Incentivizing sustainability in commercial real estate

By BEN BROESAMLE

This week’s readings were very illuminating about the Washington State Carbon Tax initiative, affecting all sectors of the State’s economy. It’s unclear exactly how the real estate industry would have its carbon calculated, but there could be a large impact. For the Washington State real estate industry, the proposed carbon tax initiative could go a long way to internalize externalities, especially because real estate developers pay sales tax for construction costs and control decisions about lowering green house gas emissions over the life of their project.

With or without a carbon tax, the State of Washington has another potent policy opportunity to internalize externalities in the real estate industry. Green building requires capital; capital comes from owners.  At the level of capital–owners and operators, the actual decision makers—we need better incentives. Washington State could institute high level requirements in leasing to foster sustainability by creating a hybrid lease requirement where utilities are either included in base rent or a base utility charge is specified for the entire lease term with all savings required to stay with the owner.

This policy would be at the cost to the State of creating a database of buildings organized by rating in any number of independent certification standards, what utility providers service the buildings, and the buildings utility costs for water, sewer, energy, etc. Then there could be set a standard base stop—one that also amortizes the cost of improvement—for these utility charges for various sustainability levels with various utility providers that would evolve as the overall buildings got more efficient. An owner would pick their target sustainability certification, and the tenant would know what the standards for utility charges are. The lease contract could be negotiated with that information.

In triple-net leases, tenants carry the costs of energy consumption, maintenance, taxes, insurance, etc. In gross leases, all of these charges are combined into the base rent. In modified gross leases that include some sort of base stop, there is a point at which the tenant pays, over the landlord’s budgeted allowance, or base. The legislated hybrid lease structure would require a base charge for utilities + overages, while other charges might be on a net basis.

Separating the utility charges out and having a negotiated base stop utility charge that is roughly equivalent to that of the average for the specified certification level gives the owner incentive to increase their efficiency on an ongoing basis and the tenant incentive to not abuse their utility usage. The owner would receive any savings and the tenant would continue to pay the minimum base charge for utilities.

The State of Washington could regulate two requirements: 1) that commercial leases are hybrid modified gross leases, specifically regarding utility charges, and 2) that savings on utility base charges must stay with the owner during the term of the lease specified. In comparison to the status-quo, this structure would give much greater financial incentive for owners to implement high-performance efficiency improvements or design and build high-performance sustainable buildings.

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