sustainability rating for a commercial building. Even if a building is not currently certified under a specific rating system, the provision gives the landlord the option to seek such certification in the future and pass through the costs to its tenants. Given that tenants are increasingly electing to require that their leased premises satisfy LEED or similar environmental compliance ratings, an express inclusion of such costs in operating expenses gives the tenant assurances that the property will continue to meet such standards and may protect the tenant from incomplete or ineffective efforts. It also gives the landlord a cost basis to implement and maintain the level of sustainability compliance that its tenants require. However, inclusion of such a provision can be contentious where the landlord is attempting to retrofit a building for environmental certification and to pass through such costs to existing tenants. These tenants may take the position that, because the building was not certified at the time of lease execution, any attempts by the landlord to pass through these costs as project operating expenses are improper.

A landlord's costs of initially meeting a "green" compliance standard include maintaining, reporting or commissioning a building in order to conform to a certain sustainability rating system or other standard.² It typically would be appropriate for initial certification costs to be amortized under GAAP or the landlord's accounting principles, consistent with the amortization requirements for capital expenditures that are included among operating expenses. However, absent some resulting measurable reduction in operating expenses, tenants may question a landlord's ability to pass through the costs of its efforts to update or recommission a building.³

The following is a sample landlord-friendly "green" operating expense clause, to be included with the other operating expense items:

"In addition to the above costs, Operating Expenses shall include all costs and expenses incurred by Landlord in maintaining, managing, reporting, commissioning and recommissioning the Building so as to conform with the U.S. EPA's ENERGY STAR® rating, the Green Building Initiative's Green Globes™ for Continual Improvement of Existing Buildings, or the U.S. Green Building Council's Leadership in Energy and Environmental Design ("LEED") rating system, or any other applicable sustainability rating or standard of the Building, or of applying, reporting and commissioning the Building to seek certification under any such rating system or standard; provided, however, the cost of such applying, reporting and commissioning of the Building or any part thereof to seek certification shall be amortized in accordance with GAAP [or Landlord's standard accounting principles]."

However, a tenant will wish to, and should, limit its obligation to reimburse the landlord for any "green" operating expenses and ensure that its overall costs do not increase. Even a "green" tenant is unlikely to agree to absorb cost increases as a result of seeking certification or maintaining a sustainability rating for the buildings that it leases, if such increases are not offset with savings through greater energy efficiency. A cost-neutral limitation on the landlord's ability to pass through sustainability costs is particularly appropriate where the building was not certified at the time that the tenant entered into the lease or where the landlord attempts to amend the original lease to add sustainability costs to the list of operating expenses.

Furthermore, the tenant should require the landlord to deliver evidence of cost savings or cost neutrality achieved through sustainability measures, including evidence of year-over-year (or base year, where applicable) comparisons.⁴ Such evidence should be delivered on a regular basis, such as annually, and, at a minimum, concurrently with the delivery of the landlord's annual reconciliation statements. The tenant should have the right to audit the landlord's records relating to the building's certification and sustainability rating costs. The tenant also may want to incorporate a percentage limitation on pass-through expenses for sustainability efforts. For example, the tenant could require that sustainability costs not exceed a certain percentage of overall operating expenses, with any excess costs automatically being excluded from operating expenses for which the tenant is responsible. A tenant with a base year for operating expenses also can negotiate for increases in the categories of base year expenses if a new sustainability-related cost is introduced in later years so that a baseline cost for the measure is established and the tenant only pays for increases over the remaining lease term.

Restrictions and Affirmative Covenants
In order to achieve or maintain a certain sustainability rating or standard for a building, a lease also needs to contain covenants that require the parties to comply with sustainability practices and programs. From the landlord's perspective, these provisions should be broad and general enough to allow flexibility, such as general restrictions on using or operating the premises in any manner that will cause the building not to conform with the landlord's sustainability practices or the building's applicable rating system. From the tenant's perspective, such operating covenants should be tailored so that they do not interfere with the tenant's business operations in any material respect or increase operating costs for its business.

A general covenant on compliance may be supplemented by more specific covenants relating to construction, carbon reduction, and recycling and waste management. The following are sample landlord-friendly tenant covenants:

"LEED Rating. The Building and the Project are or may become in the future certified under the LEED rating system. Landlord's sustainability practices address whole-building operations and maintenance issues, including chemical use; indoor air quality; energy efficiency; water efficiency; recycling programs; exterior maintenance programs; and systems upgrades to meet green building energy, water, indoor air quality and lighting performance standards. All construction and maintenance methods and procedures, material purchases and disposal of waste with respect to the Project shall be in compliance with minimum standards and specifications in furtherance thereof, in addition to any requirements under applicable Laws with respect thereto."

"Energy-Efficiency Measures. Tenant shall not waste electricity, water, heat or air conditioning, or other utilities or services, and agrees to cooperate fully with Landlord and comply with any applicable Laws to assure the most effective and energy-efficient operation of the Building. Tenant covenants to cooperate with Landlord in connection with satisfying Landlord's compliance requirements with respect to any sustainability measures implemented by Landlord, including, but not limited to, providing Landlord with monitoring data and reporting duties related to the Premises. Tenant shall use proven energy and carbon reduction measures, including energy-efficient bulbs in task lighting; use of lighting controls; daylighting measures to avoid overlighting interior spaces; closing shades in the Premises to avoid overheating the space; turning off lights and equipment at the end of the work day; purchasing ENERGY STAR® qualified equipment, including, but not limited to, lighting, office equipment, commercial and residential quality kitchen equipment, vending and ice machines; and purchasing products certified by the U.S. EPA's Water Sense® program."

