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Will Investors Warm Up to PACE Energy Efficiency Financing in 2014?

Hilton, Other Institutional Property Owners Discovering Upstart Green Property Improvement Financing Program
December 30, 2013
The year closed on an upbeat note for government-backed financing of commercial energy efficiency projects with Hilton Worldwide unveiling the largest property renovation plan to date utilizing Property Assessed Clean Energy (PACE) financing and Michigan and Connecticut among the states implementing PACE financing programs.

Cumulative project financings in the nascent PACE marketplace have increased from just over $10 million in 2011 to about $55 million as of December 2013, according to a market snapshot by PaceNow, an industry advocacy group.

The hope, according to David Gabrielson, executive director of PACENow, is that large-scale adoption of PACE funding by real estate owners will eventually lead to the development of a PACE asset class, and widescale securitization of PACE assets, which would attract capital investment at low interest rates.

Specialized commercial PACE (C-PACE) financing is now available in nine states and Washington, D.C. through 26 different programs, with 12 new programs in development in nine other states. Projects have been initiated or complete on 200 buildings through 18 programs with loan values ranging from $5,000 to $7 million.

Hilton Worldwide, recently implemented what is believed to be the largest use of commercial PACE to date, using the energy efficiency loan program to fund $7 million in sustainable upgrades at its Hilton Los Angeles/Universal City property. Hilton said it expects the hotel renovation will save an estimated $800,000 in energy costs and water savings of $28,000 annually, conserving more than 2.8 million gallons.

Under PACE, state and local agencies may set up programs for commercial landlords and other owners to obtain financing for certain energy projects as solar installations, reflective roofs and lighting, window and HVAC upgrades. Borrowers repay the loans through lien-based special assessments on their property taxes over 15 to 20 years.

In Los Angeles County, commercial, industrial and multifamily property owners can choose their own PACE project investors and negotiate interest rate and terms. The Hilton project is the second project launched since the county formed a team of PACE experts last year to assist building owners. L.A. County has 39 existing PACE financing applications in the pipeline totaling more than $36 million worth of sustainable upgrades.

While California has been the national leader in deploying PACE, Connecticut and Michigan jumped into the program in 2013. Connecticut launched a statewide program administered by its public/private Clean Energy Finance and Investment Authority (CEFIA), which established statewide C-PACE standards for the state’s 169 cities and towns, which can voluntarily pass a local law to enlist in the program. The program helps building owners perform energy savings audits that can increase annual building cash flow, and markets the benefits to owners and energy service contractors.

In addition to making money available to fund projects on demand, CEFIA is packaging its roughly $10 million loan portfolio into one of the first PACE bond securitizations to private investors, which market participants say is a key step in making the vehicles attractive to institutional investors.

Simon Property Group (NYSE: SPG), the world’s largest shopping mall owner, has been an early adopter of PACE. The REIT developed a plan, a funding source, and contractors for a project on a property near Cleveland, OH, convincing the Lake County Port Authority, a public/private company that operates regional lake port facilities and airports, to place the PACE assessment on the property. The authority collects the assessment and remits it to the capital markets project funder Simon had sourced.

The program may also become more attractive if interest rates increase.

"The one issue holding up more extensive use of PACE is that the financing is usually at substantially above market rates," said Dr. Norm G. Miller, a professor at the University of San Diego with the Burnham-Moores Center for Real Estate. "PACE users do gain a longer term for the financing, but at a higher interest rate."

Administrative costs are also an issue for some borrowers, in part because the programs have yet to reach the scale necessary to help induce PACE lenders to lower fees. However, revenue-hungry municipal governments seldom think about financing costs as an issue, so there is little pressure to bring down fees and spreads, Miller said.

PACE loans make the most sense for borrowers who may not have the ability to secure cheaper capital or for a long enough term.

"It does make sense for some property owners," noted Miller. "Of cousre, the best thing about the program is that it has helped building owners lower energy costs and greenhouse gases."

The Connecticut program has become a successful model chiefly because its rates are competitive with other debt capital sources, Miller said. Many states, including California, have PACE loan rates averaging a fairly steep 7%. However, rates in the 4.5% to 5% range are competitive with commercial mortgage loan rates.

"Combined with the other benefits, it can certainly pencil out," Miller said. "PACE demand in California would explode if the rates were as low as in Connecticut. With more scale, these funds could be securitized, especially if they were tax exempt bonds."

Under the L.A. County program, commercial PACE bonds are issued for a single property or project and can only be bought or sold by qualified institutional investors. While commercial, industrial and multifamily owners can choose their own project investor and negotiate their own rate and terms, Los Angeles County requires verification of actual energy savings.

That’s the kind of accountability that meets the rigorous transparency requirements of publicly traded companies like Hilton, which last week debuted the lodging industry’s largest initial public, raising $2.35 billion.

"PACE is the only funding mechanism that is credible in providing verifiable information to our investors and therefore is the ideal tool for us to move forward in becoming the gold standard in sustainable hotels," said Mark Davis, general manager of Hilton Los Angeles/Universal City.

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