September 01, 2017

Sustainability Gets Serious: Drafting Multi-Tenant Office Leases for Net Zero Energy Buildings

Cara A. Carmichael, Laurence G. Preble, Evan L. Randall, and Beat U. Steiner

Reprinted with permission from Probate & Property magazine, September/October 2017 (31:5), at 34-37. ©2017 by the American Bar Association. Reprinted with permission. All rights reserved. This information or any or portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

“Net zero energy” has a nice ring to it. These three words capture the imagination and fire the soul of many innovators in the building and energy industry. Constructing “green buildings” has been a popular goal for many years, but there is now an interest in seeking net zero energy. Green building, also called sustainable building, consists of constructing and operating buildings in a manner that has a lesser impact on the environment than conventionally built structures. Net zero buildings attempt to take one aspect of green building, the energy use of the building, even further.

Why Net Zero Energy?

Net zero energy (NZE) means the project will produce as much electricity from an on-site photovoltaic system as the project uses over the course of the calendar year. Aspiring to net zero is a lofty goal; achieving net zero can be a very difficult task unless all parties are aligned. In a competitive office market that is threatened by change, why would anyone endure the extra effort required for an NZE project? What’s in it for the developer, landlord, and tenant? How does the marketplace react? Is NZE an advantage in leasing and operating the project?

One analysis describes the initial motivations as follows:

One of the most common goals for the individuals undertaking net zero projects was to showcase and demonstrate “the art of the possible” in terms of achieving high energy and sustainability performance in buildings. Among the dozen projects reviewed, the main goal was not to achieve an NZEB [Net Zero Energy Building] per se, but to create highly efficient or near-zero-energy buildings. Most projects were driven by a mix of traditional factors and concerns—long-term cost and resource savings, occupant well-being, and environmental responsibility—combined with the desire to illustrate the effect of combining today’s technologies and with the right ideas and innovations. Rarely, if ever, was one single factor decisive in driving an NZEB project; in the majority of cases, the communication of an “environmental champion” image was more important than cost savings.

The Johnson Controls Institute for Building Efficiency, “The Move Toward Net Zero Energy Buildings—Experiences and Lessons from Early Adopters,” Issues Brief, March 2012, at 2, http://www.buildingefficiencyinitiative.org/sites/default/files/legacy/InstituteBE/media/Library/Resources/Existing-Building-Retrofits/Issue-Brief-Moving-to-Net-Zero-Energy-Buildings.pdf.

As a result, many early NZE projects were developed by or for a single occupant: a business, governmental agency, or nonprofit institution that has a special interest in sustainability and in supporting environmental goals. Thus, the developer and its team were able to collaborate with the occupant to design a building that achieved these goals. Now, NZE projects are moving into the mainstream market of traditional multi-tenant office buildings.

The NZE project becomes much more difficult when it is an office building with many different tenants, some of whom may not be as fanatical about sustainability and achieving NZE, and especially so if NZE means additional complexity or restrictions on the tenant’s use of its premises. In addition, many such projects may include retail or restaurant uses, for which achieving NZE is more difficult because of greater energy consumption. Addressing vast differences among the tenants and their respective uses and equipment is challenging. Further, laws applicable to public utilities may come into play if electricity is being generated and effectively sold to tenants. Such laws may need to be taken into account in structuring the electricity generating arrangement and drafting the lease.

The competitive office market is a two-edged sword. On the one hand, the rent, operating costs, and amenities offered to prospective tenants must be in line with the marketplace. Lofty environmental goals may be supported by “environmental champions” but not by conventional office tenants, who must examine the bottom line and select buildings that are affordable and suitable for their needs. On the other hand, in a crowded marketplace, it helps to stand out from your competitors. Sustainability is rapidly becoming less of an operating cost increase, and it brings increasingly more marketing advantages. Millennials, entrepreneurs, high-tech start-ups, and many others are attracted to such projects. Bicycle racks, access to mass transit, and collaborative, flexible space have replaced the corner office and the reserved parking spot as amenities coveted by building occupants. Nevertheless, designing a project that is both economically competitive and sustainable remains a challenge.

Net zero energy starts with a good base building that minimizes energy needs through efficient design and construction, installing adequate insulation, exterior solar shading, using windows that let in more light than heat, using LED electric lighting systems and controls, and ensuring the exterior envelope of the building is adequately sealed so conditioned air stays where it is needed—inside the spaces—and doesn’t freely migrate outside. Plug loads (any energy use driven by equipment physically “plugged into” the walls) are becoming one of the largest demands of energy in typical office buildings. Engaging with occupants to monitor and control plug loads is important to achieving and sustaining NZE. Once the building energy loads have gotten as low as possible, an NZE building will likely have a photovoltaic (PV) system on the roof or façade to generate on-site the energy the building needs.

NZE buildings represent more than just a beacon of sustainability. They often provide a strong business case and have other attributes of a high-quality office space that is attractive to tenants. NZE or sustainable buildings are proven to increase occupant health and satisfaction, providing long-term financial benefits to the tenant organization. NZE buildings also may eventually end up leasing up faster, have fewer vacancies, and garner higher rental rates.

