Commercial Lease Properties:
Finding the Benefit of Energy-Efficient Lighting Upgrades

By Craig DiLouie, Lighting Controls Association

Published 2002

More than 4.7 million commercial and government buildings, representing over 67 billion sq.ft., currently account for about 25% of the nation's energy bill, spending $26 billion annually. A significant number of these buildings and floorspace (23-24%) are non-owner-occupied. With an average building age of 30.5 years and average annual energy cost of about $16.4 billion or 1.06/sq.ft., non-owner-occupied buildings are a prime opportunity for upgrade to energy-efficient building technologies -- although traditionally, in general, they have been slow to embrace energy efficiency. In this special white paper from the Lighting Controls Association (LCA), we will explore the barriers to adoption of energy-efficient lighting and how to overcome them.

"Of all building upgrades, lighting is generally considered the easiest and most lucrative," said Steve Purdy, president of LCA and VP for Tridonic, a digital ballast manufacturer. "According to the U.S. Department of Energy, technologies developed during the past 10 years can help cut lighting costs by 30% to 60% while enhancing lighting quality and reducing environmental impact. And according to the New Buildings Institute, which developed the 2001 Advanced Lighting Guidelines, lighting controls can reduce lighting energy consumption by 50% in existing buildings and at least 35% in new construction. The energy savings potential of the commercial real estate market, however, remains largely unrealized. The energy-efficient products industry must understand this market to overcome its barriers to capital investment in efficiency, and building owners must understand that there is significant money on the table for them."

Table 1.  Owner Vs. Non-Owner-Occupied Buildings in the United States. Source: 1999 Commercial Buildings Energy Consumption Survey, Energy Information Administration (DOE)

Landlords & Tenants
In a lease property scenario, the owner regards its building as an income-producing asset. Net operating income in turn provides the basis of how the building is valued should the owner wish to sell it. Income is generated through leases with tenants who occupy the building, which generally include one of these provisions:

•  Utility costs, which represent 30% of the average building's operating expenses, are passed through to tenants (net lease)
•  Utility costs are paid by the owner and calculated into the fixed rent (gross lease)
•  Utility costs are locked in over the term of the lease, with the owner paying for increases or benefiting from decreases in energy costs (fixed-base lease)

A typical high-rise building can include dozens, even hundreds, of leases, and many of them may address the subject of utility costs slightly differently.

Benefits of Energy Efficiency
If a building owner can reduce its electric operating costs from $1.06/sq.ft. to $0.80/sq.ft. through new energy-efficient lamps/ballasts and advanced controls (producing a 50% reduction in lighting energy consumption), these benefits can be accrued:

•  Net operating income for the building goes up, increasing the building's value (see Figure 1). According to the U.S. Environmental Protection Agency (Energy Star Buildings Program), for every $1 invested in energy upgrades such as lighting, asset value increases by $2-3.
•  The environment includes more high-quality lighting and other systems designed for occupant needs and is therefore marketable against competitive properties.
•  Utility costs are lower, which can be used to attract new tenants.
•  Rents can be increased for existing tenants if they are enjoying a demonstrable decrease in pass-through utility costs.
•  Direct cost savings benefit in gross or fixed-base leases, increasing the profitability of the lease revenue stream.

Figure 1.  Decreasing energy costs improves the net operating income of the property, which increases its value. Source: U.S. Environmental Protection Agency, Energy Star Buildings Program

Barriers to Adoption of Energy Efficiency
While the above scenario appears to be attractive for both owner and tenant, significant barriers exist to prevent both from taking on the risk of the capital investment:

Owners

•  The owner often regards energy efficiency upgrades occurring mid-lease as benefiting only the tenants.
•  If a building has dozens or even hundreds of different types of leases, significant administration is required to sort out the cost-benefit and impact on these leases.
•  The owner may regard the investment as ideally timed to occur just before the turnover of a lease, which total conversion of its building's lighting systems developing over time based on the tenant turnover rate.
•  The vendor of energy-efficient lighting may not understand how the lease is structured before pitching the financial return on the upgrade (for example, if energy costs are split between owner and tenant, a three-year payback becomes six).
•  Real estate appraisers generally do not understand energy-efficient design and therefore it can be difficult to include positive cash flow from upgrade projects in the appraisals of real estate value. A survey among 69 certified general appraisers in California conducted by the Institute for Market Transformation found that only 13% recognized energy-efficient building features in their appraisals. Nearly half (45%) do prepare operating cost schedules, but only 20% of these include energy bills. Typically, they use historical income and expense data (59%), interviews with owners and sellers (35%) or general statistics developed by the Building Owners and Managers Association (43%).

