Heat, Hot Water, and Electric Included: Aligning Incentives in Commercial Real Estate

By Anonymous

Much of the Edward Lundberg case discussion centered around who should pay for energy retrofits in a commercial building—landlord or tenant. There is an issue of split incentives, since the landlord owns the building and has to pay up front for energy efficiency-related improvements, but the tenant reaps the benefits of smaller energy bills. To make the largest advance in building energy consumption, incentives need to align such that the landlords’ investments are repaid over time by capturing some of the value created through reduced energy usage in the structure, regardless of who writes the check.

To address this issue, commercial landlords of large office space should adopt a model common in apartments, where the cost of energy is included in the monthly rent. Such a change will provide a number of benefits to tenants and landlords:


· Tenants will have insurance against rising energy costs because they are included in the monthly, predetermined rent.

· Tenants are likely to benefit from landlords’ incentives to maintain and improve their buildings.


· Landlords with energy efficient buildings may profit above their rent levels from energy savings.

· Landlords may gain competitive advantage for energy efficient buildings, especially if their rents including energy costs are lower than others.

Some may argue that divorcing users from the true cost of the energy will not encourage the efficient use of natural resources. However, for large office buildings, the consumption of most resources are determined not by individuals but by building and facilities managers.

TEMPERATURE: The current model of tenants having discretion over building temperature is not entirely true, as a concentrated few have control over indoor air temperature.

WATER AND LIGHTS: Use of water and lights does fall more within individual user control, yet building infrastructure again will have the greatest impact on resource consumption. Changing bathroom and kitchen fixtures to be more energy efficient typically falls within a building owner’s jurisdiction, as does installing energy efficient light fixtures, bulbs, and motion sensors. Even if a building owner does not directly control these items, leases may give the owner leverage to dictate the efficiency of these items.

Unless a company sets targets for reducing energy usage, it is unlikely that employees will achieve significant energy savings on their own. Tenant changes that may yield energy savings include using energy-efficient light bulbs, turning lights off when daylight is sufficient, replacing inefficient fixtures like copiers or printers with efficient alternatives, and turning off power cords at night to eliminate so-called vampire loads. Yet these examples require behavioral changes that are more difficult to implement than structural changes of the building and often yield less energy savings than building improvements. Furthermore, individual behavior is not tied to directly paying energy bills.

The argument for having users pay for their energy usage directly relies on the fact that users have control of their energy usage and incentive to use less. While improving a building’s energy efficiency can be achieved without a retrofit, getting users to change their behavior in a significant way is more difficult to implement and does not make as large an impact as would a well-executed retrofit. Therefore, focusing on building envelope and retrofit solutions will yield more immediate and consistent results in decreasing energy and resource consumption, especially in large commercial spaces.


One thought on “Heat, Hot Water, and Electric Included: Aligning Incentives in Commercial Real Estate

  1. By John Macomber

    This dilemma is at the core of many commercial lease negotiations. When I teach the Lundberg case in Real Estate Executive Education, most of the discussion is around lease terms and modifications – particularly when the tenant is a high energy user or very aware of the cost of occupancy. Those tenants tend to be able to appreciate more efficient space, or tend to be more willing to help contribute to capital costs.

    The “moral hazard” issue of individuals wasting energy if they don’t pay for it directly is discussed a lot, too. Another post in this blog discusses data visualization as a way to engender healthy competition to use fewer resources; this might apply in commercial real estate, too.

    A major landlord, Hines, has an promoted an initiative called “Hines Green” which is intended to address tenant behavior and preferences around resource usage.

    My experience in emerging economies is that this split incentive problem is much diminished. In an environment where a) payroll rates are 1/4 that of Western service companies and b) energy costs are twice those in the US, then c) this issue is an order of magnitude more relevant to the total cost of operations, and d) everyone pays attention and can do the math on payback. The relative newness of the office fleet of buildings is also a favorable factor since it’s not that hard to build a new energy efficient building; but it is difficult to cost justify retrofitting and old one.

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