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WOOLSEY MCKERNON

CRE Finance World | Summer, 2018

 

When commercial Property-Assessed Clean Energy, (C-PACE) hit the market nearly a decade ago it was viewed in the same way as many alternative lenders – a borrower’s last option when seeking project capital. Now, as the real estate cycle reaches peak levels and banks are becoming more cautious, commercial real estate owners and developers are facing fewer and fewer cost-effective options to fill out their capital stack. Borrowers have sought capital that offers maximum flexibility, opening up the market for non-bank lenders to step in and fill the gaps with mezzanine loans, bridge financing and other debt instruments.

C-PACE as an alternative lending solution (the obligation is repaid via the borrower’s property tax bill) is gaining wider popularity as its application to individual properties and portfolios is expanding from half-a-billion dollars today, to a multi-billion-dollar industry within the next five years. C-PACE financing volume has doubled annually and is close to reaching $600 million in total financings across 1,200 properties this year according to the industry trade association, PACENation.

It’s a financing tool whose time has come, even as the use dramatically expands to ever larger deals and more use cases.

New applications for C-PACE are going beyond the renewable energy (water) and resource-efficiency areas (energy efficiency and water conservation) to improvements for office, retail, industrial, multifamily, hospitality and mixed-use real estate. Enterprising owners and developers now use C-PACE financing for infrastructure resilience and disaster preparedness. The seeming proliferation of multibillion-dollar disasters – from hurricanes like Katrina and Harvey in the Gulf to wildfires in Southern and Northern California – have sounded a wake-up call. C-PACE is a financing tool that is squarely focused on better preparing properties and protecting their value with greater resilience.

In California, C-PACE is being widely used for seismic retrofits in addition to solar, energy efficiency, and water conservation. More recently, cities and counties in California have started to enforce mandatory seismic retrofit and are promoting C-PACE as a solution for property owners who need to comply in order to protect their valuable investment from catastrophic loss and avoid fees and liens.

C-PACE Goes Mainstream with Solar and Energy Efficiency Improvements

C-PACE has gone mainstream primarily from its application toward renewable energy and energy efficiency investment. Its use in solar and energy-savings are still the backbone of the industry. Let’s consider a few examples before we look at some emerging use cases.

C-PACE funding provided $8.6 million for a research and administrative facility for Verseon, a technology-based pharmaceutical company with a proprietary drug discovery platform. Verseon has utilized C-PACE to complete the refurbishment of its 85,000-square-foot facility in Fremont, CA. The improvements provide a superior, reliable power source and offset a large portion of the electricity supplied from the grid for substantial cost savings.

In Hartford, CT, C-PACE also provided a 100,000-square-foot office complex $8.4 million of financing. These funds enabled State House Square, one of Hartford’s premiere Class-A office buildings, to significantly lower its energy and operating costs for 90% projected energy savings.

C-PACE is ideal to pay for a solar system because it offers flexible options that create positive cash flows for most projects. The long terms of C-PACE (up to 30 years in most states) lower payments by spreading them over a longer period than most traditional financing allow.

The long terms of C-PACE make it the most appropriate solar financing option because the term matches the productive life of solar, and the obligation is tied to the property and is automatically transferred when the property is sold.

 

C-PACE financing enables property owners with a broad spectrum of credit profiles to save significant amounts of money, regardless of their ability to adequately utilize all available solar tax benefits. C-PACE can be used to finance solar systems with either a direct-ownership structure or a third-party owned structure (via a SolarPACE Power Purchase Agreement). When a property is sold, C-PACE financing can transfer automatically to the new property owner without the cumbersome restrictions related to typical bank financing or PPA agreements.

Historic Property Renovation / Improvement Using C-PACE

In addition to its standard utilization, C-PACE can be used as a cost-effective replacement to other forms of financing as an instrumental tool to optimize the weighted average cost of capital in a capital stack for either a gut rehab or new construction.

C-PACE has the ability to replace high-cost mezzanine financing – at interest rates in excess of 10% – with alternative capital through C-PACE at a rate closer to 6%. This has caught many developers’ attention. One such sponsor is Dallas-based Alterra Worldwide, which in 2016 completed the transformation of a century-old Dallas office building and onetime warehouse into a 238-unit multifamily community and a 274-key, dual-branded Marriott hotel.

