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Introduction
If improvement or repairs are needed to a property that is related to any form of green energy initiatives, what are the finance options? Traditionally the answer to this question came in the form of equity, tax credits, public incentives, vendor financing, mezzanine debt or other costly financing vehicles. However, now that incentives are gone, an alternative to the remaining costly capital solutions is available for properties that are located in any of the 30+ states that have enabled legislation for Commercial Property Assessed Clean Energy (C-PACE). C-PACE is an alternative financing mechanism for the projects that improve energy efficiency, utilize renewable energy, conserve water and much more. Fortunately, in most new construction projects, virtually all of the water, wastewater, plumbing, irrigation, H-VAC, windows, insulation, roof treatments, etc. components have an energy efficiency benefit which can be financed through C-PACE.
Like other project financing, C-PACE uses borrowed capital to pay upfront capital and installation costs associated with energy efficiency or renewable energy improvements and, in theory, the amount of the savings should be sufficient to cover the increased capital cost. However, in the case of C-PACE, the borrowed capital is not repaid with these energy expense savings, as the debt is repaid over time via a voluntary tax assessment. What this means is that in most states, C-PACE is billed as a single line-item on the property tax bill and collected through the normal property tax collection process. The security interest provided by the tax assessment, which is a long-used and well understood mechanism, results in several compelling features, including longer-term, lower cost financing, and transferability of the repayment obligations to the next property owner.
In short, C-PACE makes it possible for owners of commercial, industrial, multifamily and nonprofit properties to secure what is generally thought of as a mezzanine tranche on the capital stack, but instead of the traditional higher capital costs, the C-PACE is a low-cost, long-term and fixed-rate financing option which is funded by private capital providers.
History
The concept of financial mechanisms that uses voluntary assessments for repaying municipal or quasi-governmental bonds and having it attached to the property taxes has been around since the early 1800s. These historically were utilized to fund infrastructure projects for public good, such as sidewalks, fire stations, street lighting, etc. C-PACE was able to transform this long-standing public-sector assessment concept to open similar opportunities for projects that benefit the private sector. The C-PACE concept was first conceived and proposed in the Monterey Bay Regional Energy Plan in 2005. This finance solution was designed to overcome one of the most significant barriers to solar and costly energy efficiency retrofits: up-front costs. A homeowner could spend tens of thousands of dollars on a solar photovoltaic system, upgrading windows to be more energy efficient or adding insulation throughout the home, yet all of these investments would not likely be recovered when the home was sold. PACE enabled the homeowner to capitalize and “mortgage” these improvements and pay only for the benefits they derive while they own the home.
Following the success in the residential space, the first commercial PACE program was rolled out in California in 2009. C-PACE is now available to industrial, commercial, agricultural, multi-family, and non-profit/religious properties. As a boutique industry, private firms often participate in several elements of the C-PACE food chain as lenders, developers, administrators, contractors and marketers. With limited public funding, reduced bonding capacity and the ever-increasing demands on public revenues, state and local governments are increasingly interested in attracting private-sector dollars to take full advantage of the opportunities associated with energy efficiency and renewable energy investment.
How it Works
To be eligible for C-PACE financing, the project must be located a) in a county or municipality that has approved C-PACE programs; and b) within a state that has passed PACE-enabling legislation. Depending on the authorizing legislation, eligible projects may include energy efficiency, renewable energy, energy storage and non-energy measures (e.g., storm and seismic hardening).
Once the State and local resolutions have occurred, it is also important to understand the required participants involved in a C-PACE transaction. The parties are as follows:
PACE Administrator – manages the project and ensures adherence to program requirements;
Local Government Body – bills and collects property tax assessment and remits payment to the capital provider;
Energy Services Company (ESCO) – general contractor that installs the equipment and materials;
Property Owner (customer) – Facilitates the energy efficiency upgrade (or tenants working in concert with the landlord); and
Private Investors – lenders or bondholders to provide the capital.
Following is an example of typical CPACE Structure.
The PACE Administrator is truly the resident expert that will typically conduct marketing and sales to originate potential customers. Before financing is disbursed, the project must be approved by the PACE Administrator. For properties with a mortgage, consent from the mortgage lender is also required as the additional tax assessment can prime their security interest. Depending on state statute, capital for CPACE projects may also come from the government through General Fund reserve funds or Revenue Bond proceeds, from private investors, or a combination of the two.
Once the project is approved and financing is secured, the contractor installs the equipment and the customer begins to realize energy savings. The financing is then repaid in the form of an assessment on the building owner’s property tax bill over a period of typically 10-20 years. A PACE lien in the amount of the annual assessment is also placed on the property. The lien is senior to most other debt on the property, which can encourage investors to provide capital at lower interest rates over longer terms than with standard loans. If the building is sold during the PACE repayment period, the lien securing the assessments remains on the property and becomes an obligation of the new building owner (unless it is paid off in full as part of the sale). Nonpayment of a PACE assessment results in the same set of repercussions as the failure to pay any other portion of a property tax bill.
