It’s been a while since we talked about green leasing here at GRELJ. That’s not because it’s an issue we’re no longer interested in – far from it – but frankly there has not been all that much new to report on the front, notwithstanding the ongoing market rebound.

Recently, though, New York City announced that the law firm WilmerHale signed a lease at LEED Gold-certified 7 World Trade Center. Deals at the first commercial office building in the country to earn LEED certification are always worth noting, but WilmerHale’s lease is of particular import because it is the first to incorporate form green lease language developed by the Mayor’s Office of Long-Term Planning and Sustainability. By our own (admittedly informal and unofficial) count, New York now joins Portland (Oregon), Winnipeg, and various municipalities in Australia where green lease arrangements between private sector players have been publicly disclosed.

The lease, which WilmerHale signed with 7 World Trade Center landlord Silverstein Properties, aims to address the much-discussed split incentive, which remains prevalent in most commercial office leases in New York City. As you may know, the “split incentive” refers to the scenario where a landlord pays for building capital improvements but does not benefit from any reductions in operating expenses that are created because its tenants pay for operating expenses pursuant to the terms of the lease. In addition, although many leases do allow landlords to pass the costs of capital improvements through to tenants, the time frame for recouping those costs – typically over the working lifetime of the improvement, which can extend for decades – creates a practical impediment to owners actually making any energy-efficient capital improvements to their buildings in the first place.

The new New York City lease language, whose development was spearheaded by the NRDC’s Green Lease Forum, was derived from two fundamental concepts. First, to give them an incentive to make such investments in the first place, the language guarantees landlords that they will recover the costs of any energy-efficient capital improvements from their tenants over the projected payback period for the improvement – not over the useful lifetime of the improvement.

Second, the language aims to assure tenants that those improvements will actually result in cost savings that – even when split with the landlord – will still result in a net benefit to the tenant. Accordingly, once improvements are made, tenants will not only realize actual savings, but will pay the landlord 80 percent of the projected savings as assessed by an independent, NYSERDA-approved engineer (creating a buffer in case savings are not as projected) as part of building operating costs. After the payback period compensates the landlord for the investment, the tenant will continue to enjoy the benefits of the energy savings.

Here’s the most pertinent section of the model clause, which sets forth the landlord’s ability to include capital improvements within the lease’s definition of building operating expenses:

Commencing with the first Comparison Year following the year in which such Capital Improvement is completed and placed in service, and continuing for the duration of the Adjusted Payback Period (as hereinafter defined), Landlord may include in Operating Expenses a portion of the aggregate costs of such Capital Improvement equivalent to eighty percent (80%) of the Projected Annual Savings, so that the aggregate costs of such Capital Improvement will be fully amortized over one hundred twenty-five percent (125%) of the simple payback period (such period of time, the “Adjusted Payback Period”). By way of example: If the aggregate costs of such Capital Improvement are $2,000,000, the Projected Annual Savings are $500,000 and the simple payback period for such Capital Improvement is forty-eight (48) months, then Landlord may include $400,000 of the aggregate costs of such Capital Improvement (i.e., an amount equivalent to 80% of the Projected Annual Savings) in Operating Expenses for five consecutive Comparison Years (i.e. sixty (60) months or 125% of the simple payback period).

According to Mayor Bloomberg, the lease “breaks new ground in the field of energy conservation – and we expect it will be a pioneering model for commercial leases. This is part of our broad campaign to increase the energy efficiency of large buildings all across the city. When it is fully realized, this ‘Greener, Greater Buildings Plan’ – the first of its kind in our nation – will be the equivalent of making a city the size of Oakland, California completely carbon neutral.”

More interestingly, all of New York City’s commercial office space leases are negotiated by the Department of Citywide Administrative Services, and DCAS has agreed to add the green lease language to all of its new lease negotiations. The language has also been endorsed by REBNY.

WilmerHale’s lease is particularly important to note because much of what has been written and discussed about green leasing generally over the past few years has been almost entirely theoretical. For a number of reasons, it has been difficult to identify, and subsequently analyze, green lease language which the real estate industry has implemented. While it remains to be seen what types of capital improvements (if any), whose costs Silverstein Properties will seek to pass through to WilmerHale or any other 7 World Trade Center tenants (the building was completed in 2006), the Mayor’s Green Leasing Language should demonstrate to the rest of the New York City real estate industry – and landlords and tenants in other markets – that green leasing principles can be applied in the most high profile of Class A settings.

