PODCAST: Why navigating building regulations is getting harder

James Cook: What is the biggest contributor to global carbon emissions? Yep. You guessed it. Fossil fuels. According to data from the United Nations, coal oil and gas are by far the largest contributors to global climate change. But what you might not realize is that a lot of those emissions are going to run our commercial real estate. Yup. It is estimated that globally buildings account for 40% of emissions. But here's the mind-blowing part: In cities, that number can skyrocket to 60 to 80% of emissions. And cities are now enacting new laws and regulations to try to reign in these emissions.

Paulina Torres: Historically, cities have implemented sort of prescriptive base codes that require some form of LED lighting or insulation that would result in energy reductions. Now, this approach that cities are shifting towards are more around implementing some kind of emissions limit or energy reduction target and kind of leaving it up to the owners to decide how they get there.

It is something that is happening at scale in the coming months, even. Currently, there are about 13 U. S. Cities that have building performance standards in place, but over 30 have committed to this national building performance standards coalition started by the Biden administration to pass their own form of building performance standards by Earth Day this year.

It is something that's picking up scale and they are similar, but they can differ in terms of ambition, but also in terms of what they target.

My name is Paulina Torres and I lead our sustainability and ESG research for the Americas. I've worked on reports like our decarbonizing cities and real estate report, which closely tracked a city level policy for local governments things like that.

James Cook: We've got a growing crop of mandates and a big question for owners of commercial real estate. How best can I navigate these new regulations? To get some answers. I'm talking with Paulina Torres, who you just heard from. Plus, we've got Dan Luddy and Andrew Lim also with JLL. And Spencer Robinson with Central Michigan University.

This is Trends and Insights: The Future of Commercial Real Estate. My name is James Cook, and I am a researcher for JLL.

Dan Luddy: My name is Dan Luddy. I am a senior project manager here at JLL in the climate and decarbonization strategy team. I have an engineering background and spent many years poking around all the nooks and crannies of buildings, looking for energy savings and now I work directly with clients to build asset and portfolio level strategies to help decarbonize and improve their building performance.

There is sort of a patchwork of different regulations, and they all drive in the same direction, but have different targets, different ways of demonstrating compliance, different documentation. So, the details can be kind of a headache to put together, but the overall strategies that we would recommend to make the buildings more energy efficient to reduce emissions generally follow the same approach of improving efficiency, reducing loads in your building, trying to swap out fossil fuel equipment.

James Cook: Okay. So, that begs a question in my mind is, so these building performance standards, the onus is on the owner of the building, right, to follow whatever the new standards are.

Paulina Torres: Yes.

James Cook: Is there any effect on somebody who's leasing space in that building?

Paulina Torres: Yes. A lot of the times the owners are responsible for reporting, of course and they are responsible for getting their buildings there, in theory, or paying for the fines if they don't, but they will often look to pass the cost of either compliance or of the fines in some form through operational pass-through costs through tenants. So, a lot of the times tenants might even be responsible, even if they don't even know it, for a large share of these fines if they don't act fast and make sure they're sort of protecting themselves and their lease and all of that from disproportionate responsibility.

Dan Luddy: I think if I can jump in here, I think that's important to highlight because with a lot of building owners, they may not track their tenant’s energy usage. If the tenants have separate energy meters, they just have typically said that's the energy they use, that's their problem. And these building performance standards, you have to report the energy or emissions profile for the entire building.

So even though it's their usage, it's sort of ends up that the owners responsible for that. And so, there's an opportunity for building owners to work more closely with tenants to understand how that they can together produce the impact of the building and come up with a solution that allows for improved partnership between the two parties.

Spenser Robinson: My name is Spencer Robinson. I am a professor of real estate at Central Michigan University. I'm also the 2024 president of the American Real Estate Society and fortunate enough to work with several trade organizations around the country.

