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The Case for PACE: Clean-Energy Financing for Commercial Buildings Holds Promise

New Study Projects $2.5 Billion Annually For New Property Tax-Based Loans For Commercial Retrofits. But the Program Faces Questions In the Marketplace
June 30, 2010
The pace of innovation in solar and other energy efficiency technology has historically outstripped the ability of government and the private sector to come up with creative ways to finance solar retrofit and other green technology improvements in a way that pencils out financially for commercial landlords and homeowners.

Florida State House Majority Leader Adam Hasner, R-Delray Beach, hopes to change that in the Sunshine State, along with others who are working in California and several other states to change the basic financing paradigm for clean technology retrofits in existing commercial buildings through a financial tool called PACE (Property Assessed Clean Energy) bonds. Hasner co-sponsored a measure to implement PACE in Florida, and Gov. Charlie Crist signed it into law May 27.

In simple terms, PACE programs create local bond financing districts, which then lend back capital to building and home owners to fund energy retrofit projects. Owners repay the loan through their property tax bills, typically over a 15- to 20-year term.

The concept potentially helps commercial property owners overcome the hurdle of the high upfront cost of energy upgrades. While the industry has come to agree that retrofits can sharply reduce energy costs and consumption and offset greenhouse gas emissions, private owners have struggled to finance such improvements due to capital constraints, especially in today’s economy.

Aggressive NOI goals and the need to split the benefits of tax credits and other incentives with tenants present other barriers for owners. PACE financing has emerged as a promising, albeit untested, tool for commercial owners.

“The opportunities are really tremendous from an energy retrofit perspective,” Hasner tells CoStar. “A lot of the hesitation from building owners comes from the upstream expenses and not wanting to make those expenditures. This type of financing can help alleviate some of those concerns and convince owners to make these types of investments, which are going to be cost effective as well as energy efficient in the long run.”

Hasner serves as an advisor to Clean Fund, a California-based merchant bank for clean technology. Clean Fund CEO John Kinney, a Marin County, CA, entrepreneur, said he is involved in fairly deep discussions with major property owners, including executives of some of the nation’s largest publicly traded REITs, in Los Angeles and San Francisco.

The Bay Area in particular is home to progressive and environmentally conscious real estate companies - owners that don’t need to be convinced of the potential value of retrofits and energy efficiency to their bottom lines, tenants and the environment.

“They’re trying to differentiate themselves by taking a leadership role,” Kinney said. “At the same time, tenants are shifting toward buildings that are environmentally responsible and have lower energy costs.”

PACE was launched as a demonstration project in 2007 in the Bay Area city of Berkeley. Based on its early success, states soon began passing bills enabling local cities and counties to create their own programs. At least 19 states have passed the legislation, including Arizona, California, Florida, Colorado, New York, Maryland, Massachusetts, Texas and Maine.

It works like this. A municipality establishes a PACE program, creating a special assessment district utilizing a voluntary tax lien on private property to secure financing for retrofits on existing buildings for energy efficiency, solar and other renewable energy projects, and sometimes water conservation. The liens are paid off over terms ranging from 5 to 20 years, most commonly through annual property tax bills.

Using the lien as security opens several financing options. But in most programs to date, PACE bonds are issued by special municipal finance districts or finance companies, or funding is borrowed from the municipality’s general fund, to fund loans to owners for commercial and residential retrofit projects. In some programs, each large commercial project secures its own third-party financing such as an additional loan from the primary mortgage lender.

The approach is entirely market based and each property owner in the district can voluntarily opt into the program.

A new study by Pike Research, a market research and consulting firm on the clean technology industry, has fueled the latest wave of interest in - and also questions about - the fledgling PACE programs. According to Pike, PACE will continue to grow in popularity in the U.S., with investment in PACE financing for commercial buildings totaling a projected $2.5 billion annually by 2015.

