The push in the U.S. to create buildings that use less energy and are better for the environment has, by most measures, been a considerable success. Spurred by the Leadership in Energy and Environmental Design (LEED) standards promulgated by the U.S. Green Building Council (USGBC), the commercial real estate sector has made significant strides toward reducing its carbon footprint.
As of 2019, there were more than 69,000 buildings in the U.S. with a LEED certification. This is a remarkable achievement for an entirely voluntary, third-party standard that only came into existence in 1993. But the actual impact of LEED standards goes far beyond these numbers and have now become part of the fabric of many development projects.
Fixing flaws
It’s difficult to understate the impact that LEED standards have had on commercial real estate. The program is the most widely used green-building rating system in the world. According to the USGBC, LEED certification provides a framework for green-building design, construction, operations and performance. It rates buildings and spaces while setting sustainability goals.
As market participants know, many developers build to LEED standards but don’t pay for the actual certification, advertising their buildings as “LEED eligible” or “LEED certifiable.” Some municipalities have even incorporated aspects of the LEED standards into their building codes.
Yet the market vanguard has begun to move beyond LEED for at least three reasons. First, the LEED standards suffer from some quirks and flaws that have become apparent in the 28 years since they were first introduced. Second, a number of governments have begun to push for standards that are different than or go beyond LEED requirements. Third, and perhaps most importantly, advancing the cause of sustainability means raising the bar and pushing the real estate industry to continually improve its performance.
For commercial mortgage brokers and lenders, these dynamics have changed how sustainability is discussed within the real estate sector. As new regulatory regimes are enacted, the effects on the values of some buildings may be significant. The costs of new construction may continue to rise, as could the ongoing operational costs of the average building.
Complaints voiced about LEED often involve the idiosyncrasies associated with the certification. A frequently cited example is that the standard awards two certification points (LEED-certified projects can earn anywhere from 40 to 110 points) for installing a bike rack, a nominal cost in the context of any project, and the same two points for redeveloping a brownfield site, a protracted and expensive undertaking.
Others note that the LEED standards focus on meeting certain one-time goals rather than ongoing performance characteristics (an issue that was at least partially addressed by the newest version of LEED, issued in 2019). Many sustainability experts note that the standards make little reference to the overall context of a project and some are bemused by the fact that a new Las Vegas casino, for example, could earn a LEED certification.
Carbon-free movement
Moreover, sustainability experts are moving beyond energy efficiency to focus on “decarbonization,” or a deemphasis on fossil fuels altogether. Regulations in some areas have begun to reflect this focus, most prominently in the case of New York City’s Climate Mobilization Act.
City officials estimated that 68% of the Big Apple’s greenhouse gas emissions come from its 1 million buildings. The law, which affects every building that has more than 25,000 square feet, sets specific carbon-emission reduction targets for such things as offices, apartments, schools and storage facilities. These aggressive targets ratchet upward over successive five-year compliance periods. Notably, landlords are responsible for the overall carbon emissions of their buildings, even if these emissions are generated by tenants operating under triple-net leases.
It is estimated that 25% of existing New York City buildings do not meet the requirements of the first compliance period, which starts in 2024, while 75% do not meet the requirements of the second compliance period that starts in 2030. Tough penalty provisions designed to enforce compliance are a centerpiece of the ambitious legislation. Most conspicuously, the law features a civil fine based on the difference between a building’s reported emissions and the annual emissions limit. Failure to file a report carries a monthly fine based on square footage; a 250,000-square-foot building would pay $125,000 per month.
Compliance with city’s legislation will likely be achieved primarily through expensive retrofits of existing heating and cooling systems. While financing this new required capital expenditure may be a new source of business for commercial mortgage lenders and brokers, it is too early to specifically say how this will play out.
Landlord alternatives
In response to complaints from landlords about the high costs of these improvements, the new law includes a low-interest loan program known as Property Assessed Clean Energy (PACE). This type of financing comes from an additional property tax assessment, and accessing a PACE loan will generally require consent from senior lenders and compliance with the provisions of debt already in place.
The Climate Mobilization Act includes alternative compliance options, although how helpful they will be to landlords remains to be seen. Property owners may purchase renewable energy credits to offset some of their annual building emissions, but such credits must be generated from a source directly tied to the city’s energy grid.
Many market participants assume that the costs of these credits, which are in limited supply, will rise sharply as the implementation date for the Climate Mobilization Act draws closer. Landlords also may purchase greenhouse gas offsets for up to 10% of their annual emissions, or they can invest in other clean energy projects, but only for the initial five-year compliance period.
New York City’s legislation is being studied by state and local governments around the country, and many will likely impose similar requirements. Massachusetts, for example, implemented a comparable law this past spring that takes effect statewide. This may have the effect of permanently degrading the value of an existing building as landlords face a choice between expensive retrofits, purchasing offsets or paying ongoing fines.
Concerted efforts to decarbonize the electric grid means that electric power is seen by many advocates as more sustainable than natural gas. A decision about how best to power a new building, which was previously tied to regional and cost considerations, may now be tilted in favor of electricity in some areas.
Real estate evolution
Despite the increased costs and oversight, many real estate professionals believe that the industry needs to continue to evolve. The Urban Land Institute has published multiple reports about the heat impacts of buildings. Other groups, such as the Smart Surfaces Coalition, note that “cities have historically invested in dark, impervious surfaces” that make cities hotter and more prone to flooding.
For developers and mortgage lenders, this means a greater focus on reflective, green and photovoltaic roofs, which reduce building and ambient temperatures, reduce runoff and can generate clean energy on their own. Parking lots are under scrutiny as well, with an emphasis on shading from trees, as well as reflectivity and porosity from the use of new smart surfaces.
Another idea receiving more attention is the concept that the greenest buildings are the ones that are already built, especially if they can be adapted to new purposes. Tax credits for the redevelopment of historic buildings and brownfields can help make such projects more economically feasible, as can specialized credits such as those available in South Carolina for rehabilitating old mills.
In these cases, worthy objectives can sometimes create conflicts. Common examples are the windows of historic buildings. Preservation requires keeping them — and often any tax credits depend on doing so — while energy-efficiency regulations call for replacing them with modern glass.
Sustainability is a moving target. It is not possible for commercial mortgage lenders, brokers and project developers to “check the box” and move on. Instead, market participants will have to stay abreast of this evolving field, which will only grow in importance. ●