Building on the great points that Paulina and Dan made, as we move forward, we will see more structured leases that begin to account for who is owning the GHG and the reporting because their implications, not only at the building level, and that does, as you say, get into lease structure. So, in a single tenant, industrial triple net lease, in that case, because the tenant owns and controls the GHG, there's a legitimate argument that it is scope two for the tenant since they own and control the electricity and scope three for the building owner. Whereas if it was a full-service gross lease, and the owner owns and controls the electricity, then those roles would be reversed should be scope two for the building owner and scope three for the tenant.

The other issue that is currently being worked out is in the capital stack of real estate, who is responsible for claiming various levels of GHG? Does an equity owner with 30 percent equity and 70 percent debt, in a very simple term, right, ignoring all the institutional layers that we can get into and more complicated deal structures, does that 30 percent equity owner claim all of the GHG in their reporting, or does 70 percent go to the capital stack, in which case, once the lending community gets involved, there will likely be an emerging set of standards and disclosures associated with that

James Cook: Interesting. I'm going to think out loud here for a second. So, if my building exceeds the greenhouse gas emissions target that it's supposed to meet, then I, as the building owner, depending on where I am, will get some kind of penalty. It makes me think about one of the first apartments I lived in, the cost of electricity was included in the rent. Now not me, I didn't do this, but I'm sure other people in the building were like, hey, that means I can jank up the AC to 50 degrees all summer long and it doesn't matter because they're not going to charge me extra.

So, is there, and I'm sure you guys, I'm sure smart people have already thought of this, but is there a way to make sure that your tenants are being conscientious about how they use electricity so that you as the building owner aren't getting penalized.

Dan Luddy: A lot of the buildings where the utilities wrapped into the rent is oftentimes because there is not metering in place to be able to track the tenant’s energy usage. And so, it just ends up being wrapped into the rent.

So, we will likely see a lot more emphasis on sub metering of buildings to be able to track where the energy is used in the building and determining which tenants use it. Or if it's maybe the base building systems themselves, where it's helpful to see how much is going to the elevators versus the boiler versus the lighting. That just gives you more data to work with to understand where the building is consuming the most energy and where you have the most opportunity to cut that. When it comes to the way that you can encourage your tennis to be more mindful of that, it can be written to the least that they have certain limits to their energy usage. So, there's sort of the carrot and the stick approach. You could have sort of caps. You could have certain penalties if they go over a certain amount, but you can also encourage, better behavior if they come in below a certain performance standard that it's a certain discount on the rent. There's ways that you can structure that and from a leasing standpoint, which Paulina and Spencer might be able to speak a little bit more to, but when it comes to the actual building itself, it's important to have that clarity in terms of where the energy is going.

Paulina Torres: Typically, too, when energy is measured, it's usually or historically at the whole building level. But doing exactly what Dan said, submetering so that you can actually measure tenant specific use is hugely important here because it allows what we talked about earlier that proportionate share of responsibility or burden to be distributed fairly.

So, an important example could be that there might be a tenant with a small footprint in a building that has a data center there. And then there might be another tenant that's a law firm and that has more space in the building. And typically, what a landlord would do that's only measuring whole building energy use is distribute the cost by square footage. But if the smaller tenant is much more energy intensive then the loft room, even though they occupy more space that wouldn't be a fair way of distributing that burden, right? So, sub metering is the answer there and it's what we would want to encourage to be able to secure for both the landlord and the tenant side.

Spenser Robinson: Big picture, we call this in academia, the split incentive issue where building owners may be less motivated to invest capital resources and energy efficiency if they aren't paying for the energy so that they don't directly receive the benefit of tenants happening paying for energy. Building owners might not be motivated, and reciprocally, tenants may not be motivated to invest if it's not an asset that they own.

There was a study done by some colleagues of mine, Jim Clayton, Avis Devine, and Rozier Hultermans in 2021, where they worked with a tenant in a large building, and the tenant went through a series of behavioral incentives to their employees to reduce energy, and they found that when the tenant was aligned to wanting to be energy efficient for the sake of sustainability and align with their own corporate goals that as they influenced behavior at the office level it did have a meaningful impact on how much energy that tenant used.