"Recycling and Waste Management. Tenant covenants and agrees, at its sole cost and expense, to (1) comply with all present and future Laws, orders and regulations of the Federal, state, county, municipal or other governing authorities, departments, commissions, agencies and boards regarding the collection, sorting, separation and recycling of garbage, trash, rubbish and other refuse (collectively, "trash and recyclables"); (2) comply with Landlord's recycling policy as part of Landlord's sustainability practices where it may be more stringent than applicable Laws; (3) sort and separate its trash and recyclables into such categories as are provided by Law or Landlord's sustainability practices; and (4) place each separately sorted category of trash and recyclables in separate receptacles as directed by Landlord. Landlord reserves the right to refuse to collect or accept from Tenant any trash and recyclables that are not separated and sorted as required by Law and to require Tenant to arrange for such collection at Tenant's sole cost and expense, utilizing a contractor approved by Landlord. Tenant shall pay all costs, expenses, fines, penalties or damages that may be imposed on Landlord or Tenant by reason of Tenant's failure to comply with the provisions of this Section."

The tenant will want to ensure that it is not held to a higher standard than other tenants in the building or project, and to require reciprocal "green" covenants from the landlord. The tenant should limit compliance measures to those that do not impose greater costs or liability on the tenant, or adversely impact its use or enjoyment of the premises, and require the landlord to deliver written specifications regarding any rating system as a condition to the tenant's obligation to comply with such rating system. In addition, the scope of the sustainability covenants should be restricted to the tenant's use of the premises only; the covenants should not apply to the tenant's operations at any other properties or facilities.

Assignment and Subletting
Sustainability ratings also should be considered in the assignment and subletting provisions of the lease. Although the original tenant (and customarily any assignee) is required to comply with any "green" covenants under the terms of the lease, it typically would be a matter of negotiation between the subtenant and the tenant as to those lease provisions with which the subtenant must comply. A landlord will want to require that any sublease specifically obligates any subtenant to comply with all "green" provisions of the master lease. The landlord also may wish to assess the likelihood that a proposed assignee or subtenant will, in fact, be able to comply with such covenants. If the proposed assignee's or subtenant's use of the premises may or will cause the building not to conform to the sustainability practices of the landlord and the obligations of the tenant or subtenant under the lease, this factor should be deemed a reasonable basis for the landlord's disapproval of any proposed assignee or subtenant.

The tenant will want to add language providing that a violation due to the proposed assignment or subletting must be probable (rather than possible) before any disapproval based on the compliance capabilities of the proposed assignee or subtenant would be deemed reasonable and that any proposed use by the assignee/subtenant that complies with the permitted uses specified under the lease automatically constitutes compliance with the applicable sustainability rating or standard.

Miscellaneous

There are numerous other provisions that the parties may wish to include in the lease in order to achieve or maintain certain sustainability ratings or standards. "Green" requirements may be incorporated into project rules and regulations. As most leases allow the landlord to adopt new rules and regulations at any time during the lease term, tenants will want to confirm that rules relating to "green" compliance are subject to the same restrictions or requirements for any change in rules or regulations that the tenant has negotiated in its lease. Tenant improvement work also may be subject to a landlord's requirement that the tenant improvement allowance be used to maintain and seek LEED for Commercial Interiors certification for a tenant improvement build-out. A tenant may be required to maintain such certification for its alterations during the lease term. In addition, a "green" tenant may wish to require the landlord to seek LEED certification for a new building, particularly if it is a build-to-suit lease.

The provisions highlighted above are only a few of the issues that landlords and tenants are likely to face in the near future as environmentally oriented compliance standards become the norm in commercial buildings. Landlords will want to preserve or achieve a certain rating system and have the ability to pass through related costs to the tenants, while tenants will be concerned about absorbing increased costs associated with operating expenses and performing obligations relating to sustainability measures.

Given the increasing awareness of sustainability and environmental practices and the impact these practices will have on leasing, landlord and tenants need to be mindful of "green" lease provisions. Because it is best to address "green" lease provisions at the outset of lease negotiations and avoid conflicts at a later date, regardless of whether the concerned party is the landlord or the tenant, both landlords and tenants should seek advice from legal, design and construction experts early in the lease negotiations so that both parties can mutually work toward a "green" lease that achieves long-term sustainability.

¹ CoStar Study Finds LEED, Energy Star Buildings Outperform Peers, Andrew C. Burr, CoStar Group (March 26, 2008).

² Certain rating systems and standards require that owners document the performance of their buildings, through self-reporting mechanics and/or by a third-party commissioning authority.

³ Reasons for recommissioning a building may include changes in the configuration of interior space that interfere with ventilation, plumbing repairs or replacements where pipe insulation may have been removed or changes in lighting needs as a result of the construction of new buildings.

⁴ Note that under the draft regulations recently issued by the California Energy Commission under AB 1103, commercial real estate owners must disclose energy benchmarking data commencing on July 1, 2012, for buildings larger than 50,000 square feet, January 1, 2013, for buildings between 10,001 and 49,999 square feet, and July 1, 2013, for buildings between 5,000 and 10,000 square feet. California Energy Commission, Draft Regulations for AB 1103, September 12, 2011.

Download: Perspectives on Real Estate Newsletter Spring 2012