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.
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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