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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2016

PACE Offers a Financing Boost

The program can be tapped by commercial-property owners to fund value-enhancing, energy-efficient upgrades

When the State House Square building in Hartford, Connecticut, was acquired by new owners, an integral part of the investment plan was a retrofit to replace the structure’s aging central plant.

The 1-million-square-foot Class A office building needed a new central heating and cooling plant, among other upgrades, making the building an ideal candidate for an investment in energy improvements. The question was how to finance the building retrofit to minimize out-of-pocket costs and maximize the return.

The owner of the property turned to a unique financing structure called Property Assessed Clean Energy, or PACE, which can be tapped to fund a variety of energy- and water-efficiency upgrades for commercial buildings. PACE is an innovative financing solution that has been legislatively approved in 32 states and the District of Columbia.

PACE financing allows commercial real estate owners to modernize a building’s infrastructure and lower expenses without tapping cash or credit lines. Instead, PACE allows property owners to repay investments for environmentally conscious building upgrades and new construction via their property tax bills.

Lower cost of capital

The assessment for a PACE financing deal shows up as a line item on the borrower’s property-tax bill and can be transferred to a new owner. PACE financings feature fixed interest rates and generous payback terms of up to 20 years or longer.

The design of PACE programs varies from state to state, but typically local governments set up PACE districts to provide the loans, which are funded through municipal bond issues or other municipal-tax sources. Because the PACE debt is tied to the property-tax bill, however, it does survive foreclosure as a lien.

In the capital stack, PACE can be used in concert with higher-cost capital to reduce the blended cost of capital, or to reduce traditional debt leverage. With PACE added to the mix, not only is the overall cost of capital for a commercial building potentially reduced, but the PACE-funded improvements normally produce positive cash flow immediately — as in the case of State House Square, which delivered 90 percent energy savings.

Mortgage bankers, brokers and other loan originators can serve their customers even better by understanding the PACE structure and how it fits into the commercial real estate capital stack.

Market potential

PACE financing can be used to fund energy-efficiency, renewable-energy, water-conservation and seismic improvements to existing buildings, or for similar purposes in new construction. The market potential for energy-efficiency retrofits for commercial buildings is projected to reach $55 billion by 2020, according to Navigant Research. 

PACE started as a residential program with opposition from the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac — in part because of the fact that PACE financing has a superior lien position over a bank mortgage. That objection, however, is not a major factor in commercial PACE financing. PACE financing on commercial projects complements conventional debt and equity and sometimes replaces it. In some circumstances, it’s appropriate to consider PACE as a cheaper form of mezzanine financing.

In the commercial PACE universe, loan sizes can range from thousands to millions of dollars and can cover up to 100 percent of the cost of upgrades or improvements. PACE works well with single- and multiple-tenant buildings — and the program benefits both owners and tenants. Owners often see their PACE investments become immediately cash-flow positive because of tax and utility savings as well as other cost-reduction benefits. Tenants benefit on the expense side because of lower energy costs, which help to offset any increases in property taxes passed through to the tenants.

Because PACE is treated as an assessment that is paid back via the property tax bill, it allows property owners to access value — i.e., lower utility costs and increased property value — without incurring conventional debt. That is precisely the value proposition advanced through PACE financing.

PACE funding is nonrecourse, has no covenants and is transferable. The obligation is linked to the property, carrying a low long-term interest rate.

Gaining favor

In cases where there is an existing mortgage on the property, the lender must consent to the PACE financing before the funding can close. Lenders will only agree when they understand that future PACE assessments, like property taxes, are not “accelerated” during a foreclosure, so lenders are only agreeing to be in back of late property taxes in terms of their lien position.

As familiarity with PACE financing grows, lender consent should be easier to come by, because energy-saving improvements lift the value of a property and also help to boost net operating income. PACE is a net plus for property owners and lenders, and it promises to play an increasingly prominent role as a new layer in the capital-stack financing for commercial-property transactions that involve energy-efficiency and renewable-energy building improvements. 


 
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