It is also worth noting that the basic concepts behind the language echo those that underpin the Model Green Lease (which is drafted as a full-service gross lease with an escalation clause and base year expense stop clause). As part of its definition of building operating costs, the MGL allows the landlord to reasonably amortize the cost of projects that will reduce operating costs and treat that amortization cost as an operating cost, so long as that amortization cost does not exceed savings to the tenant. The tenant’s obligation in the MGL is to “pay its pro rata share of any increase in Building Operating Costs over the Base Year.” The actual language in the MGL includes within the definition of “Building Operating Costs” the

[c]osts of any capital improvement made to the Building that reduces Building Operating Costs, the costs of such improvements shall be amortized over the minimum period acceptable for federal income tax purposes, and only the yearly-amortized portion thereof shall be treated as a Building Operating Cost. In no event shall this charge for yearly amortization be more than the actual reduction in the Building Operating Costs.

WilmerHale will be relocating from 399 Park Avenue to 210,000 square feet on the 41st through 45th floors of 7 World Trade Center, which is now 90 percent leased thanks to the deal.

A copy of the Mayor’s Green Leasing Language is available here for download.

First, although Michael Brooks of REALpac (who participated in last month’s green leasing panel at the Urban Green Expo here in New York City) is quoted in one of the articles, it is not clear that Mr. Malbranck’s lease is derived from any of the forms which were discussed during that panel, including REALpac’s, the Model Green Lease, or the BOMA Green Lease Guide. As Mr. Brooks notes, “it’s impossible to say how many commercial buildings in Canada are using green leases because no one, including REALpac, tracks that at the moment.” It’s certainly a relatively small number, but as an increasing number of landlords attempt to implement green leasing practices, questions about the uniformity of green lease provisions could become an issue. I’m also intrigued about the idea of tracking green leases and whether any other organizations have attempted to do so (none have, to my knowledge).

In terms of other landlords applying similar blanket green lease requirements across available space in their buildings, I thought it was interesting to note that Mr. Malbranck admits that “a number of leasing agents and prospective tenants have inquired about the space, but backed off when they found out about the green leases. ‘They didn’t come right out and say it, but you got the sense it was an issue with them.’” However, the lone tenant that has signed up to date with Mr. Malbranck was attracted by the green lease concept; the owner of Lux for Sprouts, a children’s clothing and toy store, states that she specifically selected 4100 square feet of space on the first floor based on (1) the image that occupancy in a green building should create for her company; and (2) her belief that green buildings make it easier to attract and retain employees. Here, I would suggest again the importance for landlords to closely scrutinize broad, aspirational representations in green leases about green building benefits or performance, particularly if such representations are overstated or ultimately unrealized by tenants.

I was also reminded of Mr. Brooks’ remarks on our panel about enforcement of green lease provisions; although the articles reporting on 1735 Corydon Avenue did not get into this level of detail, I do think it’s worth repeating what Mr. Brooks noted about green leasing practices in Australia (where he had met a landlord whose form lease included a variety of green provisions which- if breached- entitled it to terminate the lease and evict the offending tenant). If more landlords apply mandatory blanket green leases, it will be curious to see what types of specific enforcement mechanisms (if any) are included in those documents. Given that Mr. Malbranck has only signed up a single tenant, I would be surprised if he ultimately exercised any right to terminate based on the breach of any green lease provisions, but the fact that potential tenants have balked at his requirements may suggest that such enforcement mechanisms are included in the scope of his green lease.

Finally, I also think that 1735 Corydon Avenue suggests it’s not unreasonable to consider the possibility that, eventually, the LEED system (or some other third-party green building rating system) will require owners to exclusively negotiate and execute green leases in order to earn certification, whether as an individual credit, for example, under LEED’s New Construction or Core and Shell rating systems, or perhaps even as a mandatory Minimum Program Requirement that serves as a prerequisite to formal LEED certification. For example, USGBC recently released its Green Office Guide: Integrating LEED Into Your Leasing Process and, although I have yet to review it, it’s clear that USGBC is beginning to pay closer attention to the intersection of green leasing and LEED.

We’ll try to flesh out more details about 1735 Corydon Avenue and follow up here at GRELJ as appropriate.

• Green Leases Give Building Manitoba First (Winnipeg Sun)
• Green Leases Seen as Wave of Future (Winnipeg Free Press)

Unlike the BOMA Green Lease Guide (created by Jones Day partner Steve Teitelbaum, who also participated on the panel), the Model Green Lease is an extremely compact document, drafted from scratch, which is fundamentally based on the theory that, in order to make a more compelling business case for green buildings, leases must be crafted as gross (i.e., the landlord is responsible for building operating expenses, unlike in a net lease, where the tenant pays for its own share of those costs). The document, which also includes a corresponding reference guide, comprises just 17 pages plus exhibits and incorporates ten essential elements that aim to support a specific definition of a green building created by the Task Force for purposes of the project: “[a] building that is environmentally responsible, profitable and a healthy place to live or work.”