James Cook: Andrew, what specifically are you seeing going on in New York around carbon regulations?

Andrew Lim: Hey there, I'm Andrew Lim. I'm the Director of Research at JLL for New York City, and I cover office, retail, and capital markets.

New York City is an interesting example, and Paulina obviously knows this as well because New York City what is possibly considered the most, say, ambitious municipal level policy when it comes to decarbonizing buildings or net neutral goals when it comes to actual buildings here. And so, in New York City, for example, it's such an important part of sort of an overall sort of movement towards sustainability because in the city, a vast majority of the total greenhouse gas emissions in New York City come from buildings, right?

The Local Law 97, which is the name of the law here locally in New York is ambitious in the sense because it applies to all buildings, regardless of use of a certain size. So, everything over 25,000 square feet, and then it can be an office. It can be industrial, residential, other kinds of uses and sort of the standards and the thresholds in terms of being compliant ratchet up every five years or so until you get to 2040 and then you have sort of this, the top-level kind of thresholds and goals where you're looking at over 80 percent of your original greenhouse gas emissions reduced. I think overall, if you look at the law that it really came into effect on January 1st there was a lot of either one concern on how this would affect the commercial real estate market here in New York, given that it is a down period for office, especially, and I think that's why you saw in the middle of last year, the city council saying, actually, if you are a landlord and owner and you make sort of movements in the right direction, the fee probably will not be levied on your building because the law does hold the owner of the building responsible if the building itself goes over the threshold. And so, you've seen that kind of walking back, kind of be a little bit cognizant of sort of the economic conditions, right of a lot of these owners, especially for office.

But if you look at the standards, you know, the first set of standards that just went into effect this year, only about 9 percent of office buildings in the city will not be compliant right under the first level, but by 2030, a majority of buildings, if they don't take any steps to retrofit or make any actions will be non-compliant. And then that goes up to, I think, 89 percent by 2040. So, you can see how quickly it can escalate if owners don't do anything. And so that's kind of the question. These are our thoughts retrofits and things that take a long time, relatively speaking to do. And so, in that sense, maybe it is a little late.

I would say on the sort of more demand side of it, we are increasingly seeing, at least at the brokerage level, more inquiries being made from a tenant rep perspective, right? And these are often tenants who, in the case of large corporations have made it commitments to carbon neutrality or just decreased emissions. Their physical footprint is very much a part of that. In New York, I believe, if you look at the top 100 largest occupiers, that some 72 percent of future requirements are going to have some kind of commitment attached to them. And so that kind of demand is likely to increase. And I think anecdotally over the past year, as we sort of approached the start of Local Law 97 coming into force, we did start to hear, okay, what should I be doing as a tenant to protect myself?

Paulina Torres: Our point of view is that the market is actually moving faster than regulation, especially for the U.S. And we are seeing this to be true because of all those commitments that tenants have. So, we are seeing this push from tenants to want to align their operations. So, these are their scopes one and two emissions to their ambitious climate goals. And the way that they do that is through their buildings, through their leases, through their site selection. So, it is important to emphasize that though regulation is picking up and, over 30 studies by this year have committed to passing their own performance standard, it's important to acknowledge that the market in the U.S. is moving faster and a lot of the times like Andrew pointed out, the first round of limits that a lot of these performance standards have won't really do too much to the market and therefore won't really put tenants on track to meet their 2030 targets, which would mean if they're aligned with the Paris Agreement that they have to reduce emissions by 50%. So, it's less than 7 years to do that and a lot of leases average lease terms are around 10 years. So leases signed today are already colliding with that.

Spenser Robinson: I might add a little color that it is more arguably a segment of business that is pushing ahead beyond regulation, and that would be the very institutional level ownership and the Fortune 100 level companies. While they are small in number, they certainly represent a disproportionate amount of space and revenue and impact, but as you go a tier below that sort of Fortune 100 and institutional level asset ownership and management, those will have to be aligned to regulation in order to be effectively motivated as a class in order to achieve higher sustainability.

