This document discusses how the split incentive in commercial leasing inhibits energy efficiency retrofits in buildings. Under typical leases where tenants pay operating costs, landlords have no incentive to invest in efficiency since tenants receive the savings. The document proposes solutions like adjusting leases to allow landlords to recover capital costs from efficiency projects through operating cost savings or tying tenant costs directly to energy usage. Accurate measurement and verification of savings is important to ensure fairness. Overall efficiency can be improved by aligning the parties responsible for costs with those receiving the benefits through lease structures and transparency.

1. UNLOCKING ENERGY EFFICIENCY IN COMMERCIAL BUILDINGS Leasing Strategies Commercial Tenants Can Take to Make Buildings Energy Efficient

2. OBJECTIVES To clearly identify the nature of the “split incentive” in commercial leasing. To show in economic terms how the split incentive inhibits building retrofits. To explain how to fix the split incentive. To convey the importance of measurement and verification for purposes of fairness and building efficiency. To establish the benefits for tenants of adjusting traditional approaches to capital and operating costs in commercial leasing.

3. ENERGY EFFICIENCY AND BUILDINGS THE SPLIT INCENTIVE HOW TO FIX IT WHAT’S IN IT FOR TENANT AND LANDLORD NEXT STEPS

4. In dense urban areas, buildings are the principal source of energy use. CO2 Emissions by Sector, New York City 2005 *2005 Greenhouse Gas Emissions Inventory

5. Commercial buildings emit more than other types. CO2 Emissions from Buildings, New York City 2005

6. 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)

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

8. Most of the energy use comes from a building’s central systems. Efficient Building CORE BUILDING SYSTEMS Cooling 17% Core Building 50% - 60% Ventilation ± 10% dep on tenant cooling 13% Heating15% Conveying 5% Inefficient Building (30% + greater) Plug-ins (computers, appliances, etc) 27% Plug-Ins 27% Tenant Lighting 13% Lighting23% Core Building 59% - 69% ± 10% dep on tenant cooling Tenant Lighting 10% Plug-Ins 21% TENANT SYSTEMS

9. Improving these systems has a direct, measurable $ impact. “Green” Improvements LEED Existing Buildings - Operations and Maintenance Improvements that Save $ HVAC retrofits Variable Volume Chilled Water VFDs Green Globes Daylighting Demand controlled ventilation Digital controls

10. LEED and other green standards are not a requirement for saving energy and $. ≠ Energy Efficient

12. Controls, schedulingCORE BUILDING SYSTEMS

14. Retro-commissioning and tuning TENANT SYSTEMS

15. 20% - 40% savings! Why aren’t buildings getting fixed?

16. ENERGY EFFICIENCY AND BUILDINGS THE SPLIT INCENTIVE HOW TO FIX IT WHAT’S IN IT FOR TENANT AND LANDLORD NEXT STEPS

17. The most important factor affecting efficiency is who pays for it. Full service gross Modified gross Net lease Ownerpays for all core building operating and capital expenses. Owner paysfor capital and a “pool” of operating expenses. Tenant pays all increases in the pool after the first year of the lease. Tenantpays base rent and all operating costs defined in the lease, and may or may not pay for capital improvements. Tenant pays Owner pays

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

19. Tenant responsibility for capital expense is usually very limited. Typically OR CORE BUILDING SYSTEMS

20. Split incentive affects most NYC buildings. In NYC, most of the square footage is in a modified gross lease. Generally true, with some variations, in most urban settings. * 2003 leasing activity, Real Deal

21. Why? Because it gives cost predictability to landlord and lender, expense review/control to tenant. Expenses Tenant Operating Costs (Above Base Year) LandlordOperating Costs (Up to Base Year) Expenses CORE BUILDING SYSTEMS

22. But savings (e.g. from an energy retrofit) go entirely to the tenant. Expenses Tenant Operating Costs (Above Base Year) Landlord Operating Costs (Up to Base Year) CORE BUILDING SYSTEMS

23. A typical project. Energy Savings 30% Carbon Emissions Reductions 25% CORE BUILDING SYSTEMS

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

25. A building with 5 tenants, all modified gross leases with base years. CORE BUILDING SYSTEMS

26. A building with 5 tenants, all modified gross leases with base years. What can the landlord bill this tenant for the $5 M retrofit? Where do the savings go when the tenant’s lease is over? CORE BUILDING SYSTEMS

