Even Lease Language Is Going Green: How Cost Of Compliance Has Become Another Negotiation

Building owners and managers across the country are racing to upgrade buildings to meet increasingly stringent emissions restrictions and rising demand for sustainable office space. But meeting those targets requires collaboration between operators and tenants. 

Enter the green lease.

“It’s very difficult for a building to meet a performance standard if the tenant and landlord aren’t working together,” said Marla Thalheimer, senior director of business engagement at the Institute for Market Transformation, or IMT, a nonpartisan nonprofit focused on building sustainability. “The need is becoming essential.”

Green leases have been around for more than a decade. But the increasing number of local emissions laws, such as Local Law 97 in New York City, have made the use of, and negotiations around, such agreements more frequent and ultimately more vital.

There’s also significant unmet demand for such space; JLL estimates there’s 23M SF of LEED-certified office space, not close to meeting the 310M SF occupied by the top 20 office occupiers, who have 2050 net-zero carbon emissions targets. 

Getting there is expensive. The split incentive issue, where tenants benefit from owners' investments in sustainability, may not work if said owners can’t afford to make sufficient investments on their own. 

Thalheimer said the increasing risk of landlords accruing fines for emissions violations means both tenants and operators need to establish clear guidelines and agreements around responsible energy use and the responsibility around fines. If a landlord in violation is pushed to pass along that extra financial burden to tenants, it doesn’t benefit anybody, Thalheimer said. A recent JLL report on green leasing calls the current leasing system “one of the greatest challenges” to building decarbonization.

The IMT has offered a green lease program since 2014, and it has seen applications grow 390% since the initiative started. The concept isn’t new but it’s gaining traction, IMT Associate Director of Business Engagement Diana Lee said. More and more applicants are coming in from Canada, Europe and Australia, and the concept is expanding from office to industrial, retail and even multifamily. 

There is no standard version of a green lease, JLL Senior Managing Director of Value and Risk Advisory Steven Schleider said, though there are some sample documents from groups like Building Owners and Managers Association International. That means the entire agreement requires a negotiation that he says varies building by building. Traditionally, these agreements have been “owner-led, compliance-based contracts with boilerplate clauses around energy, water and waste,” per the JLL report.

Schleider sees the increasing need to either share the burdens of green retrofits, or verify the compliance of tenants and property owners, as something that will spur creative solutions. Owners without an occupier engagement strategy spelled out in a green lease don’t have a complete sustainability strategy. 

“New forms of business models need to be thought through,” he said.

In New York City, where Schleider is based, the onset of Local Law 97, which requires checking emissions beginning next year to levy potential fines in 2025, has made these negotiations all the more important. It helps that, as Schleider says, “city council has expressed militancy around pursuing these fines,” so lack of compliance may translate to a fine that will need to be paid.

He views the transition toward adopting green leases as market forces at work. Cities want to accelerate a green transition, and the mandates, especially those with teeth like LL97, will push the process along.

“It’s a challenging market so it’s a bit new,” Thalheimer said. “It’s about realistic expectations, and landlords setting realistic expectations with the tenants.” 

Green leases aren’t separate documents from the standard landlord-tenant agreement. The language will be incorporated into existing documents and familiar types of agreements.

Schleider believes the cost of compliance may be structured like a modified gross lease, with landlords and tenants sharing the operating expenses, fines or capital expenses, or it will be a triple-net lease, where occupier or tenant pays for everything via its occupying profile. High-demand users, like trading floors or data centers, will likely have much different terms than traditional office tenants. 

The most important parts of these agreements, according to IMT’s Lee, is the cost recovery clause. This legal language outlines the split incentive between the landlord and the tenant, and it typically includes sharing of utility data. If a landlord makes investments to cut emissions, and a particular tenant grossly overshoots its emissions target, then, as per the cost recovery clause, the resulting fine would be paid in part by the tenant.

It also mandates that whatever money a landlord puts into building upgrades will, in part, be recouped by contributions from the tenant. It also spells out a landlord’s responsibility in the case of tenants who are very strict about meeting net-zero standards or only leasing from sustainable landlords.

IMT argues that the next phase, performance-based standards, will push the tenant and landlord relationship even further. JLL, in a recent Green Leasing 2.0 report, made a similar argument, positing that the necessity of emissions reductions meant a new approach was needed, one that wasn’t as adversarial. JLL estimates 1.2B SF of office space, and 2.5B SF of industrial space will experience a lease expiration before 2030; green leases for all office property could, by itself, save $3.3B while also cutting the environmental impact of the built environment. 

These documents and agreements also come during a time of increased awareness and transparency over building energy emissions. Brokers and real estate teams are tracking property records and emissions data, keeping track of retrofits and potential fines, and how they might impact loan coverage and lease terms. And the General Services Administration, which controls federal real estate investment, aims to get a majority of its buildings to net-zero by 2030, meaning more of their tenants will need to sign green leases going forward.

One of the challenges is getting mom-and-pop landlords, especially those running Class-B and C office space, to get educated and updated on these types of leases. 

“There’s so many people racing to figure it out,” Thalheimer said. “There’s no escaping it.”