Green Leases: the past, the present, the future

July 2006

Green Leases - the background

A revolution in property management

We are witnessing a revolution in property management. The development of skyscrapers post WWII heralded a new city skyline, and a new urban lifestyle. It introduced new technologies - air conditioning, engineering, construction, materials production etc. Building management systems developed and were refined, along with the ambition of projects, culminating in the grandeur (some would say extravagance) of some of the product of the 1980's/1990's.
Times though have not ceased to keep 'a changin'. The environmental movement has progressed with dire warnings of climate catastrophe, fears of potable water sources evaporating, waste ruining the land and over population exhausting the capability of the earth to provide food and accommodation. The environmental movement has moved from impact assessment to resource consumption: the question of the earth's biological capacity to sustain our consumption levels.
The challenge of this question is to be addressed by the property industry, and has resulted in a revolution in interpreting the value of buildings. It is causing a reassessment of the materials being used, the energy expended, the water consumed, the waste produced and buried. The new focus is on the interior of buildings, how they work, what minimises their footprint and maximises their liveability - for the occupants and the world as a whole.

The Drivers for Change

There are many drivers for making the change, and of course many barriers.

Money Some landlords see capital increase in building value for greener product. "Implementing initiatives with a sustainability focus in existing buildings can result in significant increases in capital value of up to 10.67% , according to Jones Lang Lasalle. Significant reductions in operating costs can result .

Future proofing An alternative assessment of the drivers for change advocate the need to future proof a building for market position .
Matters for consideration include:

- Demographics - building owners (and employers) will compete to attract a diminishing workforce which is younger, more affluent and mobile (the 'Y' Generation) by offering more eco-friendly buildings
- OH&S - an associated impact is the increased liability for OH&S risk on the part of both building owners and employers
- CSR - the increase in corporate concern for CSR issues, bolstered in part by the demand for greater transparency in reporting and accounting
- Future energy prices - the possibility of price rises for water, electricity, oil and related essential resources upon which the economy is founded, whether the price rises occur by regulation or global economic influences
- Regulation - the continuing possibility of direct government intervention requiring improved performance, as well as the government imposing its own standards for leases in the administration of its portfolio
- other - ethical investment opportunities, higher tenant retention, lower risk and relative insurance costs, reduced capital costs
The Emerging Market
The uptake of green is starting. New buildings are coming on stream, and there has been some experimentation in refits. The "Early Majority" is ready to move , and other projects have gained prominence, e.g. The Bond, the National@Docklands, Ernst & Young Centre, CH2, 40 Albert Road, Melbourne, Brindabella Circuit at Canberra International Airport, Bordo International Pty Ltd Headquarters in Scoresby, Victoria, RAAF 36 & 37 Squadrons' headquarters at Richmond, 151 Pirie and City Central Tower 1 in Adelaide, 500 Collins Street, Melbourne.

In parallel, government policy is an influence.
New South Wales Existing tenancies > 1,000m2 to be 3 star ABGR by 1 July 2006, where to do so is "cost effective" (if they provide a minimum 12% rate of annual return (for example, from resulting energy cost savings)).
As tenant, the NSW government will give preference to buildings with a 3 star ABGR or better, increasing to 3.5 stars from 1 July 2006. Substantial fit-out by government tenants will also be designed with an intention of meeting a 4.5 star standard.

Commonwealth Recently reviewed Green Lease Schedules propose that landlords where the Commonwealth Government is a tenant will have to achieve a 4.5 star ABGR.
The Evolution of Green Leases
The Past
Early green leases were inspirational for their time, but more detailed understanding of the issues has revealed a need to be more sophisticated.
- The 60L Lease - the ACF headquarters in Leicester Street, Carlton in Melbourne
- Established with high ideals, this lease remains the grandfather of green leases, being as all encompassing as possible to maximise environmental outcomes.
- Critics have suggested it is too reliant on the building technology, and is not sufficiently flexible in its approach to building management.

