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UNLOCKING ENERGY EFFICIENCY IN COMMERCIAL BUILDINGS

Leasing Strategies Commercial Tenants Can Take to Make Buildings Energy Efficient

OBJECTIVES

1. To clearly identify the nature of the “split incentive” in commercial leasing.

2. To show in economic terms how the split incentive inhibits building retrofits.

3. To explain how to fix the split incentive.

4. To convey the importance of measurement and verification for purposes of fairness and building efficiency.

5. To establish the benefits for tenants of adjusting traditional approaches to capital and operating costs in commercial leasing.

ENERGY EFFICIENCY AND BUILDINGS

THE SPLIT INCENTIVE

HOW TO FIX IT

WHAT’S IN IT FOR TENANT AND LANDLORD

NEXT STEPS

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In dense urban areas, buildings are the principal source of energy use.

*2005 Greenhouse Gas Emissions Inventory

CO2 Emissions by Sector, New York City 2005

77%

3%

20%

Buildings

Transit

On-Road Vehicles

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Commercial buildings emit more than other types.

CO2 Emissions from Buildings, New York City 2005

16%

24%

32%

16%

12%Residential Small

Residential Large

Commercial

Institutional

Industrial

6

0

10

20

30

40

50

60

70

80

1995 2000 2005 2030

19.3 21.7 23.434

2022.6 23.6

29.213

12.612.4

11.8

1.41.3

1.1

1.1

Solid Waste/Methane

Combustion Vehicles

Heating Fuels

Electricity

Electricity and heating fuel represent the bulk of the emissions, and their share is growing.

Trends in Source of CO2 Emissions, New York City (millions of metric tons)

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Some emissions come from systems that commercial tenants control, others from systems they do not.

TENANT SYSTEMS

Lighting

Plug-ins (e.g. computers, printers)

Sometimes Air Conditioning

CORE BUILDING SYSTEMS

Boilers and Chillers (HVAC)

Pumps, Motors, Fans

Elevators

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Most of the energy use comes from a building’s central systems.

CORE BUILDING SYSTEMS

TENANT SYSTEMS

Plug-ins (computers, appliances)

21%

Lighting 18%

Ventilation 20%

Cooling 17%

Heating 20%Conveying 4%

Efficient Building

Inefficient Building (30% + greater)

Conveying

Lighting 23%Plug-ins(computers, applian

ces, etc) 27%

Heating 15%

Cooling

17%Ventilation13%

5%

Core Building50% - 60% ± 10% dep on

tenant cooling

Tenant Lighting

13%

Plug-Ins27%

Core Building59% - 69%

± 10% dep on tenant cooling

Plug-Ins21%

TenantLighting

10%

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Improving these systems has a direct, measurable $ impact.

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LEED and other green standards are not a requirement for saving energy and $.

≠Energy Efficient

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Typical buildings are inefficient – total energy reductions of 20% - 30% could pay back in 5 years.

• Direct digital control and sequencing of major systems

• Scheduling, setpoint and setback optimization

• Demand controlled ventilationControls

• Constant to variable primary/secondary chilled water

• Controls, valves, variable frequency drives (VFDs)

• Power factor correction capacitorsMechanical

• Constant to variable air volume with VFDs

• Automation of terminal units

• High efficiency boilers and chillersHVAC

Lighting• High efficiency lighting

• Controls, scheduling CORE BUILDING SYSTEMS

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• High efficiency bulbs and ballasts

• Daylighting/occupancy sensors

• De-lamping of overlit spaceLighting

• ENERGYSTAR computers, printers, and appliances

• Controls that shut down unnecessary night-time loadsPlug-ins

• Optimize air management and free cooling

• Load management and server optimization

• On-site generation and use of DC powerData Centers

Air conditioning

• High efficiency rooftop systems

• Retro-commissioning and tuning

Tenant system improvements can increase potential savings to 30% - 40%.

TENANT SYSTEMS

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ENERGY EFFICIENCY AND BUILDINGS

THE SPLIT INCENTIVE

HOW TO FIX IT

WHAT’S IN IT FOR TENANT AND LANDLORD

NEXT STEPS

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The most important factor affecting efficiency is who pays for it.

Full service gross

Modified gross Net lease

Owner pays for all core building operating and capital expenses.

Owner pays for capital and a “pool” of operating expenses.

