What is green due diligence and why would a prospective buyer, tenant, or lender bother with it? As in other areas of the green revolution, the answer ranges from advocacy to dollars.
Many organizations, such as federal agencies, national tenants, lenders, and investors, now have green requirements for new leases, loans, and purchases. They have made the policy judgment that they want the buildings that they lease, acquire, or finance to be green. They are advocates of green. Hence, before leasing, buying, or lending, they conduct due diligence to verify the “greenness” of a property.
Many other investors, tenants, and lenders do not care whether a building is green—they are concerned with property value. What is the return on investment? How good is the cash flow? Does the property have physical defects or problems with its legal status (zoning, etc.)? Are the lease terms competitive? These parties do not care about “green.” They must, however, because like it or not, green issues are having an increasing impact on property transactions, even for those who think green is humbug. The reason is money.
The “money” reason is not that green adds value to a property. That subject is a topic of ongoing discussion. (For example, how much if any real value does a LEED rating add?)1 The “money” reason is that there are now many actual green legal and contractual requirements, and also green financial benefits, associated with a particular property or development project. Failure to comply with these green requirements or the conditions for financial benefits can result in real money loss.
Function of Due Diligence
The main purpose of due diligence is to answer the question, “What can I lose?” A party often decides to buy, lease, or lend based on assumptions about the property. Those assumptions derive from the party’s initial research about the property or from offering materials or other representations made by the seller, landlord, or borrower. Due diligence is the exercise of vetting the property to confirm those assumptions. If the assumptions are incorrect, the business deal will likely be renegotiated.
How can failure of green assumptions result in financial loss? The answer has two parts:
(1) Green tax and other incentives, as well as green capital grants, can add direct “bottom line” value; and
(2) Failure to comply with green rules in contracts and legislation can result in loss of income, fines, and restrictions on use.
In other words, loss of financial incentives and non-compliance with green requirements can mean direct loss of value.
How Green Value Is Lost
How can green value be lost? There are several ways.
Green financial incentive such as a property tax abatement can mean a built-in cash flow subsidy. For example, a $1 million annual property tax abatement is worth $10 million over 10 years and will be reflected in the property’s capitalization rate.
As another example, a green zoning bonus of 30,000 extra square feet for a residential condo would be the equivalent of $6 million in land cost if valued at $200 per square foot and could mean a sale value of $36 million if the sale price is $600 per foot.
A buyer of, or lender to, either of these projects will clearly want to confirm the status of these green benefits because loss of either would ravage the property value. Also, to the extent that a LEED or other green rating is part of a building’s marketing campaign, loss of that rating can impact buyers—and, indeed, create possible liability for the seller—such as a condo sponsor who loses the rating after many units are sold.
Yet there are less obvious and more conventional ways green value can be lost. Suppose a tenant of 200,000 square feet insists on a rent abatement of $25,000 for each month when the landlord fails to keep a LEED Gold under LEED for Existing Buildings.2 Suppose the landlord obtained Gold for the original project but delays for 10 months to get the recertification. The landlord will lose $250,000 in rent, impacting not only the landlord but its mortgagee. This is an obvious example of how failure to comply with green requirements can reduce value.
Where do green requirements appear? The answer is “everywhere,” from building codes to zoning ordinances, special legislation (like New York City’s Local Laws relating to energy efficiency3), major tenant leases, landlord leases, mortgages, capital grants from government and non-profit sources, purchase/sale agreements, hotel and other management contracts, service contracts, easements—indeed, almost every type of agreement affecting real estate. Needless to say, green requirements also appear in many architect, engineering and construction agreements.
What to Look For
How does “green” differ from “standard” due diligence?
The purpose of due diligence is (a) to confirm facts presented by a broker, seller, landlord, or borrower, and (b) to develop facts not presented or addressed by those parties but important to the buyer, tenant, or lender. Due diligence is conducted: (a) before signing the purchase/sale agreement, lease or mortgage, (b) during any “free look” period permitted before the particular agreement becomes finally binding, and/or (c) before title or loan closing or lease commencement date.
Typical due diligence includes review of title and building department search; review of existing leases, service and management contracts; review of zoning; confirmation of property tax assessment, abatements, etc.; engineering inspection of the property for obvious defects or apparent legal non-compliance; appraisal for financing; and environmental review.
Special consultants perform many of these tasks. For example, environmental consultants perform the environmental reviews, engineers perform the physical inspection, and independent appraisers perform the market value appraisal.
