A Chance to Address Carbon Reduction in NYC Office Leases
Just months before the COVID-19 pandemic abruptly shut down the world, and brought with it an over 90% reduction in occupancy in New York City commercial buildings, the New York City Council passed a suite of environmental legislation: Local Laws 92, 94, 95, 96 and 97.
Local Law 97 mandates carbon reduction goals for office buildings exceeding 25,000 gross leasable square feet and, as such, constitutes a municipal Green New Deal in the truest sense of the term.
The law sets, as its primary goal, a citywide 40% reduction of carbon emissions by 2030 and an 80% reduction by 2050, as benchmarked against 2005 calendar year output, with actual reduction requirements beginning as early as 2024.
These ambitious goals will require a meaningful change in the way commercial office buildings are occupied and operated over the ensuing years. The mere magnitude of the objectives will require immediate and careful strategic planning by owners, building managers and tenants.
At the same time, as landlords and tenants emerge out of the COVID-19 suspension, tenants will be rethinking strategically their space needs and occupancy requirements, which strategies will be informed, at least in part, by the learning and societal changes left in the wake of a pandemic unprecedented in our lifetimes.
The primary and collateral lessons from COVID-19, are many.
Certain industries — law and accounting, to name just two — realized that less than 100% of the office space they leased was needed to effectively run their businesses effectively. We also learned that lower building occupancies did not often correlate with comparable reductions in energy output and cost.
Months of plug load mismanagement consumed wasted energy. Offices were inefficiently configured and sized — a realization which began before the pandemic. These changes, however, particularly on such wide scale, create for us a fortuitous opportunity.
The pause button, pressed in March, 2019, presents landlords and tenants with a unique opening to address effectively the daunting mandates of carbon reduction prescribed by Local Law 97 and achieve other, environmentally sound use and occupancy practices in urban office buildings.
The Performance-Based Lease
To help achieve these goals in the commercial leasing market, transactional attorneys and brokers are advised to work with agreements emphasizing a collaborative landlord/tenant relationship in certain key areas that make economic sense, while moving away from traditional, inefficient, split-incentive approaches to operations and building management.
Recently, the Institute for Market Transformation produced a performance-based lease that seeks to achieve the objectives of carbon reduction and sustainable development by modifying certain, targeted, operational, payment, reporting and compliance provisions in a typical commercial lease to create a more partnered approach to remediating the environmental impact of office building operations.
Ultimately, the performance-based lease seeks to create a shared effort in working toward carbon reduction and, in doing so, yield efficiencies by landlords and tenants working together in what were traditionally areas driven by independent, and often unaligned, economic agendas However, like any change agent, to be effective, the performance-based lease will need to be absorbed by the commercial leasing market.
The success of that absorption will, of course, depend on a myriad of factors, which will likely include challenging societal objectives such as reduced carbon output. Toward that effort, below are some fundamental ideas common to any performance-based lease.
Carbon Reduction and Capital Improvements
The overriding feature of any performance-based lease is the prioritization of carbon reduction in building occupancy and operations and promotion of sustainable construction.
To achieve the mandates of Local Law 97, commercial office building will require deep retrofitting or complete replacement of enormous elements of their base building heating, cooling and electrical systems.
At the same time, COVID-19 has caused a renewed focus on ventilation and ambient hygiene in the workplace. The confluence of these factors will result in major capital improvement costs, largely unanticipated by the market.
As part of a tenant's obligation to pay its proportionate share of operating expenses, a typical office lease will pass through to tenants certain, limited types of capital improvements as building operating expenses.
Generally, capital expenses that result in cost savings to overall building operations and capital expenses incurred due to the enactment of laws following the commencement date of the lease are absorbed by tenants proportionately, on an amortized basis over the term of the lease, or the useful life of the improvement.
A performance-based lease would add to these two buckets of capital expenses those incurred to retrofit, upgrade or replace building heating, ventilation, and air conditioning systems to comply with governmental carbon reduction mandates, including, in the case of New York City, compliance with Local Law 97.