With that, we've actually seen in the last year a large number of firms back out of net zero commitments and back out of public facing sustainability goals. And the reason why is there's been a number of lawsuits coming out of in the US, the FDC and the SEC for green claims, one of those laws in California that will be coming to effect also is aligned towards any carbon claim that you are making has to be verified and audited. Though we're seeing firms remain committed to moving forward on the sustainability track, but less publicly making statements that they could be held to in terms of net zero emissions or very specific measurable statements.

Paulina Torres: One thing at least to keep in mind with the office sector too is that there is this flight to quality happening. And what we're sort of positioning this decarbonization strategies that companies have to take on, they should form part of this flight to quality story where just like they're looking for buildings that are have better amenities, that have a better employee experience, they're going to include sort of net zero and energy performance as part of that site selection criteria and like Spencer said, it is sort of that top tier of tenant base that are holding on to these commitments for the most part and that do have the most ambitious commitments. But they do represent a large share of the market like Andrew said, it's 72 percent in New York. Across, around 20 global cities, it is between 70 to 80 percent in the office sector for industrial it is a bit lower Around 40 to 50 percent the share that carbon committed tenants represent in the top occupiers But it is a huge part of the market, especially when you're trying to attract these top quality tenants , in a market and a point in the economy that, that is struggling to sort of attract tenants, generally speaking, right? It's kind of that silver lining that owners can use to make sure that they are able to differentiate their building. And it also has the added benefit of lower energy use, less operational expenditures, and meeting sustainability targets.

James Cook: It sounds like we've got some group of early movers who are really excited about reducing carbon emissions and then some other laggards that, might need to face, I don't know, some fines. We'll start with Local Law 97 in New York. Are these significant fines that they will face?

Andrew Lim: It depends on the individual building, right? And so local 97 is incredibly nuanced in the sense that it applies to buildings of all uses and in even within that there are sub uses. So, for example, even in an office building, right, you may have a traditional office layout on a one floor, and then you have three floors above that that are trading floors, and those floors would be different in terms of the threshold that's allowed to them. And so, every building, even if they are just office buildings, will have a different makeup will have a different sort of threshold. And so, every building can be more or less out of compliance, if that makes sense. And so, you have some buildings that are out of compliance and their fines are not that onerous for the owner right there, maybe in the thousands, tens of thousands of dollars a year.

But then you do have some buildings that are very out of compliance. And so, the more out of compliance you are, the higher, your fine. From our own calculations that we did in New York, based off of the reporting data that's required by New York City for every building, we were able to sort of estimate, based off the building's reported usage and energy usage, what their fines would be again if they took no action. And for some buildings, it was in the hundreds of thousands or even millions of dollars a year in terms of overage fees or noncompliance fees for Local Law 97. You do have certain landlords and owners who are just more vulnerable than others.

And so, any sort of additional cuts to their margins are going to potentially hurt them more or less, right? And so, we already know that there are owners out there who are particularly capital poor and they are enabled to make other kinds of improvements or investments in their building. To have them spend capital on a kind of improvement, whether it's something aesthetic like a lobby or something that actually is reducing carbon emissions, they may not be able to do that in the first place. And then on top of that, be fined. So, it just kind of exacerbates the problems in some respects, right? And so, kind of leading into that whole concern about a wave of distress, properties, etc., that is the concern I think from a lot of owners and landlords is that this is another burden on them at a time when they're more vulnerable.

Paulina Torres: I do think 2030 is when most of the weight will be felt a greater scale. Even for New York Local Law 97 across the class a building stock, the best buildings in the market, only 4 percent will comply with the 2030 target while it's 86 percent with this first round, and this is true for the building performance standards that exist today for Boston's, for example, only 36 percent of Class A buildings researched in our study would comply with their 2030 limit. Denver's targets energy use intensity, and only about 43 percent, of Class A buildings in our study would comply with their 2030 limit.