- The NSW Police Headquarters at Parramatta
- A net lease obliging the lessor to achieve a 4.5 star ABGR rating, with minimal obligation on the lessee.
- A failure to do so results in the lessor paying the cost differential of outgoings.
- Critics suggest that 24 hour usage of the building makes the ABGR rating very difficult to achieve.

The Present
There are 2 main factors influencing the present state of the market for green leases.

A Young Market

The youth of the green property market is reflected in the wide variety of what constitutes a green outcome, or sustainable development. Many are concerned that it involves meeting every target for triple bottom reporting purposes, whatever the cost. Others dismiss the costs as excessive, providing too slow a return on investment. Others decry the lack of evidence supporting the productivity gains claimed for greener buildings. Others regard green simply as current best practice. Others simply don't know if the built form can address the certainties of climate change and water resource depletion forecast by science.

Whatever the case, the debate in the property industry has widened, and many companies have begun the journey of understanding and exploration of sustainable development and portfolio management. ABGR boasts a 40% take up of office space in NSW and a 20% take up in Australia.

In addition the property industry is gaining an appreciation of the new technologies that can be exploited for greener outcomes. The expertise needed to exploit those technologies is beginning to emerge, but is not commonplace. How green outcomes are influenced by the inter-relationships between stakeholders in property management is gradually being discussed (for eg the roles that the owner, tenant, building manager and contractors have in achieving waste reduction). The industry is still assessing what the benefits are - weighing up the cost savings against the capital outlay, assessing the value in future proofing a building along green lines, and assessing the brand potential of green credentials.

The relative youth of the market means that:

- the costs of implementing green strategies can be unknown or misunderstood, or even high for those who might pioneer a new way of doing things; and
- there is not yet a great deal of competition in the market place for green leased space

As a result, the impetus for negotiation of rigorous green obligations is still developing.

A lease deal is far less likely to fall over due to disagreements over green issues than for the more usual commercial issues. Very few lessees are insisting upon green benchmarks as a precondition to entry, and very few landlords are insisting that the tenant comply with detailed and costly environmental controls.

How Green is Achieved

The market has also begun to realise how complex the issue can be, as there are a number of different players which might constrain the capacity of a lessor or lessee to achieve green targets.

Some green aims are better achieved through competent building management, while others might involve capital expenditure on either the base building or tenant fit out.

Building these requirements into a lease requires a degree of co-operation and sophistication. The example above of waste management is relevant here: the lease and associated contracts (for building management, cleaning and waste collection) will need to address how the various parties' roles in the building are co-ordinated to produce a desired outcome.

Overall a balance needs to be struck between:

- a collegiate approach, under which the parties might set out desired outcomes and even defined measures to achieve those outcomes, but place less emphasis on who is responsible for implementing measures or correcting a failure to achieve outcomes
- a coercive approach, under which the parties specify with greater emphasis who is responsible for implementing measures or correcting a failure to achieve outcomes

The shift from collegiate to coercive will occur when one of the parties holds the achievement of green outcomes in high regard, in a marketplace where there is competition for lettable floor space. For example:

- if a party gains a great deal of brand importance for green credentials, it may be able to insist upon a tenant complying with set green benchmarks
- if a government department proscribes a certain ABGR base building rating as a prerequisite to the government taking up a tenancy then the lease will need to pay attention to how the ABGR base building rating is maintained in the context of the ongoing operational issues associated with the tenancy

The Future

If the drivers for green property management discussed above are as effective as many suggest they will be, then the market place will, in due course, achieve a critical mass which will see the emergence of more detailed (and possibly coercive) forms of green lease.

The Commonwealth Government's draft Green Lease Schedules represent a move towards the coercive form of green lease. While they propose a mutual approach to the establishment of green priorities (dealing primarily with energy consumption) , they also propose appropriate cure periods, combined with expert determination of disputes, with the cost of compliance falling to the defaulting party.

Creating a Green Lease

The uncertainty in the marketplace about what constitutes 'sustainability' or 'going green', and the variety of 'green' measures that might be adopted in a building mean that anyone aspiring to establish a green lease needs to go back to basics. What do the parties want out of the deal is a question that needs to be asked anew.