While market forces ultimately may discount of inflate the value of such a pass-through, it's an expense the market must be prepared to absorb now and with much greater focus and precision than in the past.
Initially, landlords may need to offset this pass-through expense by adjusting other components of the overall rent package, for example by allowing for an additional half month of free rent, a 10% greater tenant improvement allowance, shorter term, etc.
On the other side, as an increasing number of business, nongovernmental organization and not-for-profit tenants focus on environmental, social and governance goals, tenant management teams should become less resistant to these types of costs items in conducting their businesses.
Capturing and Sharing Information for Accountability
Central to a performance-based lease is the notion that all parties need to be on an even playing field in the sharing of information and data as it relates to energy consumption and the building mechanical and utility systems that are energy dependent.
While this requirement coincidentally comports with a trend in corporate culture toward greater transparency and accountability, information flow between landlords and tenants is particularly important in achieving the efficiencies necessary to reduce carbon production and construct sustainable buildings in any meaningful way.
While tenant energy consumption today is often captured in submeters measuring electricity usage, landlords under a performance-based lease would install submeters to capture common area consumption.
This information would be shared by building management with tenants to help verify that landlords are optimizing efficient base building energy systems while providing backup to tenants for certain operating expense charges otherwise only discoverable in an audit of the landlord's books and records.
Such information access will also support the shared responsibility of landlord and tenants to comply with carbon reduction requirements, as tenants are held accountable, through submeter readings and data, for the exclusive and direct pro rata impact of their excessive energy usage.
Ultimately, to effectively facilitate information exchanges, landlords and tenants should be required to designate one or more individuals from each camp as carbon wardens to interface on all carbon reduction and sustainability matters under the lease.
While sustainable building construction practices have long been in place in certain portions of the marketplace, such designated parties will advance the monitoring of compliance with these practices as landlords and tenants establish greater efficiencies and more effective oversight procedures as they relate to all building construction.
Periodic Recommissioning and Assessments
The ability to garner and share information is fundamental to the ability of landlords and tenants to evaluate, at appropriate intervals, their own best practices as they relate to consumption of energy and evaluate ways to improve efficiencies and reduce carbon load.
To this end, the performance-based lease will require a periodic (every 3-5 years) commissioning or recommissioning of a tenant's space as it relates to operational elements like plug load consumption, nighttime/off-peak utilization and optimal functionality, all of which will be aimed to reduce energy consumption and carbon emissions.
Landlords would meet with all tenants and review energy use data, recommissioning outputs and recommendations, and the effectiveness of efficiency programs and mutually establish an energy optimization plan, including energy management and cost-effective savings opportunities for the building and each tenant premises.
The cost of any changes or alternations to the base building heating, ventilation, and air conditioning, or lighting systems and their controls due to the recommissioning could initially be borne by the landlord and billed as an operating expense.
Building management would devaluate specific commissioning standards of building common areas, at several year intervals, and update the building standards as may be appropriate. At a minimum, recommissioning will address heating, ventilating, air conditioning and refrigeration systems and associated controls, lighting and lighting controls, plug loads, and domestic hot water systems.
Landlords would be required to share building-wide energy performance ratings with all tenants in an effort to compete in a marketplace increasingly driven by a compliment of stakeholders and constituents with environmental concerns.
A performance-based lease should result in tangible value to all parties involved by helping landlords and tenants of commercial space achieve the newly enacted and challenging mandates relating to carbon reduction.
The added emergence of the corporate environmental, social and governance mindset and the growing awareness and acceptance of those in national leadership of the needs for carbon reduction should comport with this effort.
While this approach indeed is timely, we are also in an opportune time. As we progress through the early 2020s, significant and permanent changes in the urban office leasing market are inevitable.
We would be well served to leverage the opportunity granted by the COVID-19 pause button and reenter this new marketplace with a lease form that addresses these new challenges facing building ownership and all space users now and for years to come.
“A Chance to Address Carbon Reduction in NYC Office Leases,” by Stuart D. Kaplan was published in Law360 on February 19, 2021.