Lease structures and occupancy costs in eco-labeled buildings

Pages31-46
DOIhttps://doi.org/10.1108/JPIF-07-2019-0098
Publication Date04 Oct 2019
AuthorJeremy Gabe,Spenser Robinson,Andrew Sanderford,Robert A. Simons
SubjectProperty management & built environment,Real estate & property,Property valuation & finance
Lease structures and occupancy
costs in eco-labeled buildings
Jeremy Gabe
School of Business, University of San Diego, San Diego, California, USA
Spenser Robinson
Central Michigan University, Mt. Pleasant, Michigan, USA
Andrew Sanderford
College of Architecture, Planning, and Landscape Architecture,
University of Arizona, Tucson, Arizona, USA, and
Robert A. Simons
Cleveland State University, Cleveland, Ohio, USA
Abstract
Purpose The purpose of this paper is to investigate whether energy-efficient green buildings tend to
provide net lease structures over gross lease ones. It then considers whether owners benefit by trading away
operational savings in a net lease structure.
Design/methodology/approach Empirical models of office leasing transactions in Sydney, Australia,
with wider transferability supported by analysis of office rent data in the USA.
Findings Labeled green buildings are approximately four to five times more likely than non-labeled
buildings to use a net lease structure. However, despite receiving operational savings, tenants in net leases
pay higher total occupancy costs (TOC), benefiting owners. On average, the increase in TOC paid by tenants
in a net lease is equal to or greater than savings attributed to an eco-labeled building.
Practical implications A full accounting of TOC in eco-labeled buildings suggests that net lease
structures provide numerous benefits to owners that offset the loss of trading away operational savings.
Originality/value The principal-agent market inefficiency, or split incentive,is a widely cited barrier to
private investment in energy-efficient building technology. Here, a uniquely broad look at rental cash flows
suggests its role as a barrier is exaggerated.
Keywords Commercial real estate, Energy efficiency, Green building, Real estate investment,
Split incentive, Sustainable real estate
Paper type Research paper
1. Introduction
Private benefits associated with energy efficiency utility cost savings create a theoretical
market incentive for greenhouse gas mitigation, a public good. Yet, there is a literature
that observes contradiction between uptake and expected profitability of energy efficiency
investments (Kok et al., 2011). Exploration of the observed investment gap often arrives
at a convincing principal-agent market failure narrative called the split incentiveor
landlord-tenant dilemma: while building owners must fund capital asset upgrades,
their occupants benefit from the operational efficiencies created by those investments
(Heinzle et al., 2013; Janda et al., 2016; Schleich and Gruber, 2008).
In response, complex schemes have been implemented to influence managerial decisions and
fixthe split incentive problem. Environmental upgrade financing[1], whereby repayments of
capital improvement loans are added to property tax collections (Van der Heijden, 2017), is an
attempt to directly alter financial incentives. Environmental upgrade financing offers a potential
solution because property taxes are paid by whichever party landlord or tenant takes on
liability for paying operational expenses, thereby matching costs and benefits. Other solutions
seek to influence corporate governance. For example, Janda et al. (2016) find increased use of
greenlease clauses negotiated environmental or social performance obligations in an
Journal of Property Investment &
Finance
Vol. 38 No. 1, 2020
pp. 31-46
© Emerald PublishingLimited
1463-578X
DOI 10.1108/JPIF-07-2019-0098
Received 21 July 2019
Accepted 23 August 2019
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1463-578X.htm
31
Lease
structures and
occupancy
costs
Australian and UK context, though very few of their model clauses involved legal liability or
dispute resolution in the event of a breach.
But are these interventions necessary? In theory, total occupancy costs (TOC) should be
at equilibrium as tenants trade increased rent for their own operational savings (Mooradian
and Yang, 2002). Importantly, we observe that current discourse on split incentive theory is
limited to analysis of direct cash flows. However, little broader property market perspectives
exist in the literature beyond an initial estimate by Eichholtz et al. (2010) that operational
cost savings may be fully capitalized in rent. Two recent studies suggest building owners
are not concerned with trading away savings to tenants. Christensen et al. (2018) found that
institutional owners strategically focus on energy savings, implying meaningful incentives
to eco-label investments beyond operational savings. Brotman (2016) implies that collective
tenant demand for energy efficiency motivates medical office owners, who always use triple
net leasing, to invest in energy upgrades in competitive markets.
We pose two questions to establish the salience of the split-incentive-as-barrier theory:
RQ1. Since a gross lease structure is the simplest means to eliminate a split incentive, do
owners disproportionally agree to gross lease structures to capture the savings
from targeted investment in operational efficiencies?
RQ2. When net lease structures are used in energy-efficient buildings, can it be
quantified how energy savings affect the gross income received by the owner?[2]
To answer these questions, we study lease transactions in markets with substantial
identification of eco-certified, energy efficient, buildings and choice in lease structure.
The findings present compelling evidence that the split incentive is not a significant
barrier to private investment in environmental building upgrades. Where markets offer
diversity in lease structures, energy-efficient building owners are significantly more likely to
enter into net lease arrangements, granting tenants subsequent operational benefits.
However, landlords are indirectly compensated without the need for environmental upgrade
financing. Besides the traditional role of a net lease in removing cost risk for the owner, we
find that tenants offset the small operational savings from energy efficiency with higher
total costs of occupancy. For a well-managed building, the overall outcome of trading away
operational energy savings can be higher net income.
2. Background and hypotheses
At a fundamental level, there are two primary financial incentives that attract private
investors intothe market for eco-labeled property investment: capital valuesecurity (i.e. lower
obsolescence risk) and operational expense savings. Capital value benefits accrueexclusively
to owners. However, lease negotiations determine which party benefits from operational
expense savings.
2.1 Commercial lease structures
Lease contracts create windows for insight into commercial real estate markets, cycles and
participant behavior (Clapham and Gunnelin, 2003; Ibanez and Pennington-Cross, 2013;
Wheaton, 1987). Worldwide, leases can beclassified along a spectrum from grossto net,
based on the liability for operational charges over the term. The gross lease classification
assigns the risk and responsibility of operational costs to the landlord; tenants only pay a
fixed base rent as written in the contract. Net leases assign the tenant a lower base rent and
liability to pay its share of future operational expenses. Economic theory suggests that
landlords should extract the same value from a property regardless of lease structure
(Ambrose et al., 2002; Booth and Walsh, 2001; Grenadier, 1996). However, despite these
expectations,there is limited qualitative or empirical support to this theory( Bondet al., 2008).
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