The particular nature of the issues in green leases requires a fresh examination of the elementary considerations that will form part of the lease obligations, in addition to the more common commercial matters such as rent, market review and valuation, maintenance issues (structural or otherwise) , make good, quiet enjoyment, fit out etc.

Considerations in developing a green lease include:

- Knowing what you want out of green

The multiplicity of "what green might mean" requires parties aiming for green outcomes to be clear on what it is they are seeking to protect or achieve. What is it the landlord or tenant is trying to achieve for itself, or what are the mutual ambitions of both parties? Is it:

- market position;
- brand position;
- compliance with standards (eg an ABGR rating);
- a comprehensive green result (eg cover all issues by a Greenstar rating) or only certain specific outcomes (eg energy and water reduction targets);

- Knowing where the parties are when the lease starts

If the parties want to improve energy consumption, then undertake an energy audit at the start of the lease. This is axiomatic to measurement of any particular benchmarks that the lease might stipulate.

For example, if a landlord promises a base building ABGR rating, the tenant will need to have evidence of the rating before the relevant lease provisions take effect.

This would also include agreeing on the particular benchmark to measure performance, both at the start of the lease and during its term. This could be by reference to one or more of a number of possible rating tools that are being developed in the market, or by matters specifically upon by the parties.

- Knowing how to get there - technology and building management

What technology or product is available to achieve results? Chilled beams, waterless urinals, etc. Some methods will require management, others capex, other maintenance costs. Some methods will place greater responsibility on the landlord, others on the tenant.

The lease may:

- simply apportion responsibility
- establish mechanisms to apportion responsibility, such as a building management committee (BMC), with agreed rules about the extent to which the parties will be bound by BMC decisions and commit funds to the measures it decides ought be taken

- Knowing who gets the benefit

Cutting costs will resulting costs savings. Are there NSW Greenhouse Abatement Certificates (NGAC's) to be had? Who gets the benefit?

- Knowing where you have got to

Auditing the outcomes will be important in:
- addressing shortcomings
- fixing the remedies for failure to achieve any particular benchmark

Parameters for the green lease

Once these elemental issues are clarified for the parties, the scope of the green lease becomes clearer.

In general there are 2 broad forms of green lease that might be established:

(a) an issues specific lease - where the parties want address a set number of issues, not the whole spectrum of sustainability. For eg the parties want to address issues of waste, energy efficiency and water management.
This arrangement has the best chance of working well where the issues to be addressed are readily measured and responsibility for them is clearly defined and readily distributed. For eg:
 the building has achieved a particular base building performance rating (eg 4 stars ABGR) and the parties want to ensure that ongoing operations and fit out works do not detract from that rating, which requires committed action by landlord and tenant;
 one or both parties want to achieve a certain rating and want to ensure that the other assists in maintaining that rating, eg a NSW government tenant will not enter into a lease for a building that is less than 3 stars ABGR;
(b) the complete package - where the parties commit to achieving a comprehensive green result for the whole building, either by reference to a rating tool (eg Greenstar), or by criteria agreed between them and set out in a scheduled document (such as an environmental management plan).
This arrangement has the best chance of working well where there are only a few organisations involved in the building. For e.g.:
 the building is owned and tenanted by related companies (eg a holding company and an operations arm of a corporate group). In such a case there is great commonality of interest; or
 there is one landlord and one tenant for the building (as opposed to an office block with 20 floors of different tenants with divergent interests). For eg, in the Bond, the building was purpose built by the tenant for the landlord, and occupied by the tenant, again creating a unity of interest.

Benchmarks and KPI's

Once the scope is clear, benchmarks can be developed and responsibility for their achievement apportioned.

