Imagine that by investing $5 million to install high-performance windows and rooftop solar arrays you could cut your commercial property’s energy consumption by $7 million to $8 million over the next decade or so. “Sounds great,” you would probably think, “but what’s the catch?”
As many commercial landlords are all too aware, the catch is that it is tough to finance sustainability upgrades economically when the payback period covering the investment runs ten to 12 years—or a bit longer. Most lenders are unwilling to tie up funds for 15 or 20 years—and frankly most profit-minded property investors prefer upgrades that pay for themselves through improved cash flows within five years or less.
And how many entrepreneurial owners have $5 million in hard cash lying around these days?
But as a growing number of building professionals are also realizing, an innovative public/private financing structure aimed at resolving such dilemmas is being rolled out in locally customized programs across the United States. After a half decade of smallish pilot commercial programs, the structure known by the acronym PACE—for property-assessed clean energy—is becoming available to owners in several major markets, including Washington, D.C., Los Angeles, and San Francisco.
The PACE structure allows for repayment of qualifying expenses for improving energy efficiency (and water efficiency, in some cases) through lien-protected assessments on property tax statements. Repayment terms run up to 20 years and are not accelerated with a sale or foreclosure.
With this financial mechanism, also known as tax-lien financing, the PACE lien claims security priority over recorded mortgage liens. While this does not necessarily thrill first mortgage holders—who in most cases must consent to a PACE transaction—the priority position encourages provision of new retrofit capital at reasonable interest rates.
Promising PACE programs for homeowners across the country have been in limbo for more than a year after they received a thumbs-down from the Federal Housing Finance Agency (FHFA), which regulates giant mortgage investors Fannie Mae and Freddie Mac.
Nevertheless, with the launch of commercial PACE programs in key metropolitan areas, the expectation is that property owners across the United States will be tapping PACE for billions and billions of dollars in retrofit financings annually within just a few years. While activity so far among less than a handful of inaugural commercial PACE programs has hardly hit eight figures, a few sizable financings at the new programs will likely double the to-date figure in short order.
It probably will take three years for activity to ramp up as cities and counties across the country customize iterations of the PACE structure, but the multiple benefits are hard to ignore, experts emphasize. In addition to reducing carbon emissions and creating coveted jobs, PACE financings are structured to improve property cash flows even as owners service the new debt, says John Kinney, CEO of Clean Fund, a PACE transaction facilitator in San Rafael, California.
Kinney and others point out that retrofit investments entailing longer payback periods remain difficult to pencil out amid purely private market forces. However, if energy audits convince building owners that they can cut utility bills significantly—without having to foot the entire bill out of pocket upfront—many will embark on comprehensive upgrades, perhaps including modern energy management systems, Kinney says.
U.S. commercial properties represent vast potential for implementing PACE-financed retrofit programs through which annual energy savings will clearly exceed the corresponding assessment payments, continues Kinney, who this summer was finalizing a $6 million transaction financing a northern California solar energy installation.
“Lots of owners have indicated they’re interested in certain retrofit projects—if they can find the right financing program,” says Dan Probst, chairman of the energy and sustainability services group at Jones Lang LaSalle in Chicago. “So there’s clearly lots of demand out there [for PACE financing], and it will only grow over time as energy costs continue to rise” and efficiency becomes a more critical competitive characteristic.
Indeed, clean technology specialist Pike Research in Boulder, Colorado, estimates that commercial PACE programs nationwide could be collectively funding from $2.5 billion to $7.5 billion in retrofits annually within five years. Whereas Pike analyst Eric Bloom suggests $3 billion is a realistic figure, Kinney for his part thinks the annual tally could end up closer to the high end of that range, especially if recently proposed legislation can revive PACE residential programs.
Madison, Wisconsin; New Orleans; and northern Ohio jurisdictions, including Cleveland, are among the numerous large metropolitan areas where commercial programs are being developed as more than half the states have now enacted PACE-enabling legislation.
Also, New York City’s long-term Greener, Greater Buildings Plan appears likely to embrace PACE, notes Bloom. Relatively modest pilot programs such as in Sonoma County, California, and Boulder County, Colorado, have demonstrated considerable promise for motivating property owners to pursue retrofit programs, he adds.
The bulk of the PACE commercial financings to date nationwide, in fact, have come through Sonoma County’s Energy Independence Program. That program has funded more than 70 such transactions, with most of the money financing solar photovoltaic energy generation installations and solar-assisted water heating systems.