Tenant pays all increases in the pool after the first year of the lease.

Tenant pays base rent and all operating costs defined in the lease, and may or may not pay for capital improvements.

Owner pays

Tenant pays

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In modified gross leases, tenants pay for a pool of core building operations as they exceed Year 1 of the lease.

CORE BUILDING SYSTEMS

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Tenant responsibility for capital expense is usually very limited.

• Only operating costs included as “Additional Rent”

No capital expense sharing

• Amortized to tenant by useful life (GAAP)

Capital expense sharing only for items that save

operating

CORE BUILDING SYSTEMS

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Split incentive affects most NYC buildings.

* 2003 leasing activity, Real Deal

Small Leases

Large Leases

Leases

Small Leases

Large Leases

Square Footage

In NYC, most of the square footage is in a modified gross lease.

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Landlord Operating

Costs (Up to Base Year)

Tenant Operating

Costs (Above Base Year)

Exp

ense

sEx

pen

ses

Why? Because it gives cost predictability to landlord and lender, expense review/control to tenant.

CORE BUILDING SYSTEMS

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Landlord Operating

Costs (Up to Base Year)

Tenant Operating

Costs (Above Base Year)

Expen

ses

But savings (e.g. from an energy retrofit) go entirely to the tenant.

CORE BUILDING SYSTEMS

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A typical project.

IMPROVEMENT SAVINGS COST

Bldg Control System $270,000 $1,000,000

Lighting $190,000 $450,000

Variable Freq. Drives $90,000 $550,000

High Efficiency Chiller $450,000 $3,000,000

$1,000,000 $5,000,000

Simple Payback 5 years

CORE BUILDING SYSTEMS

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Capital sharing restrictions substantially alter the economics – and GAAP requires silo’ing of measures.

IMPROVEMENT SAVINGS COST

USEFUL

LIFE

ALLOCABLE

RECOVERY(AT 7%)

Bldg Control System $270,000 $1,000,000 10 $142,378

Lighting $190,000 $450,000 7 $83,499

Variable Freq. Drives $90,000 $550,000 12 $69,246

High Efficiency Chiller $450,000 $3,000,000 25 $257,432

$1,000,000 $5,000,000 $552,554

Adjusted Payback 9 Years

IMPROVEMENT

TOTAL

SAVINGS TOTAL COST

Energy Retrofit Package $1,000,000 $5,000,000

Payback 5 years

CORE BUILDING SYSTEMS

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A building with 5 tenants, all modified gross leases with base years.

TenantsSquare

Feet Lease TypeLease End

DateCapital Expenditure

Sharing

A 200,000Modified

Gross 1/1/2013 Useful Life

B 200,000Modified

Gross 1/1/2015 None

C 200,000Modified

Gross 1/1/2017 Useful Life

D 200,000Modified

Gross 1/1/2019 None

E 200,000Modified

Gross 1/1/2021 Useful Life

CORE BUILDING SYSTEMS

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A building with 5 tenants, all modified gross leases with base years.

TenantsSquare

Feet Lease TypeLease End

DateCapital Expenditure

Sharing

A 200,000Modified

Gross 1/1/2013 Useful Life

B 200,000Modified

Gross 1/1/2015 None

C 200,000Modified

Gross 1/1/2017 Useful Life

D 200,000Modified

Gross 1/1/2019 None

E 200,000Modified

Gross 1/1/2021 Useful Life

CORE BUILDING SYSTEMS

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A building with 5 tenants, all modified gross leases with base years.

TenantsSquare

Feet Lease TypeLease End

DateCapital Expenditure

Sharing

A 200,000Modified

Gross 1/1/2013 Useful Life

B 200,000Modified

Gross 1/1/2015 None

C 200,000Modified

Gross 1/1/2017 Useful Life

D 200,000Modified

Gross 1/1/2019 None

E 200,000Modified

Gross 1/1/2021 Useful Life

CORE BUILDING SYSTEMS

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$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

0 1 2 3 4 5 6 7 8 9 10

E

D

C

B

A

Cumulative

Tenant 1 2 3 4 5 6 7 8 9 10

A $ 110,511 $ 110,511 $ 110,511 $ 225,102 $ 231,855 $ 238,810 $ 245,975 $ 253,354 $ 260,955 $ 268,783

B $ - $ - $ - $ - $ - $ 238,810 $ 245,975 $ 253,354 $ 260,955 $ 268,783

C $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 253,354 $ 260,955 $ 268,783

D $ - $ - $ - $ - $ - $ - $ - $ - $ - $ 268,783

E $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511 $ 110,511

Total $ 331,532 $ 331,532 $ 331,532 $ 446,123 $ 452,876 $ 698,643 $ 712,971 $ 870,573 $ 893,375 $ 1,185,644

Recovery 7% 13% 20% 29% 38% 52% 66% 84% 101% 125%

As leases turn over, the landlord recovers the savings, but still the recovery takes 9 years.

