14 June 2010 – The new mandatory disclosure regime for office buildings is about to shake up the industry and ratchet up the focus on energy use in existing buildings. However, new green developments will also face huge challenges, especially when they are subject to commitments to pre-lease space.

How are green standards for these developments agreed, and what are the cost implications? This will probably be manifested in some form of green agreement to lease and lease schedule between developers and tenants.

But the big questions are: what are the issues in these forms of leases; and what remedies are available to the tenant if the building’s promised green performance is not delivered?

Rating Tools
The industry has generall come to grips with the industry’s main rating tools –  NABERS and Green Star. In simple terms the key distinguishing features between these two rating tools is that NABERS is based on actual performance of buildings – to date mainly energy and water and Green Star is about the attributes of the building covering a more holistic range of environmental outcomes in the design and the “as built” phase.

NABERS energy ratings are based on energy use of the building tested over a prescribed period of occupancy. Green Star ratings are based on certification at various stages during design or after completion of the development. The process considers a broad range of building attributes and requires extensive documentation and evidence. The final ratings are not known until after the certification process – even if every design decision is focused on achieving these ratings. The final “as built” outcome can only be certified after completion. With both rating tools therefore the final outcomes are not known until the building is complete and after certification.

Commercial Outcomes
The commercial arrangements to support green outcomes in pre-commitment lease agreements can be complex. Developer guarantees sound good but are subject to final certification by others.

With the NABERS rating tool, if the target is not initially achieved, the outcome may be able to be delivered via retro-fitting – a potentially expensive and disruptive process. With Green Star rating, retrospective actions are more problematic. If target points are missed during construction – from whatever causes including, for example, not meeting recycled material targets, innovative ideas not accepted; or defective documentation, the rating may not be achieved and not much can then be done.

As a result developers may view guarantees as too risky to make commercial sense.

One trend to emerge in the wake of these challenges is to structure joint commitments by the developer and tenant to achieve specific green performance, but this changes the dynamics of the outcome.

However, this means the tenant is part of the design process and able to provide input.and this now makes the tenant a collaborator in the process and there is a fundamental transfer of the risk.

If the building does not achieve the target rating both parties are responsible and remedies, if any, are complex.

Best endeavours undertakings by the developer may be the way to go – if available.

But what happens if best endeavours are not good enough and the target rating is not achieved? No doubt the tenant may feel aggrieved and one of the key accommodation objectives will not be achieved.

This can be particularly irritating if alternative accommodation options that were passed over previously, are shown to deliver the target rating.

Tenant Remedies
The remedies available to the tenant need be included in the pre-commitment lease agreement and are fundamental to the commercial outcome. If the agreement is structured to give the tenant the right to cancel its lease commitment, the objectives of either party are unlikely to be met.

The building owner is suddenly without a tenant and the tenant probably does not have alternative accommodation options with the required rating. And even more complex is the timing and logistics.Certification is usually only received after the tenant has moved into the new building.
An alternative remedy is linked to rental reductions. But for the tenant committed to environmental outcomes with corporate statements about reducing “carbon footprints”, is this acceptable?

And by how much should the rent be reduced – a notional, market or penal quantum? This remedy does not achieve the desired outcome for the tenant who may now be locked into a 10-12 year lease agreement in a building not meeting their environmental benchmarks.

Probably the most equitable remedy is structured around the enforcement of rating commitments – no matter what the cost – through retro-fitting. This can only be done with NABERS rating tools. As such this remedy has complications but can provide assurance to the tenant about the required green statement.

Green Lease Economics
As more developers and users commit to green leases, the economics of developing green-rated commercial buildings is becoming more evident. Discussions tend to revolve around the significant cost premiums that green initiatives add to development feasibility. Certainly during the pioneering period when developers experimented with various innovative technologies, this was true. But as the building industry has become more familiar with rating tools and technologies have evolved, the cost premiums are trending downwards.

The other side of the discussion has been the argument that green buildings produce lower building operating costs.

In general this principle may be true – certainly in energy and water savings initiatives – but other initiatives such as blackwater treatment plants are not cheap to run and require a minimum throughput to justify the capital costs. Alternative energy-generating technologies seldom provide an acceptable pay-back period compared to cheap Australian brown-coal energy tariffs. And until an effective carbon-tax regime is introduced, this is likely to prevail.

From an owner’s perspective there is a push for premium rentals for premium buildings with green credentials to provide the required return on development costs. However as green initiatives become the norm and entrenched as part of commercial building quality grades, it will be difficult to argue that these initiatives should justify premiums above a normal “market” rental. In the tension of negotiating, the tenant’s argument will focus on the belief that future-proofed green developments will be able to command much firmer (lower) required investment yields  – hence pushing up property end-values. This is particularly true if the new premium green building has its income underpinned by a strong tenant covenant that justifies the development cost premiums. However tenants should note that in green leases there is usually a reciprocal commitment on the tenant to deliver a green-rated fit-out – no matter what it costs.

In the final analysis high profile tenants will seek green leases to make a commitment statement to lowering their carbon foot-print in new accommodation. In this market astute developers will be keen to obtain a competitive edge and attract quality tenants by creating buildings with reduced carbon footprints. Parallel but complementary objectives but ultimately the transaction is all about the willingness of the parties to understand each others objectives and to reflect these in equitable terms. It is likely that the commerce of green leases covering rentals, remedies, lower operating costs and enhanced building life-cycles will mature over the next few years as these become the norm.

Rodney Timm is a director of Property Beyond Pty Ltd.  Contact rodney.timm@propertybeyond.com.au

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