By Adam Murchie
FAVOURITES – 9 July 2010 – Initiatives such as water recycling, photo voltaic cells, tri-generation plants, grey and blackwater recycling and lighting improvements typically take much of the focus as ways to improve the environmental performance of property. But while all of these outcomes certainly play a significant part in the ongoing improvement of our existing (and future) building stock, some of the other more rudimentary ways in which we can effect change are often ignored.
One element often debated in the context of investing in sustainability is the breakdown between who pays for capital works to improve sustainability (the owner) and who receives the benefits of such works (the tenant). While leasing structures often dictate the terms of this breakdown, the purpose of this article is to investigate how changes to leasing arrangements may ultimately lead to an increased investment in sustainable outcomes.
In order to explain how this disconnect arises, it’s worth reviewing typical commercial leasing structures using an example where rental for commercial building floor space is $250 a square metre and outgoings are $80 a sq m. On this basis, the typical leasing structures would be applied as follows:
- Gross Leases: Gross leases comprise a total rental figure charged to tenants which encompasses both the rental for the building space and also an allowance for outgoings. In this example, the tenant would be charged a flat rental of $330 a s qm.
- Net Leases: Net Leases are a function of two discreet charges – rental and outgoings. Whiles the tenant is charged a total occupation cost of $330 a sq m, this in fact comprises two different charges of $250 a sq m for rental and $80 for outgoings.
When considering the above examples, you may be wondering what the difference is. While it may appear subtle, the difference lies in how outgoings are addressed – and that outgoings are impacted by any building efficiency improvements.
If the owner invests in sustainable capital works that improve efficiency, this should reduce outgoings. Using the above example, let’s assume outgoings fall from $80 a sq m to $60 a sq m. On a gross leases basis, the owner now receives an extra $20 in net effective rent. On a net lease basis, the saving accrues to the tenant, not the owner. So while the owner has made the investment, he or she does not directly benefit from the capital employed (save for the fact that they probably have a happy tenant, saving money).
Given the majority of leases for Australian commercial premises are on a net basis, you can appreciate why leasing structures may be an impediment to increased capital allocation to sustainability initiatives. This is not a new issue, and while the concept of “split incentives” has addressed the issue – where both the tenant and the landlord share in any savings made – it is still not a perfect solution. Green leases have also had a positive impact on this matter but there is still some hesitation from owners in making the necessary investment as there are still some “grey” areas about who benefits.
While on face value it appears that gross leases may be a solution, they can still be problematic. If there is not an escalation clause (which covers an increase in outgoings over a base level which is on-charged to the tenant), the owners wears the risk for an increase in tenant outgoings should the tenant increase resource consumption during the term of the lease.
The potential for gross leases with escalation clauses
A reversion to gross leases with strong escalation clauses may well be an outcome that assists the transition of the property sector to a low carbon economy. Such leases would allow owners to gain the benefit of outgoings savings, but also protect them from increases in tenant consumption.
Using the earlier example, on a gross lease with escalation clause basis, the tenancy occupation costs would work as follows:
- Assuming a rental of $330 per sq m on a gross lease basis ($250 per sq m for floor space and $80 for outgoings), if the owner makes a capital investment which results in an outgoings saving of $20, the $20 improvement in net effective rental will accrue to the owner.
- Conversely, if the tenant dramatically increases consumption, which results in outgoings rising to $100 a sq m, the tenant’s total occupancy cost would rise to $340 a sq m. Under this leasing arrangement, the owner benefits from undertaking appropriate capital works and is also protected from any adverse shift in outgoings costs.
At this point, you might ask, where the benefit is for the tenant in such an arrangement?
While the tenant might not directly benefit from an investment in efficiency improvements by the owner, they will accrue other benefits. These could include improvement in building services, better lighting, improved common area fittings, more comfortable working conditions and improved employee satisfaction and productivity which may be more desirable than a reduction in occupancy costs.
A change in leasing structures, such as detailed above, may result in a more equitable distribution of the benefits arising from sustainability initiatives. Should this occur, commercial logic would suggest a more profound shift in capital allocation to sustainability initiatives will result.
Proving a strong positive correlation between the financial and environmental benefits of suitably identified capital works is essential to greater engagement by the broader property sector. Capital will flow via the path of best return (and least resistance) and the removal of structural impediments limiting investment in sustainability will assist in transitioning the property sector to the low carbon economy we require.
Adam Murchie is director, Forza Capital, a Melbourne based boutique property investment group. He is also vice president of the Australian Direct Property Investment Association and a member of its Sustainability Committee.