Benefits to Borrower
The benefits to the property owner are self-evident. However, the clear financial gains are as a result of the additional capital on favorable terms. As an example, the graph below shows the difference between utilizing a C-PACE versus a traditional mezzanine loan under the following assumptions:
$10M Mezzanine or PACE loan
Capitalize 2-year interest reserve
Mezzanine debt is assumed to be a 14.0% interest rate
PACE debt is assumed to be a 6.5% interest rate
As seen in the foregoing table, a potential $6 million savings is plausible over a 5-year investment horizon when given the opportunity to utilize the C-PACE as an alternative to mezzanine debt at current market rates. This is in addition to the potential increased efficiency and decreased expenses that should come as a result of C-PACE. Of course, these two line-items are materially compounded with a 20 year term on the loan, resulting in lower annual payments throughout the lifetime of the installed equipment, and thereby generating higher cash flow.
Other benefits include flexible balance sheet treatment. Due to the nature of C-PACE, it can be structured as off-balance sheet or on-balance sheet. Further, property owners are able to treat their C-PACE assessment as an operating expense under this same logic, and some treat it as a “below-the-line expense,” similar to interest, as you would in calculating EBITD while others may treat is as a property tax for determining the Net Operating Income.
Disadvantages to Borrower
Even with all the unique opportunities presented by the C-PACE, there are some glaring disadvantages that need to be articulated. The first issue to consider is the limited availability. C-PACE is limited within the jurisdictions that has PACE-enabled legislation, which are currently 30+ states and the District of Columbia. This means that, at least for the time being, borrowers are presented with clear geographical limitations.
The second issue comes from the fact that approval from the senior mortgage lender is required to move forward with C-PACE. As a program that has been around for over 15-years, C-PACE is still not well known to many in the banking and development sector. Consequently, education and approval from the senior lender can sometimes be difficult and time-consuming to obtain. However, as time goes by and the benefits are more easily understood, lenders are starting to accept and welcome C-PACE financing. As of June 2020, there are over 200 national, regional and local lenders which have consented to C-PACE financing.
The third disadvantage comes from C-PACE’s need to have unique financial structure for each specific property. This makes it very challenging to use the capital for portfolio-wide initiatives. This, in turn, means that more effort and time in a “deal-specific transaction” needs to be spent to ensure all of the properties in the portfolio will be presented with the same financial structure.
Benefits to Senior Lender
There are many aspects of the C-PACE financing that can entice senior lenders to allow borrowers to utilize this financial mechanism, with 3-benefits that especially stand out. These are as follows:
Assessments Cannot be Accelerated – While the full assessment amount is recorded on the property records, only the annual payment may be collected, even in a default situation. The past due portion that is senior to a mortgage lender’s claim is typically, only 1-3 percent of the property value. If the property owner did not pay the C-PACE assessment in year 1, the C-PACE lender can only collect the delinquent payments. The remaining payments are due according to the original repayment “assessment” schedule.
C-PACE Financing Does Not Restrict a Senior Lender’s Foreclosure Rights – Unlike other debt, C-PACE does not require an inter-creditor agreement. Rather, in the event of a default on the senior lender’s debt, the senior lender can foreclose on its mortgage interest in the property in the same manner as if it were the sole secured creditor on the property. The C-PACE capital provider may not prevent, restrict or otherwise impact the senior lender’s foreclosure.
Improvements Increase the Value of the Senior Lender’s Collateral – Increased value to the collateral comes from the fact that C-PACE capital is used to install cost-reducing assets, and offers lower interest rates (when compared to mezzanine debt or preferred equity) and offer longer maturities, resulting in lower payments and a higher debt service coverage ratio. Most states also require that an engineer establish the monetary savings expected to result from the C-PACE project. Therefore, a PACE project directly reduces a building’s operating costs, increasing its net operating income and valuation.
Trends
Based on what is seen in the marketplace, C-PACE is clearly gaining traction as a very viable alternative to financing green energy projects on value-add projects, as well as new construction. In fact, PaceNation, a nonprofit association that advocates for PACE financing, showed that C-PACE had its best year ever in 2019, with approximately $677 million in C-PACE investments—bringing the total over the past decade to more than $1.5 billion.
Forecast for 2020 … and Beyond
Many of the sophisticated lenders and participants in the C-PACE space agree that even with the 2020 pandemic and other market slowdowns, they’re expecting growth in production. In fact, it is estimated that as banks pull back on lending, it will create more space in the capital stack for C-PACE to fill in some of the gaps. This may prove to be true especially for the hospitality sector as they were the first to pick up on the use of C-PACE funding.
Sources
https://www.energy.gov/sites/prod/files/2017/10/f39/FL1710_WIP_CPACEv2.PDF
Mortgage Lender’s Guide to C-PACE: Lender Consent
https://betterbuildingssolutioncenter.energy.gov/financing-navigator/option/cpace
https://www.cpexecutive.com/post/c-pace-the-financing-program-that-changes-cre-conversations/
https://www.cpexecutive.com/post/whats-next-for-c-pace-financing/
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MarketSpace Capital, LLC is a Houston, Texas-based private equity real estate development firm focused on ground up developments and value-add investments throughout the United States.
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