Green due diligence also requires lawyers and special consultants. However, green tasks include both property-specific inquiries and types of due diligence not previously considered standard. For instance, counsel must consider green factors in reviewing leases, mortgages, purchase and sale agreements and the other subjects of standard legal review. Counsel also must know the green consultants who provide expertise in areas not previously part of standard due diligence. (Counsel must similarly be aware of these green issues to negotiate representations and warranties, covenants, conditions, and remedies in purchase/sale agreements, leases, and mortgages.)
Property and Development
Green due diligence must be tailored to the type of property and the stage of development. “Risk of green loss” will always be greater for a project in development or under construction than for a completed project, and the earlier the stage of development, the greater the risk. Thus, for an investor considering a green project still in design, or an early-stage construction lender, due diligence must include an expert review of the planning and construction documents to confirm the prediction that the property will achieve all needed green criteria.
The early-stage investor or lender may need to enlist, for example, LEED or other green consultants to review the green design, construction consultants to advise whether the design can be built as designed, tax counsel to review prospective compliance with green tax incentives, zoning counsel to review green zoning rules, code counsel to advise on the applicable green building code criteria and the consequences of non-compliance, etc. As the project moves forward, there may also be milestones at which each of these points is reconfirmed.
A buyer of a completed project does not have such “process” risk—The building is constructed, and a temporary (if not a permanent) certificate of occupancy has been issued, which usually evidences compliance with the green criteria. For example, the LEED or other green rating has been issued. The property has confirmed eligibility for green tax incentives. The green criteria of major leases can be confirmed by estoppel certificates. For a completed building, therefore, green due diligence mainly involves a static, as opposed to a moving, target.
Even with a completed project there is still a nascent but evolving risk that a post-completion audit by a rating organization, major tenant, or building department may result in loss of a green (e.g., LEED) rating or a retroactive determination of non-compliance with green code, or even a challenge by a community group asserting, for example, that a green condition to a planning permit was not really achieved.
Categories of Due Diligence
There are many types of green due diligence, including matters not readily available on the public record. Some examples are:
(a) review of LEED or other green rating applications for projects in development;
(b) review of LEED or other green rating documentation for completed projects;
(c) review of compliance with government green building and zoning codes for new and completed projects;
(d) review of compliance by major tenants with green lease requirements;
(e) review of compliance by landlords with major tenant green lease requirements;
(f) review of compliance with green rules in mortgages and other funding agreements;
(g) review of tax credit, property tax, zoning, green tax-exempt bond and other incentive rules and compliance/qualification for new or completed projects;
(h) review of energy benchmarking, such as the Energy Star rating and/or compliance with energy-use reporting and retro-commissioning laws; and
(i) other project-specific green due diligence keyed to the goals of the buyer, tenant, or lender.
Benchmarking and Metrics
Due diligence is, of course, property-specific. But there is now an effort to develop a means of comparing green buildings to each other and to national norms. An objective, quantifiable matrix (or perhaps index) of the “greenness” of a property would be an important tool for investors, lenders, insurers and others. To the extent that such a matrix or index is based on actual property-specific data, it would, and certainly will, expedite due diligence.
The existing green rating systems like LEED,4 Green Globes,5 and ICC 700 National Green Building Standard,6 etc., are of course in place and cornerstones of the due diligence exercise. These rating systems are getting better each year, and most have evolved dramatically in only a short time and continue to do so in response to the demands of the marketplace. Also, new programs, such as the International Green Construction Code, are now being promulgated. The code will apply both to construction and ongoing building performance. LEED is also addressing the need for ongoing post-construction monitoring. Recertification of a previously-issued LEED rating under LEED for Existing Buildings: Operations and Maintenance, already available, will become an important due diligence tool.
The Energy Star Portfolio Manager program is another very important due diligence tool now available, and likely to be more and more important.7 Using the Energy Star performance rating system, this enables a building owner to enter data through an online system to compare results to a national database. The Energy Star ranking system identifies buildings that are in the top 25 percent of efficiency in the United States.
Green Search Services
Another new trend is the green search service. This is a search, like a title or judgment search, that provides property-specific data available on green data bases. An early pioneer in this area is Fidelity National Financial, which now offers a “LEED Project Certification Data Report” providing the following information: that the project is currently LEED certified; the date of certification; the LEED rating system; the LEED version; the LEED certification level; certification challenges, if any; and the status.8 As demand for green due diligence grows, other services of this type will certainly emerge.
Green Due Diligence Issues
How might different types of green diligence be needed for a major project? Here is an example.