The following table is suggestive of the types of benchmarks that might be referable to the landlord and the tenant, depending on the detail to which the parties want to go. The list is by no means exhaustive:

Facility KPI - Landlord Tenant
Energy issues
Air conditioning Base building level to be set at particular fresh air component;
A/C to be totally clear of germs such as Legionella etc
Lighting Base building level to be set at particular lux or light power level, eg Lighting power density of less than 7W/m2 for 320 Lux
Base building to have specific type of lights Fit out lighting to be set at particular lux level;
Fit out to have specific type of lights
Other energy needs Base building to achieve specified ABGR rating Fit out to achieve specified rating;
Fit out to operate within overall ABGR rating;
Specify computer screen types;
Specify demand management standards;
Water
Water supply Base building to minimise leaks;
Base building appointments to have set levels of water usage eg flow regulators on taps; Fit out to minimise leaks;
Fit out to have set levels of water usage eg flow regulators on taps;
Toilets Base building appointments to have set levels of water usage in toilets (eg waterless urinals, dual flush etc; Fit out to have set levels of water usage in toilets (eg waterless urinals, dual flush etc;
Showers Base building appointments to have set levels of water usage in showers, eg AAA rating heads; Fit out appointments to have set levels of water usage in showers, eg AAA rating heads;
Waste
Collection/separation/
management Landlord to incorporate recycling strategies in waste collection contracts to met outcomes agreed with tenant;
Base building to minimise waste (eg reuse of base building carpet tiles)
Tenant to promote agreed waste management outcomes, eg by separated/commingled waste streams;
Fit out to minimise construction waste;
Fit out to minimise/exclude use of non-plantation timber;
Indoor Environmental Quality
Air quality from a/c As above As above
Paints etc Base building to minimise/
exclude use of Volatile Organic Compound (VOC) paints and adhesives; Fit out to minimise/
exclude use of Volatile Organic Compound (VOC) paints and adhesives;
Natural lighting Base building to meet standard for daylight transmission amount or quality of window glass;
Base building to maintain set external solar control systems on windows (if any)

