The Villain of Building Energy Efficiency: Triple-Net Leases. Not Picking the Low-Hanging Fruit
An old friend dropped by recently and we had a few beers on the back deck. He runs his family’s commercial real-estate business; they own and operate half a dozen or so pretty large properties (and just bought another) — a mall, office buildings, mixed use.
I was really curious to talk to him about why commercial property owners don’t invest more in energy efficiency. By all accounts there’s great ROI in doing so — serious low-hanging fruit.
Why do commercial property owners leave five-dollar bills lying on the sidewalk?*
At least, it sure looks like there are five-dollar bills lying around. Here from a McKinsey report (PDF; see page 15) showing how much it costs to save (not buy/pay for) a million BTUs of energy, by instead investing in energy efficiency:
Sorry, it’s hard to see without going to the PDF. But short story: there are quadrillions of BTUs in efficiency savings available for less than $2 per million BTUs.
Now look at the cost of buying a million BTUs instead, to heat your building or power your plant (2011 figures, Energy Information Administration):
Coal: $2.39/MMBTU
Petroleum: $12.48
Natural Gas: $4.72
This is the cost to a utility company buying these fuels. The meter cost of the electricity produced (after line losses, administration, profits, etc.) — the cost for building owners — will of course be somewhat higher.
So it sure seems like there’s money to be picked up. Why don’t building owners do it? The short answer my friend and I came to? Triple-net leases — the ubiquitous standard in the commercial real-estate industry.
In these leases tenants pay per-square-foot rent, plus their pro-rata share (by square feet) of the building’s 1) taxes, 2) insurance, and 3) repairs, maintenance, and energy expenses. (Many NNN leases don’t include pro-rata energy costs, but tenants are separately metered and either pay directly or through the landlord. There are lots of variations, but landlords rarely pay all energy costs.)
Notice what is not included: the cost of improvements — for instance improvements to increase energy efficiency. So the owner gets all the costs, right up front. And the benefits go mostly or completely to the tenants, in the form of lower energy bills.
“But hey,” I asked my friend, “don’t lower energy costs for tenants mean you can charge more rent? Doesn’t it all come out in the wash?”
“Welllllhh,” he said… Most tenants are on long leases. “We just signed a ten-year lease with the anchor tenant for our mall.” My friend won’t see any dollar benefit from those energy savings for a long time, as leases turn over and are renegotiated. And it’s not at all clear how much benefit he’ll get, because tenants tend to fixate on the square-footage rental rate, which would go up.
Imagine you’re a leasing agent for the building, trying to rent some space. You’re competing with other buildings that haven’t done the energy upgrade, so their rent/square foot is lower. You’re stuck saying “yeah yeah yeah yeah but you’ll spend less on energy!” This, if you even get the chance: Prospective tentants scanning the listings might never even call you because your rent is so high.
A building owner considering a big spend for energy efficiency really has to think thrice: would I rather have a million dollars, cash in hand, or the likely but uncertain prospect of higher profits somewhere (perhaps way) down the road? It’s easy to understand why they make the choices they do.
And all of this is true even though there’s money lying on the ground waiting to be picked up.
It’s a classic coordination problem — people acting in their own best-guess best interests, with ridiculously inefficient results — that is caused or at least greatly exacerbated by the institutional convention of triple-net leases. (The reasons the convention arose are yet another subject, about passing off risk and retaining returns.)
Obviously triple-net is not the sole villain in this very big picture. From the McKinsey report:
Got central planning?
* For those who don’t know the old joke: Two economists walking along, they see a five-dollar bill lying on the sidewalk. One of them gestures for the other to pick it up. “I’m not picking that up,” says the other. “If it were there somebody would have picked it up already!”
Cross-posted at Asymptosis.
It is not really a guess, it is sound application of managerial accounting models.
Having manged buildings through these processes, it can be incredibly complicated, difficult, and if the building is occupied even more complicated and difficult.
rusty
you seem to be saying that sound application of managerial accounting models leads to higher prices for everyone.
that would have been my conclusion from watching the results of “sound management” for decades. but i didn’t think it was something to be proud of.
@ Save_the_rustbelt: “It is not really a guess, it is sound application of managerial accounting models.”
This is certainly true, but it is only true:
1. From a perspective sitting inside the property management company, looking only at the interests of that company and its investors,
And/Or:
2. Within that perspective, looking at ROI/IRR over a short period versus a long one. Five or ten years instead of 20 or 30.
I’m not saying either of those is irrational or evil. Hell we might all be dead in 30 years. Perfectly reasonable.
But that approach does not guarantee the largest “economic profit.” Often QTC. To quote Steve Randy Waldman:
“there is a difference between accounting profits and economic profits.”
http://www.interfluidity.com/v2/4043.html
“Accounting profit is what a firm, under generally accepted accounting principles, can claim to be the earnings that accrue to shareholders. Economic profit is revenue that exceeds the true cost, defined as the value of the next-best opportunity, of all inputs. According to theory, in a competitive market, economic profits should be relentlessly pushed toward zero while accounting profits should stay positive but very near the broad market return on capital placed at comparable risk.”
But in reality, of course, there are economic profits lying around on the sidewalk like $5 bills, because of coordination failures.
So while the individual decisions may not be irrational or evil, we can say that as a group, a collective, we’re being foolish.
Outstanding. This is a brilliant important post. I am absolutely convinced you are right. I think that you can make huge amounts of money and prevent huge amounts of global warming based on your insight. OK not really money for you personally (which is a market failure too).
I guess the reason leases pass energy costs on to tenants is that they are highly variable and must be passed on all the way to consumers, To me, the solution seems to me to be rent including a term indexed to the price of energy. A silly contract for a simple model not the real world is: tenants pay at time t BTUs used now at time 0 times the price of a BTU at time t. This gives the landlord the gains from conservation while also having tenants bear the risk which they can pass on to consumers.
Of course in the real world this is electricity used now times the price of a joule plus heating fuel used now times the price of a BTU etc and the contract has to guarantee that the building isn’t freezing in winter and stuff, but hey I don’t do real world.
@Robert:
May I offer a simpler solution?
As a small retail tentant in a very large downtown commercial building, I think I can echo the feelings of many other tentants with the statement:
“Just tell me what goddam monthly rent is, and pay your own goddam bills.”
The negotiations on these things, the length of the leases, and the accounting required to manage them, are simply ridiculous.
So it’s simple: make triple-net leases illegal! 😉
(This would put a lot of people out of work…)
Why do landlords like them? It passes the expense risk off to the little guys, while retaining the cap-gains upside.
And it seems to work. My friend says that looking back over two or three decades, his investors’ ROI has probably run somewhere north of 16% a year.