Big Investor LLC (Buyer) is negotiating to buy the retail condominium unit in mixed-use Huge Iconic Building from Big Developer LLC (Seller) who developed the project. The retail unit has 50 tenants, mostly high-end luxury stores, including a brand new Green Apple Computer store that gives the tenant $15,000 per month rent abatement during any time the landlord fails to keep a LEED Gold rating for the entire retail unit. Buyer is negotiating to assume Seller’s $400 million first mortgage that requires at least LEED Gold recertification every three years. Buyer has received a $100 million financing commitment from GreenMezz, which requires two Green Globes as a condition to funding. For the original development, Seller received $30 million in state green income tax credits, of which $15 million are unused and assignable to a subsequent owner. For the entire project Seller also received a zoning bonus of 30,000 square feet for achieving LEED Gold and a 10-year 25 percent property tax abatement for achieving two Green Globes. For the zoning bonus, to secure that the project would satisfy “verification requirements” for LEED Gold, Seller had to post a $10 million surety bond with the Planning & Zoning Agency; if not drawn, the bond is returnable one year after the projected closing date for this sale.9
You represent Buyer. What due diligence tasks you would undertake?
You would confirm the status of state tax credits. You would check the green rules for obtaining the tax credits, e.g., Is a LEED rating required or does the state have its own green criteria? You would review Seller’s state filings, including any annual certifications or reports required to keep the credits; and you would review Seller’s state tax returns to check the credits already claimed and the amount remaining.
In reviewing the tenant leases you would watch for any green obligations of the landlord (Seller) which might impair cash flow or create capital liability. You would review the Green Apple Computer lease and related documentation. Also, you would review lease pass-through clauses to ascertain whether the landlord can pass-through green capital and operating costs to the tenants, which will be important if (for example) your client—Buyer—must spend money to keep the LEED Gold rating for the Retail Unit.
As to the $400 million mortgage to be assumed, you would check whether Seller has yet applied for recertification of the LEED Gold rating. You would suggest that Buyer’s engineer and LEED professional inspect the Retail Unit and the LEED rating file to advise on any obvious issues in getting recertification. (This would be important, also, for the Green Apple Computer lease requirement.) As to GreenMezz, you would engage a consultant to confirm that two Green Globes can be achieved in time for funding.
The results of your due diligence will then shape the green representations, warranties, covenants, conditions, and remedies that you negotiate in the purchase and sale agreement.10 Those contract terms are the subject of another article, but suffice it to say that as green issues become more important, the terms of the purchase/sale contract must be tailored very precisely to reflect the green due diligence—and to confirm the green “money” factors in the deal
Peter S. Britell, a partner at Venable in New York, is the author of Green Buildings: Law, Contract and Regulation (Law Journal Press, 2010, updated 2011 and 2012).
1. See, e.g., “Appraisal Institute Issues Form to Help Real Estate Appraisers Analyze Green Issues,” available at http://www.appraisalinstitute.org/newsadvocacy/news/2011/09292011_green_features.aspx; see also the Memorandum of Understanding between the U.S. Environmental Protection Agency and Appraisal Institute, creating a collaboration to focus on energy efficiencies in green buildings: “[G]enerally accepted standards of the appraisal profession…are applicable to green buildings…,” discussed in http://www.multihousingnews.com/features/green/appraisal-foundation-and-department-of-energy-to-collaborate-on-green-valuation/1004036492.html.
2. See, e.g., http://www.usgbc.org/DisplayPage.aspx?CMSPageID=221.
3. Local Laws 84, 85, 87 and 88 of 2009. See, e.g., Peter S. Britell and Stuart Saft, “Who to Pay for New Energy Laws Compliance,” New York Law Journal (June 21, 2010).
4. See, e.g, Introduction to USGBC and LEED; http://www.usgbc.org/DisplayPage.aspx?CMSPageID=222; http://www.usgbc.org/ShowFile.aspx?DocumentID=3330.
5. See, e.g., Green Globes Rating/Certification, http://www.thegbi.org/green-globes-tools/ratings-and-certifications.asp.
6. See, e.g., ICC 700 National Green Building Standard of the National Association of Homebuilders; http://www.nahbgreen.org/NGBS/default.aspx.
7. See U.S. Environmental Protection Agency, Energy Star, “How the Rating System Works,” available at http://www.energystar.gov/index.cfm?c=evaluate_performance.pt_neprs_learn.
8. Available at https://www.disclosuresource.com/leed/.
9. Miami and Washington, D.C., have bond requirements of this type.
10. For numerous specific examples of green representations, warranties, conditions, covenants, and remedies, see Peter S. Britell, Green Buildings: Law, Contract and Regulation (Law Journal Press, 2010, updated 2011 and 2012), available at www.lawcatalog.com, at ch. five.