Seismic Retrofitting, Burden or Benefit?
How All Three Stakeholders - Owners, Brokers and Lenders - Find Value Through Commercial PACE
PACE outlives its acronym, moving beyond ‘Clean Energy’.
A little background on the evolution of Commercial PACE. When PACE legislation was origionally passed in California back in 2008 the industry was excited to have a new financing product that allowed building owners to access capital for improvements centered around solar and energy efficiency projects, with repayment via the property tax bill up to 30 years.
Now, 9 years later, the Commercial PACE (“C-PACE”) industry has grown beyond just clean energy. With legislation passed in 34 states and the District of Columbia, the application of PACE has evolved to form new and valuable solutions that meet the unique needs and challenges of the communities it serves. Some of the most valuable real estate in the United States sits in areas where natural disasters such as hurricanes and earthquakes are imminent. PACE has emerged as a solution for financing storm strengthening and seismic retrofitting in these areas to help protect buildings and their occupants against natural disasters.
Storm strengthening and seismic retrofit improvements are typically viewed as a “nice to have”, however many cities in California, like San Francisco and Los Angeles, have enacted mandatory programs that require property owners to perform seismic retrofits on building types deemed to present an increased risk of danger during an earthquake. Owners, brokers and lenders alike are feeling the mounting pressure to find the best financing solution for these projects.
Since there is no true “payback” for seismic retrofit work, the C-PACE structure provides a powerful financing option that allows owners to access fixed rate, non-recourse capital for seismic retrofit work that is repaid via the property tax bill and stays with the building upon sale with terms up to 30 years. In the case of multi-family, several municipalities allow for the seismic retrofit costs financed using PACE to be passed through to tenants.
While the numerous features of C-PACE financing help to improve NOI for commercial building owners, the commercial mortage broker community is beginning to realize the benefit of C-PACE. For a commercial broker, PACE is a powerful tool for sourcing complementary capital to fund projects where finding financing would otherwise be difficult. From a seismic standpoint, as more owners are required to retrofit their buildings, brokers may encounter challenges in sourcing capital for these projects because of limitations in the existing capital stack.
Mortgage lenders, brokers and other loan originators can serve their clients well by understanding the C-PACE structure and how it fits in a project capital stack. PACE allows owners to increase their leverage beyond a typical senior loan and can effectively replace much higher cost mezzanine or preferred equity with non-recourse assessment financing, resulting in lowering the overall cost of capital. PACE can also be a solution for deals where an owner has a lower leveraged property but marginal credit.
When it is comes to seismic retrofit projects, many lenders view the benefit of their clients accessing C-PACE from a risk mitigation perspective. Lenders typically will require their clients to comply with local ordinances related to bringing buildings to current seismic code. There are, of course, a number of ways a building owner can finance a seismic retrofit project, including using their own capital (if available), refinancing their building, or taking out a second mortgage. With the recent advent of C-PACE being available to owners to finance the retrofit projects, owners have a more cost effective, long-term option.
Generally speaking, lenders who understand the value of C-PACE acknowledge PACE liens for 5 primary reasons. First, PACE financing does not accelerate in the event of non-payment of the property tax bill, there will never be a ballon payment that shows up ahead of a senior lender. Second, the passed due property tax payments is the only obligation that may be senior to a mortgage in the event of a foreclosure, which is a fraction of the value of the property and hence a very small amount of exposure and risk for a lender. Third, a typical annual C-PACE payment equates to 1% to 2% of the property value, so a year’s missed payment does not represent a significant amount of seniority. Fourth, lenders recognize C-PACE financing enables improvements to properties that may increase the value of their collateral and reduce their downsize risk (not being up to seismic code). Lastly, in many cases PACE increases the NOI of the property and modernizes the equipment so the property would be subject to fewer price concessions in the event of a sale. Most lenders are relationship-focused and value the relationship with their borrower, C-PACE would be a creative solution to their borrower’s property upgrade needs.