Green Leases and the Split Incentive Problem

As mentioned earlier this week in our “Ask the Expert” interview with leasing expert Katie Murphy, one of the obstacles confronting green leases is the “split incentive problem.” In typical modified gross leases, the landlord must pay for major capital expenses such as energy retrofits, but most of the savings from reduced energy usage are realized by the tenant. Even when a lease permits the landlord to pass some of the improvement costs to the tenant as an operating expense, the landlord may be limited to amortizing those costs based on the useful life of the improvement. In addition, actual energy savings are difficult to measure, and tenants are often suspicious of a landlord’s savings estimates, making the recovery of such costs even more difficult.

The New York Mayor’s Office of Long Term Planning and Sustainability (OLTPS) recently assembled a group of real estate professionals to discuss this problem. The group examined industry experience and found that actual commercial energy savings for retrofits usually fall within +/-20% of the predicted savings. The group concluded that a landlord’s cost recovery for energy retrofits should be based on predicted energy savings, but that tenants should also be protected from under performance.

The OLTPS has developed model lease language to align the interests of tenants and landlords hoping to mutually realize the benefits of energy retrofits. To see the OLTPS’s presentation, including model lease language and financial models, click here.

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