Commercial owners who are initially most likely to be candidates for the program include those with modestly sized buildings burdened by high energy bills - owners who plan to keep their property for a while and have accumulated 10% or more in equity. Initial applications will probably include office buildings of less than six stories, select service hotels, small malls with central HVAC, and grocery stores. “Until now, private buildings such as these have had minimal access to financing for energy retrofits,” the Pike report said.

The Pike report also addresses several concerns and barriers to implementation for the programs, mostly centered on the fact that they are untested in the marketplace.

Potential buyers and lending institutions may be wary of existing PACE liens, with first-mortgage holders concerned about how the liens would be transferred in an ownership change, and whether they would hold a senior position to lenders’ own loans, Pike said.

Also, it’s yet unclear whether a voluntary PACE lien will be treated under generally accepted accounting principles (GAAP) as a loan or as a lien on a company’s balance sheet -- an important distinction in evaluating a company’s debt position. Unlike assessment liens such as school district assessments, loans count against a business’s debt capacity.

The question of who is held accountable in the event of default is already being tested, at least on the residential side. Government-sponsored mortgage-finance entities Fannie Mae and Freddie Mac, in letters sent to lenders in May, expressed concern about how the agencies will be repaid if homeowners participating in PACE later default on their mortgages. At least one municipality, Boulder County, CO., this week canceled its PACE program for residential, although its commercial program is still active.

Although PACE improvement projects can be fully financed under property tax bills and passed to future property buyers, some experts say most PACE programs are currently financed at relatively uncompetitive rates, which can present its own challenges.

“It will take time to educate people,” Florida’s Hasner acknowledged. “We’re still early in the first quarter of a four-quarter game. Everyone is very quick to recognize the innovations in technology in energy efficiency and new technologies. But PACE is really about an innovation in financing. It can be a very useful financial tool for commercial property owners to complete energy efficiency projects that will help them save money.”

CoStar Group Director of Analytics Norm Miller co-authored an influential study in 2008 with CoStar CEO Andrew Florance and Senior Director of Research and Analytics Jay Spivey that found strong evidence of both significant office rent premiums, faster absorption of space, lower cap rates and higher prices per square foot for green buildings bearing either an Energy Star or LEED certification. A retrofit program could potentially extend those premiums to a greater number of owners of existing properties.

“If PACE could offer lower financing rates, we would see more interest,” Miller said. “The mechanism makes sense. Many third-party vendors are pushing the program to cover new lighting, solar cells, improved water heating systems, HVACs, window glazing, reflective roofs and other improvements, all of which qualify. In concert with other incentives and federal rebates, these investments generally have payback within 10 to 12 years, and PACE programs can be utilized for up to 20 years.”

Because PACE assessments hold superior lien positions, lenders may one day restrict the ability to tack significant energy projects onto the property tax bill, especially when the total debt and improvement cost of a project exceeds a loan-to-value threshold deemed reasonable by the mortgagee, Miller said.

Kinney agrees that said PACE projects will require lender approval and cooperation to move forward due to the complexity of commercial mortgage loan covenants. However, PACE can be used in concert with tax credits and other incentives to reduce the cost of capital and shrink the total cost of a retrofit project.

“The lower the cost, the easier it is to justify, and in a commercial situation, projects aren’t going to get done just to improve the environment -- they will get done because they are cost justifiable,” Kinney said.

The fact that the property owner needs to cooperate with their mortgagee is “in some cases a different paradigm than property owners are used to,” especially in times of economic distress when relations between between lenders and owners are often strained, Kinney said.

Kinney said he is even talking with owners of distressed properties that are underwater and their lenders, who are intrigued by the PACE approach because of the possibility of making energy improvements, adding value and possibly recovering their costs in distressed assets -- without having to spend a lot of money on a building that might be lost to foreclosure.

"The steps that property owners take to retrofit are easy to justify financially," Kinney said. "Frankly, taking an inefficient building and making it more efficient is much more valuable than taking a new building that is already highly efficient and simply certifying that it is in fact, highly efficient."

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