Tenants

•  The tenant often regards energy efficiency upgrades as benefiting only the owner of the building, even though the remaining period of its lease may be much longer than the typical payback for energy-efficient lighting.

The bottom line in every upgrade opportunity among the commercial lease property market is, "Who pays? Who benefits?"

Overcoming the Barriers
The owner generally has a strong incentive to upgrade its lighting systems to benefit both itself and its tenants (which in turn benefits itself). Energy costs in general have been increasing. If the lease is structured so that the tenant bears these increases, the strapped tenant may put pressure on the owner to lower the rent or risk losing the tenant. If the lease is structured so that the owner itself bears cost increases, net operating income erodes with each cost increase, depressing the property's value. As the effects of deregulation, lack of sufficient supply for a stable market, dependence on foreign oil and other factors will bring continued uncertainty to future energy prices, energy will most likely increasingly be a flashpoint in lease negotiation. In today's environment, tenants are more likely to negotiate for leases in which utility costs are fixed.

Administration & Analysis

•  Use QuikScope software, developed by the U.S. Environmental Protection Agency, which is designed for commercial property managers. QuickScope, a component of the EPA's Energy Star Buildings Program, helps property owners allocate the costs and benefits of energy performance improvements and determine the financial viability of energy investments.

  For more information: http://yosemite1.epa.gov/Estar/business.nsf/content/CRE_Tools_QS.htm

Figure 2.  QuickScope, the energy investment performance software from EPA

•  Use NOI Builder, proprietary software developed by RealWinWin, Inc., an energy consulting firm specializing in the commercial rental property market. NOI Builder can be used for an investment-grade analysis and modeling to calculate costs, benefits and what-if scenarios.

  For more information: http://www.realwinwin.com

Ensuring Higher Property Valuation

•  If the owner wants to sell the building, it is not the right time to avoid a capital investment that will increase the building's value.
•  If the real estate appraiser does not recognize the value of low energy costs in a valuation, the lending bank usually won't either. In this event, find a lender that will recognize the benefit of energy efficiency in relation to net operating income (and property value) through proper documentation. Documentation includes complete financial analysis (see above) but also complete engineering analysis recognized by a third party such as a reputable engineering firm, Energy Star Buildings Program, Energy Star Benchmarking tool ("Portfolio Manager"), local utility or U.S. Green Building Council's LEED Program.

Example: Building A with $200,000 energy cost savings through energy efficiency measures including electronic-ballasted T8 systems and advanced controls.

•  The owner can also split the savings with the tenant in exchange for an increase in rent. For example, the owner can increase the rent by 50-75% of the energy cost savings, which are passed along to the tenant. The tenant reduces its electric energy costs by 25-50%, while the owner generates an increase in lease revenue. This increase in lease revenue in turn increases the net operating income of the building in a more traditional form accepted by appraisers and lenders.

Example: Building B with $200,000 energy cost savings, passed along to tenants, with 75% of the amount added to rent

With the potential cost savings and added building value, energy efficiency upgrades are often more profitable for investors than riskier speculative investments in new building development.

Cost Savings

•  If utility costs are passed along to the tenant, most leases enable owners to recoup these costs before passing through the energy savings.
•  If the lease locks in utility costs, the owner keeps the savings.
•  Waiting many years for a lease to expire before investing in an upgrade is not the best financial strategy, since there is money on the table today.

Financial Incentives

•  New energy legislation currently being reconciled between the Senate and House of Representatives is almost certain to include a tax deduction of up to $2.25/sq.ft. for energy upgrades that exceed the ASHRAE/IES 90.1-1999 energy code by 50%.
•  More than $1.5 billion in rebates were made available in 2001, more than twice the amount available in 2000, which can be used to reduce the cost of the upgrade.
•  Energy service companies (ESCOs) offer guaranteed savings and other performance contracts that start with upgrade financing.

Vendors

•  Work with vendors of energy-efficient products and their representatives who understand the commercial real estate market. For example, if energy cost savings are projected to produce a 1.5-year payback but energy savings are split because of the given lease then the payback for the owner is really 3 years. The vendor should be able to produce a complete analysis of the project to help sell senior management and demonstrate that the investment will meet the owner's hurdle return rate.

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