CORE BUILDING SYSTEMS

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29

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In other words.

The landlord drives one of these…

…and you pay for the gas.

But what motivation is there for a landlord to buy one? CORE

BUILDING SYSTEMS

One of these will do the job just fine.

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Sustainability Investment

Energy Savings ≠↑ Net Operating Income to Pay

for Capital Cost

This cost allocation problem is called the split incentive.

CORE BUILDING SYSTEMS

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• Incentives affected by the type of metering

TENANT SYSTEMS

• Incentives driven by the type of lease, e.g. gross, modified gross, net

CORE BUILDING SYSTEMS

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Cost allocation for tenant systems is independent of lease type, and usually carried by the tenant.

TENANT SYSTEMS

• Tenant pays utility directlyDirect Meter

• Owner bills tenant based on private submeter reading, usually marked up 2-12%

Submeter

• Per sf estimate of tenant electric costs included in the rent

Electric rent inclusion

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Under Electric Rent Inclusion, there is no connection between actual tenant usage and tenant electric bills.

Tenant Electric Charge

TENANT SYSTEMS

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An exercise: who pays, who benefits.

Submeter

Improvement Capital Cost

Savings

High Efficiency Boiler

Ventilation Fans

Tenant Lighting

Landlord Landlord

Landlord Landlord

Tenant Tenant

CORE BUILDING SYSTEMS

TENANT SYSTEMS

Full Service Gross Lease

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An exercise: who pays, who benefits.

Improvement Capital Cost

Savings

High Efficiency Boiler

Ventilation Fans

Tenant Lighting

Landlord Landlord

Landlord Landlord

Tenant Landlord

Electric Rent Inclusion

MISMATCH

Submeter

CORE BUILDING SYSTEMS

TENANT SYSTEMS

Full Service Gross Lease

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An exercise: who pays, who benefits.

Improvement Capital Cost

Savings

High Efficiency Boiler

Ventilation Fans

Tenant Lighting

Landlord Tenant

Landlord Tenant

Tenant Tenant

Modified Gross LeaseFull Service Gross Lease

MISMATCH

MISMATCH

Submeter

CORE BUILDING SYSTEMS

TENANT SYSTEMS

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An exercise: who pays, who benefits.

Improvement Capital Cost

Savings

High Efficiency Boiler

Ventilation Fans

Tenant Lighting

Landlord Tenant

Landlord Tenant

Tenant Landlord

Electric Rent InclusionSubmeter

MISMATCH

MISMATCH

MISMATCH

Modified Gross LeaseCORE BUILDING

SYSTEMS

TENANT SYSTEMS

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An exercise: who pays, who benefits.

Improvement Capital Cost

Savings

High Efficiency Boiler

Ventilation Fans

Tenant Lighting

Landlord* Tenant

Landlord* Tenant

Tenant Tenant

Modified Gross LeaseNet Lease

Submeter

CORE BUILDING SYSTEMS

TENANT SYSTEMS

* Landlord may be able to share capital cost with tenant – depends on degree of “net”

ENERGY EFFICIENCY AND BUILDINGS

THE SPLIT INCENTIVE

HOW TO FIX IT

WHAT’S IN IT FOR TENANT AND LANDLORD

NEXT STEPS

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The simplest solution to the split incentive – a full service gross lease.

Landlord

Retrofit Cost

Energy Savings

Management Responsibility

CORE BUILDING SYSTEMS

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If “modified gross” with a base year is unavoidable, lease must adjust capital recovery.

