PACE Financing: A Brief Overview

Source: Sean Pollock on Unsplash

This week I decided to take some time to write about one of the financing structures I find the most interesting – Property Assessed Clean Energy (PACE).  PACE is an innovative structure that makes it possible for owners of residential and non-residential asset classes to obtain relatively low-cost, long-term financing for projects that leverage energy efficiency, water conservation, seismic strengthening, and renewable energy sources (such as solar, wind, and biofuels). PACE is a program authorized at the state level and implemented at the municipal and county levels that allows coordination with private capital providers to offer financing to property owners for qualifying improvement projects. This post will provide a quick breakdown of how PACE programs are structured and how PACE fits in a typical capital stack for a commercial real estate transaction.

PACE Program Structure

PACE was originally introduced in California in 2007 as a form of assessment financing to fund improvements to “qualifying properties,” namely properties that reduce energy and water usage, leverage a renewable energy source, enhance the resiliency of a structure, and which are ultimately considered a public good. There are currently 36 states that have approved the PACE structure in the U.S., below is a breakdown of how a PACE program is implemented through legislation and funded via a private capital source.

  • State legislature must approve PACE legislation.
  • Counties and/or cities are able to “opt-in” to the PACE based on the program implemented at the state level.
  • The source of private capital (typically a fund) will essentially underwrite the PACE financing as a loan to ensure eligible borrowers have adequate repayment capacity.
  • Once underwritten, the PACE transaction is submitted for program approval. Upon receipt of approval, the transaction is funded (typically through bond proceeds).
  • Post-funding, the transaction is recorded by the county/municipality as an additional line item added to the property’s tax assessment. The PACE assessment is collected bi-annually or annually with the normal tax assessment and then remitted to private capital source for repayment.

To put it simply, PACE is originated as a debt instrument and assessed as an addition to property taxes. Though the PACE assessment is structured similarly to a mortgage, repayment is filtered through the county or municipality. However, unlike a mortgage, a deed of trust is not filed as part of the recording process for the transaction. Therefore, PACE financing is ultimately tied to the property and not the borrower. If the borrower decides to sell the property, they are required to provide documentation recording the PACE assessment, but they are not required to pay off the assessment. The assessment remains with the subject property until it is repaid.

PACE in the Capital Stack

In commercial real estate transactions PACE is typically utilized to replace expensive mezzanine debt (or equity, depending on the size/scope of the transaction). A typical financing structure or “capital stack” is comprised of (1) a senior bank note and equity from partners/investors or (2) a senior bank note, mezzanine debt, and equity – depending on project/sponsor level constraints. Moreover, mezzanine debt tends to carry a shorter time horizon of 5-10 years. As discussed above, PACE financing is structured like a mortgage with a time horizon of 25-30 years.

Stretching out the time horizon can make the project bankable as the payments over a longer period can reduce debt service burdens. Mezzanine debt is relatively expensive, usually priced at a rate of 10-15%. In addition to a longer maturity, PACE financing is priced more competitively, around 5.5-7%. Finally, PACE financing usually accounts for a larger amount of the capital stack than you would see with mezzanine debt. The illustration below captures the benefits described in this section and provides a side by side view of a typical mezzanine structure compared to a PACE structure.

Source: CleanFund

Though not applicable to all transaction types, PACE provides a competitive alternative to equity and mezzanine financing when developing or retrofitting a property with energy efficiency in mind. Moreover, this type of financing strikes a good balance between financial flexibility and renewable energy incentives which makes it attractive to a large base of developers – hopefully expanding the reach of sustainable development at the urban level.

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Main Street Lending Program – What Businesses Should Know

Source: Sonder Quest on Unsplash

On April 9th, 2020 the Federal Reserve announced the creation of the Main Street Lending Program – a novel pair of credit facilities that will provide credit to eligible businesses with a maximum of 10,000 employees or a maximum of $2.5 billion in annual revenues. The Program will achieve this by purchasing up to $600 billion in loans.

The Program’s facilities are designed to support lending to both investment-grade and below investment-grade borrowers. Moreover, these facilities are separate from the other mid-sized business loan program contemplated in the CARES Act. Since I dedicated last week to expanding on the programs designed for large firms, I wanted to take some time this week to dive into the Fed’s solution for medium-sized businesses. I’ll start by providing an overview of the two facilities that comprise the Main Street Loan Program and then wrap up the post by identifying potential risks businesses should be aware of before applying for relief under this program.

Overview

The Program is comprised of two facilities: first, the Main Street New Loan Facility (MSNLF) applies to eligible unsecured new terms loans originated on or after April 8th, 2020. Second, the Main Street Expanded Loan Facility (MSELF) applies to eligible “upsized tranches” (sometimes referred to as debt accordions) to existing secured or unsecured loans originated before April 8th, 2020 (provided the upsize occurs on or before April 8th, 2020). The primary differences between the terms of the two facilities relate to maximum loan amounts and collateral requirements (see table below).

Similar to the other Fed facilities explored on this blog, the Main Street Lending Program will utilize an SPV to facilitate transactions. Specifically, the SPV will purchase a 95% stake in each of the loans made to borrowers under the program and eligible lenders will retain the remaining 5%. The SPV will be seeded by $75 billion from the Treasury and will utilize leverage to meet the $600 billion obligation discussed above. Eligible lenders are U.S. insured depository institutions, U.S. bank holding companies, and U.S. savings and loan holding companies. Non-bank lenders are currently ineligible.

Table 1 – Differences Between MSNLF and MSELF:

Source: Miller Canfield

Risks for Businesses

First, unlike the PPP loan program, loans made under the Main Street Program need to be repaid in full. There are no provisions for loan forgiveness under this program. As shown above, the loans are underwritten to 4 year terms with variable interest rates. Repayment can be deferred for up to 1 year, but this is only grace period allowed.

Second, despite being called the Main Street Lending Program, the minimum loan amounts for both credit facilities are $1,000,000 – a far larger sum than is normal and customary for small-to-medium sized business loans. Typically, a commercial bank will lend up to 2-3 times a borrower’s earnings before interest, taxes, depreciation and amortization (EBITDA) and require some form of collateral. For many small businesses, 2-3 times EBITDA still falls well below $1,000,000. Under the Main Street Program facilities, many small businesses would be required to leverage themselves 4-6 times above EBITDA (depending on whether or not they are accepting a new loan, or adding on to an existing loan). Banks tend to be hesitant about providing excess leverage, as the likelihood of default increases when repayment capacity is diminished or all together inadequate. Conversely, there are few incentives for a small-to-medium sized business to take on excessive leverage given the 4 year expiry and variable rate.

Finally, it is also important to consider the fact that some lenders may not be interested in originating these loans. As currently written, the Fed’s term sheet implies that loans made under the Main Street Program will be senior to any other existing notes. Moreover, the Main Street Program facilities cannot be utilized to refinance existing debt. While it is still unclear to what degree these loans will be made senior over others, the ambiguity in the existing term sheet doesn’t help much in terms of establishing buy-in from eligible lenders. Ultimately, it appears that significant deterrents exist on both sides of the equation. While the impact of the Main Street Lending Program remains to be seen, I believe the overall result will unfortunately be underwhelming.

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