We are often asked by tenants and landlords about the “split incentive problem” surrounding energy efficiency upgrades in tenant-occupied buildings.  This week, we are pleased to feature a guest blog by Justin Pless, an attorney specializing in real estate law at Pless Law Firm, LLC, addressing strategies to mitigate the split incentive problem.

Many landlords are enthusiastic about the possibility of tapping the potential benefits (especially in energy cost savings) of retrofitting commercial buildings with green improvements.  However, many of these same landlords are often reluctant to make building-wide energy efficiency improvements because, in most multi-tenant commercial buildings, the building owner will bear the cost of the improvements, while the building tenants will benefit from the resulting energy cost savings.  This problem has come to be known as the “split incentive” problem.  The split incentive problem can be mitigated by using lease pass-through provisions to shift the cost of building-wide energy efficiency improvements onto the building tenants who will ultimately reap the benefits of those improvements.

Most leases for space in multi-tenant commercial buildings provide that the operating expenses of the building, including energy costs, are passed through to the tenants, pro-rata to the percentage of space they occupy in the building.  Well drafted, landlord-friendly leases also typically permit certain capital costs to be passed through to the tenants as building operating expenses, including  capital improvement costs required by laws enacted after the date of the lease and capital improvements costs expected to reduce the building’s operating costs.

Because green building improvements will likely be designed to reduce the energy consumption, and thus the overall operating expenses of the a given building, landlords can likely pass through those capital improvement costs, on an amortized basis, under a provision similar to the one described above.  However, some leases may not permit the pass through of capital costs for certain improvements or may limit the amount of expenses which can be passed though, through a cap on controllable expenses, for example.  Accordingly, some landlords may not be comfortable undertaking a green retrofit project based only on the pass-through language contained in their existing leases.

If this is the case, landlords may seek to amend their leases to specifically permit the pass-through of costs of proposed green rehabilitation projects.  Such an amendment should specifically describe the energy efficiency improvements the landlord will make to the building and should provide for the tenants’ consent to the pass-through of those specific costs on a pro rata basis.  Such an amendment should also include language requiring the tenants to waive any claims of constructive eviction or business interruption related to the improvement work.  While not required to pass through costs, this language provides protection for landlords in the event that the improvement work interferes with the tenants’ business operations, temporarily prevents the occupation of any tenant space, or damages any tenant space.

Before beginning any green retrofit projects, landlords should carefully review their leases to confirm that necessary capital costs can be passed through to building tenants or attempt to amend their leases to specifically permit the pass-through of the costs of the proposed project.

Further details are necessary for a complete understanding of these subjects.  For that reason, the specific advice of legal counsel is recommended before acting on any matter discussed above.

Justin D. Pless

PLESS LAW FIRM, LLC

600 Seventeenth Street

Suite 2800 South

Denver, Colorado 80202

Office: 303.454.3712

Fax: 303.416.4231

jpless@plesslaw.com

www.plesslaw.com