NZE buildings can increase capital development costs, sometimes by 10%–15%. This cost increase can be recovered through increased rent premium, reduced vacancy, and utility rebates and incentives, particularly for solar energy. It is possible for a market rate building to achieve NZE with no additional cost if the developer and design team are forward thinking and aligned from the outset.

Once a developer has committed to an NZE design, other challenges loom: How to translate the requirements and standards of an NZE building into a tenant lease? How to assure (and reassure) investors and lenders that the concept makes sense? How is NZE measured, monitored, and maintained? Who sets the standards? What happens if the project fails to achieve NZE?

The different demands during the day and during seasons can pose challenges for creating and operating a net zero structure. Although the energy use of office buildings is less variable than residential (that is, offices are dominated more by internal loads generated by plug load equipment), the amount of energy consumed by an office building and its occupants can vary by as much as 50%, depending on the season. For example, during the late afternoon in the summer, the amount of electricity for air conditioning can be much greater than at other times of the day or in other seasons. The amount of energy produced by a building’s energy generation systems can vary greatly. For example, solar panels produce much more energy during cloudless summer days than during the shorter, lower sun angle winter days or during overcast conditions. Being able to match the building’s energy consumption needs with its energy generation can be difficult, but almost all NZE buildings are able to use the electricity grid to purchase the building’s overages in energy generation and to buy power during low solar generation times or at night.

Lease Provisions

A fundamental aspect of the NZE lease is the landlord’s commitment to achieve NZE. The lease negotiations will range from the aspirational to a defined legally binding commitment. If the project is designed for NZE, but has no actual energy track record, and if the landlord is making a legally binding commitment, the landlord takes on the risk that the project will not perform as designed. What assurances should the landlord expect from its design team (and from potential tenants) regarding performance of the system? In a multi-tenant office building, there may be several reasons why the building fails to achieve NZE: (1) incorrect design or operation of the project and its common areas; (2) a tenant may not comply with its plug loads or energy budget; (3) there may be weather variables or other force majeure events beyond the control of the landlord; and (4) there may be project elements (retail or restaurant uses, for example) outside the scope of NZE requirements. Each element may have different consequences for the landlord.

A landlord seeking to hedge these risks might suggest that the lease require only the landlord’s “reasonable efforts” or “best efforts” to achieve NZE. With such a commitment, the tenant is not guaranteed a result but can only expect the landlord to exert efforts to achieve NZE. One challenge to the tenant’s enforcement of an efforts-based obligation will be coming up with adequate standards to measure the degree of required effort, given the newness of this technology. Further, can the tenant expect to find an expert who can credibly testify on the tenant’s behalf? And how can a developer be expected to properly size, purchase, and install the PV system based solely on predicted loads of the building when actual operating energy use may vary?

Fortunately, there may be a solution to the “all or nothing” approach. The “fudge” factor in NZE achievement is accommodated when the parties agree it is acceptable to purchase renewable energy certificates (RECs) to make up any shortfalls between generation and use (that is, if on-site generation is not sufficient to meet all on-site energy use, RECs will be purchased such that 100% of energy use in the project is provided either through on-site renewable energy or RECs). RECs represent the environmental attributes of the power produced from renewable energy projects and are sold separate from commodity electricity. If NZE is not achieved, the landlord (or the tenant) may be required to buy RECs or green certificates whether or not it has access to green power through its local utility. The type of RECs preferred to achieve NZE should be Green-e Energy certified, or an equivalent if that certification is not available. Green-e Energy is a program of the nonprofit Center for Resource Solutions, based in San Francisco and a recognized global leader in clean energy and carbon offset certification. Who obtains the RECs, and who pays for them (directly or as a pass-through), will be negotiated between the landlord and the tenant, depending on the cause of the noncompliance. Of course, the first priority would be to achieve NZE on-site without purchasing RECs. It does provide some security, however, that NZE and sustainably generated, outsourced power are an option, regardless of the installed capacity on-site.

In a multi-tenant project, the tenant will want to be sure the landlord is obligated to enforce the NZE obligations against other tenants (for their overconsumption of energy or failure to undertake energy-saving measures, for example). Provisions to this effect should be included in all tenant leases. The tenant also will want to be sure the landlord meets the NZE obligations for the common areas of the project. For example, if noncompliance is caused by the action or inaction of another tenant (but excluding, perhaps, retail and restaurant uses), the cost of the RECs should be passed through only to that tenant and not to all tenants as an operating cost. If noncompliance is caused by the failure of the landlord to achieve NZE for the common areas, then the cost of the RECs should be absorbed by the landlord. If noncompliance is caused by force majeure or other factors beyond the reasonable control of the landlord, the cost of the RECs would be passed through to all tenants as an operating cost. As noted above, measuring and monitoring performance is an important part of the lease provisions.

The NZE obligations imposed on the landlord will be only as good as the enforcement allowed under the lease. Thus, limitations on the landlord’s liability and releases of the landlord following a transfer of the project will diminish the tenant’s enforcement rights. If the landlord is a single-purpose entity, the tenant might seek to have the NZE obligation guaranteed by a party with greater financial resources.