James Cook: Interesting. And do you think that there'll be a large number of landlords that'll just say, I think it's cheaper for me just to pay the penalties than to retrofit the building?

Paulina Torres: Yes, if they're not looking at the full picture, but we did do a study with Local Law 97 where just as an example was a class a standard building that had the most. typical features in the market. So it was powered by natural gas and electricity. We mapped out what the decarbonization pathways would be and the ensuing fines. A max net zero carbon retrofit for that building would have cost $17 million as an example. They would avoid fines of around $4 million total between now and 2050. So that delta doesn't really make sense, right? You'd probably rather pay for the fine if you're just looking at that. But then when you even just account for operational savings, savings and utility expenditure between 2024 and 2050 would total to estimated $25 million.

So, the savings alone, if you're able to figure out how to use those to pay for the improvements can help pay for that and then that's not to mention the green premiums that you could look for, the increase in asset value, the improvements who you're building and the benefits that that brings about outside of those factors.

Spenser Robinson: You ask a really good question, James, is are firms evaluating the fines versus the upgrades? All of the people on this panel understand the benefits of improving energy efficiency. And arguably, the majority of the listeners understand those benefits. Not all firms do. As an example, in L.A., all buildings over a certain square footage have theoretically been required to report to the L.A. Better Buildings their energy usage. A large percentage do not because the fines are, I can't recall whether $200 a year or $200 a month, which either way, if you own a very large building, it is cheaper to pay the fine than it is to effectively measure it if that's not something we've done before.

James Cook: So, Spencer, do you think we should anticipate future mandates in more places? Is this just sort of the beginning of things?

Spenser Robinson: Some sources have indicated as many as 38 states are already looking to follow California's lead in having state level reporting requirements. We understand the SEC requirements, and there are a number of cities, as Paulina indicated, that are setting city level decarbonization targets. The only way to achieve a city level decarbonization target is to include your building stock because as we opened with it is depending on the analysis 40 to 60, 70, 80 percent of the carbon output of a city comes from the built environment.

Paulina Torres: During our research we did meet with a local city to understand how they were implementing their performance standard and sort of the process that they took and she clarified that every city essentially is going through an exercise of making sure that the fines that they place, when energy savings and all of the kind of external factors are taken into account retrofitting is always the cheaper option than paying the full course of the fines over that time span. So, they are sort of being intentional. It's just that it's hard to see that if you're not ensuring that you're going beyond cost versus fines.

As far as it growing, I could talk about this for a long time, but it is, it is true with the with the U.S. cities are behind in terms of policy that that sort of forces the hand of building owners to decarbonize their stock. A lot of European cities are ahead in this respect, but U.S. cities are leading with data disclosure. These energy benchmarking requirements that we've talked about do exist in a large share of cities. I think, to speak to kind of the increase in performance standards that we expect, I don't think anyone would expect these cities not to do anything with that data. The first step is collecting the data, the next step is management, and that management at the city level usually comes in the form of these building performance standards. So, across the board, essentially every city that has some form of energy reporting requirement can be expected to at some point pass a performance standard in due course.

Spenser Robinson: Europe is very much ahead on regulation. The U.S. historically is a different market and one of the phrases that I like to use is where there's darkness shine a light. Much of the regulation we're seeing being pushed out is focused much more on transparency than on prescribing exactly what firms need to do. I would envision over the next several years, the market forces in the US having a larger impact and regulation as we begin to be able to track and see in very public ways, the output that buildings are using that firms are using, the different ways they're managing that, that we will begin to see a transition that is pushed on from the investors and the consumers rather than by government alone.

James Cook: If you're not dealing with these now, you will be in the near future. So, get ready everybody for more building performance standards. We'll have to do a roundup in a year and see how things change. I'm especially curious to see in a city like New York with just so many buildings, how compliance is going to happen over the next number of years. So, this is something we're going to continue to watch. Thank you all so much for joining me today.

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