 

Originally constructed in 1910, the nine-story, 510,000 square-foot Butler Brothers Building had long sat empty across from City Hall. The new Fairfield Inn/Town Home Suites by Marriott, plus retail and office space, is expected to spur additional revitalization in the area. C-PACE financing replaced much higher-cost mezzanine financing, significantly reducing the debt service requirements and increasing project returns. C-PACE financing also helped to optimize a complicated capital stack, which included EB-5 debt and historic tax credits. Lower utility costs with the project’s investment in efficiency make the luxury apartments appealing to tenants with an annual projected savings of $2 million.

C-PACE for New Construction Projects

Traditional banks have been broadly reducing their Lien-to-Value/Loan-to-Value (LTV) more recently, creating a vacuum for non-bank lenders and alternative forms of capital to step in. Direct C-PACE lenders see the opportunity and have been demonstrating how C-PACE can benefit commercial/industrial ground-up and new construction projects. Property owners can benefit from higher performance building technologies while using C-PACE financing to pay for it. All too often a property owner may have the ambition and desire to incorporate these technologies into their design, only to see the suggested improvements value-engineered out. Leaving aside the lower capital cost of C-PACE to alternatives, many owners have found C-PACE as a solution to provide additional capital for their projects allowing them to keep these items that will provide operational cost savings and drive Net Operating Income.

C-PACE for new construction projects is currently allowed in 12 states and the District of Columbia. All of the following are eligible: direct and indirect costs for material, labor, and soft costs related to project design, evaluation, demolition, installation, and construction necessary to implement energy efficiency (HVAC, thermal barrier), water conservation, and renewable energy measures. In California, that list is extended to include seismic upgrades to buildings for ground-up construction, existing-structure retrofits, and renovations. In all cases, improvements must be permanently affixed to the property.

For new construction the annual assessment can be as much as 20% of the total LTV of the property based on the as completed valuation from the senior lender. Additionally, the annual assessment amount can be up to 5% of the appraised value. Given the costs of the PACE-eligible improvements, it is easy to qualify the C-PACE eligible improvements to take advantage of the maximum amount.

Earthquake Resilience-Retrofitting and Storm Strengthening

Now, nine years later, the C-PACE industry has grown well beyond clean energy and efficiency. With legislation passed in 33 states and the District of Columbia, the application of C-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” when the capital is available to pay for the improvements, 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.

“We see C-PACE as the intelligent, innovative solution for earthquake retrofit, clean energy, and resilience, of all kinds,” said Yat-Pang Au, CEO of Veritas Investments, San Francisco’s largest owner and operator of multifamily and retail mixed-use property. “Lenders, regulators and other constituents are finally getting comfortable with C-PACE, and it’s appreciated by owners facing significant, and more frequently mandated financial obligations. We need flexible sources of capital like PACE.”

PACE Preparedness for Hospital, Institutional Property

Northern California has also seen the largest application of PACE financing, demonstrating its diversity in application to institutional real estate.

C-PACE also provided funding for a seismic upgrade at Seton Medical Center Campus. This $40 million project is the largest in the history of commercial PACE. The upgrades allow the hospital to meet California’s mandatory Hospital Facilities Seismic Safety Act and ensure the long-term safety and continued service of this acute care facility.

Owner Benefits in Seismic C-PACE

Because 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 multifamily, several municipalities allow for the seismic retrofit costs financed using PACE to be passed through to tenants.

Broker Benefits

While the numerous features of C-PACE financing help to improve NOI for commercial building owners, the commercial mortgage 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.

Lender Benefits

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 its own capital (if available), refinancing the 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.

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 can replace much higher cost mezzanine financing or preferred equity with non-recourse, assessment financing, thus lowering the overall cost of capital. PACE can also be a solution for properties for which an owner has a lower leveraged property but marginal credit.

Conclusion

As C-PACE financing continues gaining popularity, owners and developers of commercial real estate are finding that C-PACE provides the kind of flexibility and improved cost-of-capital that has earned a key role in the capital stack. As resilience needs grow from storm, sea-rise, earthquake, and owner’s desire to have the most efficient asset with the lowest utility expenses, C-PACE is gaining prominence as a cost effective foundational tool.

Woolsey McKernon | Senior Vice President and Chief Revenue Officer

Print article found in this summer’s issue of CRE Finance World | Summer, 2018

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