Operating Expenditure Clause

1. Additional rent may include amortization of capital items that save operating costs.

2. Amortization can bundle cost and savings of retrofit items (i.e. will notfollow GAAP “useful life” method).

3. Landlord may amortize the expense in an amount equal to total savings.

CORE BUILDING SYSTEMS

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And consider adding an “expense stop” to isolate energy use from other operating.

compels more careful measurement

savings not subsumed by rise in other operating costs

incentive for landlord to save to get below base year

CORE BUILDING SYSTEMS

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On the tenant side, submeter (!).

TENANT SYSTEMS

46TENANT SYSTEMS

If a submeter is infeasible, a landlord’s annual electric survey MUST:

Increases in rates

Additional electric systems

ENERGYSTAR

Daylighting

AC retrofits

BUT

REWARD

NOT JUST

PENALIZE

ENERGY EFFICIENCY AND BUILDINGS

THE SPLIT INCENTIVE

HOW TO FIX IT

WHAT’S IN IT FOR TENANT AND LANDLORD

NEXT STEPS

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If the landlord does not implement the project, there are no savings anyway.

Tenant retains savings

Project payback>5

years

Landlord cannot finance

project

No retrofit occurs

Landlord and tenant overpay for inefficient

building

X

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Retrofit may prevent rising usage and repair costs from increasing “Additional Rent” to the tenant.

Retrofit arrests rising cost of declining systems

Annual Operating Costs

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A good retrofit leads to better tenant comfort and operations.

• New technologies allow better control over temperature

• Fewer hot/cold callsTemperature

• New central building systems allow integration with tenant systems for smoother operations

Systems Integration

• Fixing inadequate building ventilation improving fresh air flow and tenant health

Ventilation

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$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

$4,500,000

Historical energy costs vs Post-retrofit costs

Year

Historical energy usage

Post-retrofit usage

After the project is amortized, it may generate a rent decrease for existing leases.

Used to pay for project

Shared between landlord and

tenant*

* Degree ofsharing depends substantially on turnover/renewal schedule

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Possible reduction in carbon offset requirements.

Tenant Operating

Contribution

Major Green Renovation

Reduced Emissions

Lower carbon offset

expense

• Tenants effectively pay for emissions reduction instead of high utility usage

• Fulfills corporate sustainability policies

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In return, tenants should expect reports on success of energy efficiency – they helped pay for it.

What is being expensed to me?

• An absence!

• LACK of energy use

What does that mean?

• Have to assess a counterfactual

• What would have happened if there were no retrofit

How do I do that?

• Compare real energy usage data from before and after

• Adjust for weather, occupancy

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Not all measurement methods are created equal.

• Measurement using manufacturer’s specifications (stipulated savings)A

• Measurement of new equipment operation in isolation from rest of building systems.

B• Measurement based on comparison

of actual “before and after” bills to reflect interactivity.

C

D • Savings measured based on actual “after” bills and a simulated “before.”

Leases should require disclosure of overall building resource use and ENERGYSTAR score.

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Tenants should ask for rigorous measurement and reporting of energy efficiency projects.

Ap

pro

ach Whole

building, before and after, actual metered usage

Met

ho

do

logy IPMVP Option

C and ASHRAE Guideline 14

Co

st < 5% total project cost and <7.5% savings

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Building Master Meters

Tenant Direct

Meters

And tenants should provide landlord with any separately metered usage.

ENERGY EFFICIENCY AND BUILDINGS

THE SPLIT INCENTIVE

HOW TO FIX IT

WHAT’S IN IT FOR TENANT AND LANDLORD

NEXT STEPS

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Apply these three principles.

1.Landlord should operate the building and tenant its premises as efficiently as is feasible.

2.Responsibility for capital expense and benefit of savings should reside with the same entity.

3.Consumption and demand for resources throughout the building should be measurable and transparent to both Landlord and Tenant

All of the savings from a system improvement should be available to pay for the improvement

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What can you do now?

1. Get buy-in from senior leadership to apply these principles.

2. Look for opportunities to change leasing approaches – upcoming renewals, new leases.

3. Ensure the term sheet for new space specifically calls out capital recovery equal to savings.

4. Consider adjusting an existing lease for these issues alone.

OBJECTIVES

1. To clearly identify the nature of the “split incentive” in commercial leasing.

2. To show in economic terms how the split incentive inhibits building retrofits.

3. To explain how to fix the split incentive.

4. To convey the importance of measurement and verification for purposes of fairness and building efficiency.

5. To establish the benefits for tenants of adjusting traditional approaches to capital and operating costs in commercial leasing.