A Guide to Retrofitting Leases for Retrofitted Buildings

As discussed in a previous Otten Johnson Alert, many Denver and Colorado property owners are subject to a slate of new benchmarking and energy performance requirements. Property owners will be implementing energy reduction plans that include building retrofitting, tune-ups, and operational changes, and such plans will impose upfront costs for both landlords and tenants.  In this month’s Alert, we will discuss the necessary updates to leases for existing commercial buildings.

Capital Improvements

In order to comply with the new clean energy laws, many property owners will perform capital improvements to reduce operating costs, utility consumption, and/or greenhouse emissions.  Potential improvements include electrification of gas-fired equipment, LED lighting retrofitting, and green roof replacements. The lease language will determine whether the costs of such capital improvements can be passed through to tenants. In most commercial leases, tenants pay a proportionate share of the day-to-day expenses for the operation, maintenance, repair, replacement, and insurance for a building.  Operating expenses that can be passed through to tenants typically do not include capital repairs and improvements for a building, other than capital improvements that are (1) required to conform to applicable laws or (2) incurred with the intent to reduce operating expenses.  Such capital costs are amortized over a specific time period, together with interest thereon.  The new clean energy laws will require many property owners to perform capital improvements, but such laws do not specifically dictate how the applicable Energy Use Intensity (EUI) or Greenhouse Gas Intensity (GHGI) targets are met.  Accordingly, some tenants may try to argue that clean energy improvements made by landlords should not be passed through.  However, because the capital improvements are reasonably necessary to meet the EUI and GHGI targets and to comply with the clean energy laws, with appropriate lease language, they will fall within both categories of permitted capital improvements that can be passed through as operating expenses.  With appropriate lease language, many landlords will be able to pass through amortized retrofitting costs as operating expenses. Some landlords will be limited by any controllable expense cap language, which limits the total amount of pass-through expenses on an annual basis.

Alternatively, some landlords may elect to pay the full cost of capital improvements and subsequently charge tenants for the cost savings for such improvements. For example, if an LED lighting system reduces the overall electricity bill by 25 percent each month, the landlord may still charge tenants for the 25 percent difference to recoup the initial installation costs and reap the benefits of such energy-reducing improvements.  If taking this approach, landlords will need to include explicit language outlining this structure in the applicable leases.  Some tenants will push back on this approach, but, with proper lease negotiations, landlords can reap additional benefits from their energy reduction plans.

Some property owners may use the Colorado C-PACE program to finance certain energy-reducing improvements in their buildings. C-PACE assessments, which include the costs of the capital improvements, plus finance closing costs, program administration fees, and interest, are special assessments on a property owner’s tax bill and payable with real estate taxes.  Therefore, landlords may pass through the C-PACE assessments as real estate taxes under their leases.

Reporting Requirements

Under the clean energy laws, property owners are required to provide prospective buyers and tenants with an electronic copy of reported benchmarking data from the previous calendar year or the most recent 12-month period of continuous occupancy.  Landlords will want to include language in their letters of intent and leases stating that this requirement has been met.  Property owners will also need tenants to deliver any electrical, gas, water, and utility usage information with respect to their premises during the lease term.  If a tenant contracts directly for utility services and does not deliver such utility information, the landlord will want written authorization in the lease to obtain such information directly for the applicable utility provider.  Most importantly, regardless of whether the tenant provides utility consumption information, it is the obligation of the property owners to confirm the benchmarking reports and the underlying information is accurate.  If a property owner discovers errors in data that has been supplied in past benchmarking reports, there are avenues under the clean energy laws to correct those errors, but they may come with fees and an application process.  When errors in reporting data are attributable to a tenant, lease language can be used to pass onto the tenant the expenses of making corrections.

Tenant Operations

Even if property owners install energy-reducing improvements and make tune-ups to their buildings, they will need tenant cooperation to reduce the day-to-day energy use of such buildings.  The energy used by equipment plugged into an electrical outlet, called Plug and Process Loads (PPLs), is a significant part of building’s energy use, and tenants may not be motivated to reduce their own PPLs.  Landlords will want to update the building rules and regulations to include various energy efficiency measures, such as limiting water, electricity, and other energy use, recycling, cleaning, maintenance, repairs, and adjusted hours of operation.  Landlords will want to carefully monitor and enforce compliance with such updated building rules and regulations.  For any tenant improvements and tenant alterations, landlords will want sufficient review and approval rights to ensure that the tenant’s construction work complies with the landlord’ s energy efficiency measures and does not increase the overall EUI or GHGI for the building.  Furthermore, landlords will want to confirm that the tenant’s newly installed equipment complies with any electrification and other appliance replacement requirements that are or will soon become applicable to the building.  Lastly, landlords may want to withhold approval for proposed assignees and sublessees with high energy use at the building.

In some cases, certain tenant improvements and tenant alterations may enable tenants to seek tax incentives, renewable energy credits, and other financial incentives.  Carefully crafted lease language can help ensure that landlords retain rights to and control over such incentives.

Penalties for Noncompliance

Property owners may face significant penalties if their building fails to meet its applicable targets.  Even if such failures result from the acts or omissions of tenants, the governmental penalties will be imposed solely on the property owners.  The lease can reallocate the risk between the landlords and the tenants. Landlords will want to include strong enforcement mechanisms for a tenant’s failure to cooperate with the landlord’s energy efficiency measures, including self-help and the tenant’s payment of penalties.  For single-tenant buildings, landlords may include lease language that requires the tenant to be responsible for upgrading the building in compliance with the applicable clean energy laws and paying any penalties arising from the building’s noncompliance.

As property owners begin to implement their clean reduction plans, they will want to review their leases, determine which expenses should be passed through to their tenants, and revise their leases going forward.