27. A building with 5 tenants, all modified gross leases with base years. What about this tenant? CORE BUILDING SYSTEMS

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

29. So what? It’s the landlord’s building. The landlord should fix it, right?

30. Yes. But the old systems still work , you can’t see them, and I can expense the rising cost to you.

31. Besides, to lease my building I need to spend on this...

32. In other words. The landlord drives one of these… …and you pay for the gas. One of these will do the job just fine. But what motivation is there for a landlord to buy one? CORE BUILDING SYSTEMS

33. This cost allocation problem is called the split incentive. Sustainability Investment ≠ Energy Savings ↑ Net Operating Income to Pay for Capital Cost CORE BUILDING SYSTEMS

36. Data Centers

37. Lighting

38. Sometimes ACTENANT SYSTEMS

39. Under Electric Rent Inclusion, there is no connection between actual tenant usage and tenant electric bills. Tenant Electric Charge TENANT SYSTEMS

40. A Thought Exercise WHO PAYS, WHO BENEFITS

41. An exercise: who pays, who benefits. CORE BUILDING SYSTEMS Full Service Gross Lease TENANT SYSTEMS Submeter Landlord Landlord Landlord Landlord Tenant Tenant

42. An exercise: who pays, who benefits. CORE BUILDING SYSTEMS Full Service Gross Lease TENANT SYSTEMS Electric Rent Inclusion Submeter Landlord Landlord Landlord Landlord Tenant Landlord MISMATCH

43. An exercise: who pays, who benefits. CORE BUILDING SYSTEMS Modified Gross Lease Full Service Gross Lease TENANT SYSTEMS Submeter Landlord MISMATCH Tenant MISMATCH Landlord Tenant Tenant Tenant

44. An exercise: who pays, who benefits. CORE BUILDING SYSTEMS Modified Gross Lease TENANT SYSTEMS Electric Rent Inclusion Submeter Landlord MISMATCH Tenant MISMATCH Landlord Tenant MISMATCH Tenant Landlord

45. An exercise: who pays, who benefits. CORE BUILDING SYSTEMS Modified Gross Lease Net Lease TENANT SYSTEMS Submeter Landlord* Tenant Landlord* Tenant Tenant Tenant * Landlord may be able to share capital cost with tenant – depends on degree of “net”

46. ENERGY EFFICIENCY AND BUILDINGS THE SPLIT INCENTIVE HOW TO FIX IT WHAT’S IN IT FOR TENANT AND LANDLORD NEXT STEPS

47. The simplest solution to the split incentive – a full service gross lease. CORE BUILDING SYSTEMS

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

50. savings not subsumed by rise in other operating costs

51. incentive for landlord to save to get below base yearCORE BUILDING SYSTEMS

52. On the tenant side, submeter (!). TENANT SYSTEMS

53. If a submeter is infeasible, a landlord’s annual electric survey MUST: NOT JUST PENALIZE BUT REWARD TENANT SYSTEMS

54. ENERGY EFFICIENCY AND BUILDINGS THE SPLIT INCENTIVE HOW TO FIX IT WHAT’S IN IT FOR TENANT AND LANDLORD NEXT STEPS

55. Why should I give up my claim to the savings? Aren’t I worse off?

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

57. Retrofit may prevent rising usage and repair costs from increasing “Additional Rent” to the tenant. Annual Operating Costs Retrofit arrests rising cost of declining systems

58. A good retrofit leads to better tenant comfort and operations.

59. After the project is amortized, it may generate a rent decrease for existing leases. Historical energy costs vs Post-retrofit costs Historical energy usage Shared between landlord and tenant* Used to pay for project Post-retrofit usage Year * Degree ofsharing depends substantially on turnover/renewal schedule

62. Not all measurement methods are created equal. •Savings measured based on actual “after” bills and a simulated “before.” International Performance Measurement and Verification Protocol (IPMVP)

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

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

65. And tenants should provide landlord with any separately metered usage.

66. ENERGY EFFICIENCY AND BUILDINGS THE SPLIT INCENTIVE HOW TO FIX IT WHAT’S IN IT FOR TENANT AND LANDLORD NEXT STEPS

67. Apply these three principles. All of the savings from a system improvement should be available to pay for the improvement

68. What can you do now?

69. OBJECTIVES To clearly identify the nature of the “split incentive” in commercial leasing. To show in economic terms how the split incentive inhibits building retrofits. To explain how to fix the split incentive. To convey the importance of measurement and verification for purposes of fairness and building efficiency. To establish the benefits for tenants of adjusting traditional approaches to capital and operating costs in commercial leasing.