Overcoming the Split Incentive Problem - Part 1

The Opportunity and the Split Incentive Problem

According to the US Department of Energy, commercial buildings consume nearly 20% of all energy and 36% of all electricity in the US. That comes out to about $190 billion spent on electricity bills every year. A recent report from McKinsey estimates that commercial buildings could save 30% of their energy spend by investing in NPV-positive energy saving measures. Based on those estimates, commercial buildings could be saving $57 billion every year by making NPV-positive investments. 

If you are a building owner who’s trying to maximize the return on every dollar you invest, you should purchase another building, right? Maybe not. A recent report from Morgan Stanley found that investing in energy efficiency opportunities within current portfolios yielded an average of 24% return on cost — 3× to 4× higher than the return of an additional property acquisition. 

It seems like an easy decision for building owners. There are lots of opportunities in their buildings to make them more efficient AND it’s financially beneficial to do so.  

However, if you are a building owner that passes all the energy expenses through to the tenant (like in a modified gross lease or a multi-tenant net lease), you might not get an immediate financial benefit from making your building more efficient. This is called the “split incentive” problem. Building owners pay the capital expenses for the energy retrofits to the base building, but tenants receive the financial benefits of energy savings. 

Enter the “Green Lease” (also known as “Energy Aligned”, “High-Performance”, or “Energy-Efficient” leasing). 

 
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What is a Green Lease?

The goal of a green lease is to allow both building owners and tenants to benefit financially from base-building energy retrofits. They’ve been around for more than 15 years and are gaining traction. To date, Green Lease Leaders (as recognized by IMT) have implemented green lease clauses in over 1.3 billion square feet. 

The process of green leasing involves adding clauses to an existing lease (with a split incentive problem) to create a pass-through structure allowing the building owner to recover the costs associated with improving the energy efficiency of the building and generating energy savings. Below is an example of the cash-flows to the building owner and the tenant in a lease with energy-aligned clauses in it. As you can see, the owner takes a majority of the energy savings associated with the retrofit to recover the capital spent plus a return, while the tenant reduces their spend on energy as well.

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Benefits to Owners

Aside from the immediate financial benefit of reducing energy expenses, energy efficient buildings command higher rents (~6% more), have higher occupancy rates (~10% more), sell for more money (10-20% more), and have lower maintenance costs (20% lower)

 
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Benefits to Tenants

While a majority of the energy savings are passed through to the building owner to recover the cost of the energy efficiency upgrades, the tenant gets an immediate 5-20% decrease in their energy bills (as shown in the cash flow chart above). Along with the immediate financial benefit, tenants in high-performing buildings are more comfortable, more productive, AND healthier. 

 
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Are you convinced of the benefit of implementing energy aligned clauses in your leases yet? If so, you’ll like my upcoming blog post, in which I go into detail on how you can implement them, examples of green lease language, and further resources to help. If you can’t wait until then, send me an email at frank.hartmann@bractlet.com. I’d like to show you how you can see ALL the energy saving opportunities in your buildings and be able to prioritize them by ROI before you invest. 

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Frank Hartmann is the Director of Sales at Bractlet and has 20+ years of experience in the commercial real estate industry. Frank understands the challenges owners face with underperforming buildings and wants to help building owners and operators make smart energy efficient investments using the Bractlet platform.