It is also possible in some leases (more appropriately for a complete package lease, to incorporate an environmental management plan which sets out the benchmarks to be achieved, and those of a less certain kind which the parties will use their best/reasonable endeavours to achieve.
In addition, the lease may need to specify the means by which performance against the benchmarks is measured, whether by separate metering or other ways.
Apportioning the benefit - agreeing the base level outgoings
There are often tangible benefits to be derived from achieving many benchmarks. For eg, an increase in energy efficiency leads to reduced energy costs.
However, before the parties apportion who takes the benefit of achieving any particular benchmark, they need to agree on the financial base they are working from.
If the benefit to a tenant organisation of occupying a 'green building' is in positive brand recognition then agreement needs to be made on the value of this, apportioned to the level of building environmental performance.
In the case of investing in environmental upgrades such as a new lighting system, the parties may want to apportion the decrease in outgoings that results from implementing those measures, they have to agree on the base outgoings level prior to implementing the fit out, whether in the context of a gross or net lease.
Typically in a gross lease, the outgoings are incorporated within the rent for the base year, and increased as the term of the lease progresses. To accommodate a green lease which wants to apportion the benefits of a particular benchmark, the base year outgoings will need to be agreed upon, and the means by which the rent will be altered in the event of a benchmark being achieved.
In a net lease, the tenant pays a set rent and whatever outgoings are proportional to its use. Again, the base level outgoings which will be used to apportion any benefit derived from a particular benchmark will need to be agreed between the parties.
It may be difficult to agree on the base level, because:
 the building may be new (or newly refitted), so there are no figures upon which the base calculation can be made;
 the base figures can only be referable to outgoings derived from use of the premises without the implementation of the agreed green measures. The parties will want to refer to a benchmark which best results in a win for them. For eg, a tenant seeking to pay a reduced energy bill will want to have a benchmark set by reference to prior reckless energy consumption, so that the savings achieved by installing energy efficient lighting will appear greater.
The parties agreement, they utilise some form of expert determination of the benefits, as described below, unless that is too cumbersome in the pre lease negotiations.
Compliance and Breach Issues
The lease provisions incorporating the benchmarks will be easier to enforce where the benchmarks are clear. The level of remedy available under the lease will depend upon the commercial importance of the particular benchmark which is not being met.
In such circumstances conditions could be enforced as follows:
(i) in respect to the landlord's obligations:
If the landlord fails to achieve a specified benchmark, then the tenant has a right to require it to be remedied within a period set by the lease, by notice in writing to the landlord.
If the landlord then fails to rectify the breach within the notified period, the tenant has rights to the likes of:
 fix the breach and claim damages from the landlord (whether by reduced rent/outgoings or other mechanism);
 rent abatement;
 reductions in outgoings contributions;
 termination of the lease;
 possible damages.
(ii) in respect to the tenant's obligations:
If the tenant fails to achieve a specified benchmark, then the landlord has a right to require it to be remedied within a period set by the lease, by notice in writing to the tenant.
If the tenant then fails to rectify the breach within the notified period, the landlord has rights to:
 fix the breach and claim damages from the tenant (whether by additional rent/outgoings or other mechanism);
 increased rent/outgoings payment;
 termination of the lease;
 possible damages.
In many case damages may be difficult to assess. They may include the cost of extra outgoings incurred by the failure to maintain energy efficient benchmark, but may also encompass the cost of capital works to improve performance and even damage to reputation (possibly by reference to a liquidated amount).
The importance of reporting and auditors
The ability of both parties to report on compliance with benchmarks is crucial to achieving agreed benchmarks.
The lease needs to contain cost effective mechanisms for reporting, both on a regular and exceptional basis, to bring issues to the attention of the other party. It may be prudent to set up procedures in a building management committee structure to manage ongoing micro issues, or to have the building manager as a central point for communication and information transfer.
This may involve a novel transparency on accounts for such matters as energy and water consumption, or extend to more detailed auditing of benchmarks by consultants or rating tool assessors. It may also involve new forms of metering for clear measurement of performance.
The technical nature of many matters may also require periodic auditing of specified benchmarks to ensure ongoing compliance with the lease. For example, a building may need to be audited annually to ensure that it continues to meet the 4 star ABGR rating.
These audits can be conducted annually (or other period), or pegged to a specified lease event, such as rent review. As with expert appointments, the auditors will need to be briefed according to the lease, listing either essential or comprehensive considerations.
The cost of the audit will need to be apportioned under the lease. There are any number of ways of apportioning the costs, whether they are shared equally or paid (in whole or part) by a party found by the audit to be in default in some regard.
Dispute Resolution - Experts
Green building issues are often technical and require a level of expertise that is currently beyond the experience of most landlords and tenants. In addition, many of the requirements for green leases such as annual certification of star ratings or measurement of energy efficiency, require specialist auditing services.
Given the technical nature of the issues, it will be prudent to build the involvement of an independent expert into a lease mechanisms:
 to clarify if there is a breach - it may be that a breach which is alleged to have occurred has not actually occurred;
 to apportion responsibility for repairing a breach;
 to determine the best means of remedying a breach;
 to settle the dispute.
For example, if the landlord is required to maintain a 4 star ABGR base building rating, and does not, then an expert will need to assist the parties to determine:
 if the landlord was responsible for the failure to maintain the rating, or whether there was some other cause recognised by the lease (such as over consumption of energy by another tenant);
 the extent to which the landlord was responsible for failing to meet the 4 star rating;
 what works need to be undertaken to regain the 4 star rating;
 what increase in outgoings resulted from the failure to maintain the 4 star rating;
 other technical aspects of the dispute that become relevant under the lease terms.
This will involve careful and detailed briefing of the expert, in much the same way as a valuation expert is briefed to determine market rent in some leases. It may be prudent for the parties to stipulate in the lease what matters the expert might consider in making a determination. The list of considerations could be minimal matters that need to be considered (while recognising that the expert may consider other matters), or a comprehensive scope for the expert.
The selection of the expert needs to be carefully considered, as the novelty of much of the technology surrounding green leases may mean that not very many people are sufficiently expert to assess the performance of a particular item of plant or equipment.

For further information, please contact:

Robert Wilcher
Partner
Tel: 02 9239 4517
Email: rwilcher@hgr.com.au

Tony D'Agostino
Partner
Tel: 02 9239 4505
Email: tdagostino@hgr.com.au

Level 26 Chifley Tower, 2 Chifley Square SYDNEY NSW 2000 hgr.com.au