If there is a commitment to achieve NZE, the lease should specify (1) the standards for measuring, monitoring, and reporting performance by, for example, providing energy-use data (the more specific, the better) to the tenant on a periodic basis throughout the lease term, (2) the right of the tenant to audit the project’s energy use, (3) if NZE is not being achieved, the steps required to be taken to achieve NZE, and (4) remedies of the tenant against the landlord for the landlord’s failure to achieve or maintain NZE. Building “commissioning,” which is the process of reviewing the building periodically (typically annually or semi-annually) to ensure base building systems are being maintained and operating as designed and up to performance, is a critical process for any building, let alone one with ambitious NZE goals. Commissioning should be required by the lease. If performed, it will save both the landlord and tenant money through reduced energy costs.

Remedies for Noncompliance

The remedies available to the tenant if the landlord breaches its NZE obligations necessarily are limited. Rarely is a tenant given a right to offset rent. The right to terminate the lease is also rarely given and, if given, may not be to the tenant’s advantage. Specific performance is a cumbersome, and certainly not speedy, remedy. Damages may be difficult to prove, as discussed below. Liquidated damages are often the most helpful of remedies a landlord is likely to accept. Liquidated damages, however, do not assure the achievement of NZE. Instead, they merely establish how much the landlord must pay to the tenant in lieu of achieving its NZE obligations. If the lease provides that the landlord can comply with its NZE obligations by purchasing RECs to compensate for any shortfall, then the remedy for failure to achieve NZE is settled.

For other failures to meet NZE obligations, the question is: what are the tenant’s damages and how are they measured? If the problem is that the tenant had to purchase RECs when it was not obligated to do so, or electricity because it needed it, money damages may be adequate. If the claimed damage is the loss of “good will” or advertising value to the tenant, determining the extent of the loss and measuring the damages become much more difficult. As noted above, the motivation for many tenants to lease space in an NZE building is a mix of economic and sustainability factors. Thus, the tenant will want to ensure the landlord remains committed to the NZE goal throughout the term of the lease. A properly drafted liquidated damages provision should provide sufficient economic incentive to motivate the landlord to continue to pursue NZE.

The landlord’s remedies against the tenant for failure to meet its NZE obligations would include all of the landlord’s standard remedies: termination of the lease, damages (including penalties and interest), or both. As noted above, if the tenant fails to meet its energy budget, the landlord can purchase RECs and pass the cost through to the tenant as additional rent. If RECs (or an equivalent alternative) are not available for purchase by the landlord, the question of damages becomes more difficult. The landlord, however, faces the same issues in determining the existence and measure of damages as does the tenant. Again, liquidated damages for specific breaches offer a possible solution.

Lender Issues

A landlord cannot negotiate a lease without keeping the project’s lender in mind. Real estate lenders are not, generally speaking, early embracers of new technologies. Thus, the landlord’s commitment to an NZE project might scare a potential lender. Of particular concern will be NZE obligations that the lender cannot quantify the cost to perform or the damages that might arise from the landlord’s failure to perform. Likewise, a lender will not want the tenant to have a right to offset rent because of the landlord’s failure to achieve NZE.

If the lender gets over those hurdles in its underwriting, it might nonetheless accept the landlord’s NZE obligations but require that the lender will not be obligated to assume them if it takes over the project. Thus, such obligations may not survive a foreclosure. In addition, the customary subordination, nondisturbance, and attornment agreement may contain similar conditions confirming that the lender will not be bound by NZE provisions following a foreclosure. Getting a lender to agree that the NZE clauses of the lease will survive the lender’s taking over the project is a tall order.

Other Sustainability Measures

The same motivations that cause a landlord to develop an NZE project are likely to lead to other sustainability obligations of the landlord or tenant or both. The measures might include low water consumption, recycling programs, green construction means and materials, and a transportation management plan. The question always arises whether, however “good” such measures are, do they create value for the landlord and the tenant? Some of the more traditional green building standards may cover such sustainability practices, such as those provided by the United States Green Building Council’s (USGBC) Leadership in Energy and Environmental Design (LEED) certification program. The NZE commitment goes much further than LEED.

Conclusion

Multi-tenant NZE office buildings are poised to compete in the marketplace with conventional buildings. A few lessons for the first time one undertakes negotiating a lease for an NZE project for the landlord or the tenants: nothing new is easy. You need energy experts to help you. Flexibility and creativity will be rewarded.

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Cara A. Carmichael, Laurence G. Preble, Evan L. Randall, and Beat U. Steiner

Cara A. Carmichael is a manager for the Rocky Mountain Institute in Boulder, Colorado. Laurence G. Preble is of counsel in the Boulder, Colorado, office of Holland & Hart LLP. Evan L. Randall is a partner in the Denver, Colorado, office of Holland & Hart LLP. Beat U. Steiner is a partner in the Boulder, Colorado, office of Holland & Hart LLP.