The ten essential elements of the Model Green Lease as developed and subsequently drafted by the Task Force are as follows:

• Environmental performance objective clauses (broad aspirational provisions that purport to provide context and clarity to the lease, which also recognize that the parties who draft the lease may not be the parties that ultimately operate the building);
• Gross lease rent structure (acknowledging that the landlord is in the best position to optimize building performance, provided it has the financial incentive to do so);
• A fixed per square foot energy allowance for tenants;
• Objective building performance standards;
• An annual building performance reporting requirement; and
• Provisions related to green cleaning and recycling, building rules and regulations, tenant fit-out guidelines, and a tenant manual and development guidelines.

With respect to the gross lease rent structure and addressing the split incentive, defining the scope of building operating expenses is a major green leasing challenge, particularly with respect to landlord-initiated capital improvements to the building’s infrastructure during the term of the lease. The Model Green Lease addresses this issue by including within its definition of building operating expenses the amortized cost of any capital expenditures that reduce those expenses, but only to the extent that they create actual savings for the tenant. One important related point which we did not delve into on the panel is whether the ongoing costs of certifying the building under a third-party green building rating system – such as LEED-EB: OM, Green Globes or Energy Star – should be included in the definition of building operating expenses; the Model Green Lease does not include these costs, the BOMA Green Lease does (within its Section 4.2 definition of building operating expenses).

One of the many interesting issues that were raised during the course of the panel discussion that followed the presentation of each leasing effort was a hypothetical proposed by one of our audience members. Suppose Tenant A leases space in a multi-tenant LEED-certified or Energy Star-rated building. Tenant A’s lease is green, Tenant B’s is not. In the course of conducting its business, Tenant B does something that jeopardizes either the building’s LEED rating (under LEED-EB: OM or with respect to one of the new Minimum Program Requirements under the LEED 2009 system) or pending Energy Star application (by using an increased amount of energy over what is contemplated by the lease). Now suppose that Tenant A is a public company with a shareholder mandate to occupy space in a LEED-certified building, or for similar reasons relied on the landlord’s representations regarding Energy Star. Could Tenant A sue the landlord for Tenant B’s actions based on violating certain provisions in its green lease?

As the panel pointed out in response, it’s rare that a lease would obligate either party to perform in a certain manner with respect to other third parties, but a broadly drafted environmental performance objective clause might provide the tenant’s attorney with, at a minimum, the ability to assert a claim that might either assist the tenant in renegotiating more favorable lease terms, or rescinding the lease outright. Nevertheless, as we noted previously here at GRELJ, the Model Green Lease puts the onus on the landlord in Section 5.02.3 to “use its reasonable efforts to cause other tenants of the Building to conduct their operations in the Building and their premises in conformity with the Environmental Performance Objective.” Accordingly, everyone on the panel stressed that form green leasing documents are tools and not designed for imminent signature; it’s clear that these types of issues will need to be discussed and vetted in detail as green leasing practices continue to disseminate.

I also thought that the discussion on enforcement of green lease provisions was particularly insightful; the panel discussed whether certain breaches might be more egregious than others from a sustainability perspective. The Model Green Lease, for example, provides tenants with an allowance for electricity. If the tenant exceeds that allowance, it is required to reimburse the landlord the extra per kilowatt hour cost; the landlord, however, is not given the right to terminate the lease. (Of course, a significant boost in energy consumption might be indicative of the tenant violating the lease’s use provision (Section 4.01 in the Model Green Lease), which would give the landlord the right to terminate). Little consensus was reached during this line of discussion.

However, one final thought about enforcement struck me as particularly noteworthy; Michael Brooks of REALpac explained that while studying green leasing practices in Australia, he met a landlord whose form lease included a variety of green provisions which- if breached- entitled it to terminate the lease and evict the offending tenant. Although this is a drastic remedy, and the panel agreed that most landlords would likely not want to create such a self-imposed gap in their building’s net operating income, it could suggest the direction in which green lease enforcement might head in a rapidly shifting domestic regulatory climate.

The legal issues associated with green leasing are fascinating, emerging, and present an opportunity for the real estate community to make a major contribution to the more efficient operation of commercial and industrial buildings. As energy efficiency continues to rank as a high priority, and retrofit work expands as the economy slowly turns around, the four green leasing tools presented at last week’s Urban Green Expo will become increasingly important for landlords and tenants alike to review, implement, and build upon. Simultaneously, the requirements of LEED 2009 and other third-party systems will need to be translated into or otherwise sufficiently addressed by such documents in order to safeguard the rights and remedies of the parties. We’re looking forward to continuing the discussion here at GRELJ about these critical issues, with particular continued emphasis on the legal implications of various green lease provisions.

• It’s Not Easy Leasing Green (GlobeSt.com)