Some of the jurisdictions launching commercial PACE programs—including San Francisco and Los Angeles—are contracting with private companies to administer them. Those two programs—as likely will be most, if not all, others in larger markets going forward—are structured a bit differently from the residential and pilot commercial programs.
In most PACE programs, public agencies with bonding authority provide upfront dollars funding approved retrofit improvements—with owners volunteering properties for inclusion in special assessment districts. This model typically entails pooling the PACE repayment obligations into bonds that agencies issue and sell to investors, freeing up additional lending capacity.
In contrast, under the owner-arranged model that the new big-city programs follow, a participating property owner seeks out a private lender group interested in investing funds to be paid back with interest long term through the property-tax assessment. These investors agree to acquire corresponding privately placed bonds secured by the PACE assessment—with some likely aiming to sell them into the secondary market.
Decision makers in cities such as San Francisco are discovering that for commercial PACE programs, owner-arranged models are more appropriate than publicly financed alternatives primarily because local stocks of commercial properties are so much more diverse and complex than their residential counterparts, Probst says. Because each property and ownership has a unique set of circumstances determining how its retrofit progresses through the approval process, it makes more sense to go with owner-arranged financing rather than pooling funds from a common source into bond issues, as has been the case in the more homogeneous residential sector, he says.
Probst acknowledges that some lenders are initially skeptical of PACE programs, given that upgrade expenditures will not necessarily boost rental revenues anytime soon. But most become comfortable once it is made clear that programs are structured to immediately improve cash flows through lowered operating costs and the long-term tax-lien repayment structure, he says.
Some lenders holding existing debt become amenable to extending additional PACE credit once they see how it can improve a property’s value over the long term—as well as boost near-term cash flow, Kinney says.
Bloom is quick to note that some lenders holding senior mortgage debt will hesitate to let owners add PACE obligations superior to first mortgages. “Many will consent, but I’m sure there will be some that just won’t,” he says.
But as activity at early programs progresses, PACE jurisdictions are likely to tweak program particulars to address issues raised by lenders and other parties, Bloom and others also note. Various experts have also tinkered with the idea of seeding moderate-sized loan-loss reserve funds, which would encourage greater participation by private capital.
While PACE programs put few municipal and county general fund dollars at risk, public sector participation dictates that financed improvements should benefit society. Hence, qualifying retrofit and upgrade programs are generally limited to investments that boost energy efficiency and/or generate renewable energy—with some programs improving water efficiency.
As commercial PACE programs continue to develop, the emphasis among profit-minded property owners most likely will be on improvements with payback periods spanning perhaps a decade or more rather than the low-hanging fruit, such as lighting upgrades. Accordingly, experts expect to see PACE-funded investments in more energy-efficient building materials, such as modern windows and insulation, and renewable energy generation such as solar installations.
In locales boasting plenty of sunshine or liberal subsidies and incentives, or both, property owners logically will tap PACE programs to finance solar generation, as has been the case in Sonoma County, Bloom notes. “Solar costs are high, and PACE is a way to lower the bar,” he says. Likewise, depending on various factors including financial incentives, climate, building orientation, and the quality of existing panes, payback periods for window upgrades might be a good fit for PACE, adds Probst.
In many cases, the availability of PACE funding should induce owners to go beyond short-term plans and pursue comprehensive retrofits, he says. These might include upgraded lighting and windows, as well as replacement of older heating, ventilation, and air-conditioning systems with efficient-energy management technologies more compatible with the other improvements. “The goal is to broaden the portfolio of efficiency measures that private building owners will look to implement,” Bloom says.
It is difficult to generalize about the property owner profiles most likely to tap big-city commercial PACE programs in coming years. Key factors such as the prospects of individual properties for improved energy efficiency and micro-market competitive conditions vary widely even within moderate-sized metro areas. Nevertheless, Probst notes that owners of large office properties have demonstrated particular affinity toward pursuing PACE-funded retrofits. Also, investors who tend to hold investments long term would generally tend to be more open to PACE than shorter-hold strategists.
Occupancy rates and lease expiration schedules can also be factors, Probst says. Owners of properties that will remain at high occupancy levels for many years are less likely to be motivated than those facing higher turnover.
Acceptance of PACE by Fannie Mae and Freddie Mac for residential retrofits—as would be required by recently proposed federal legislation currently in the House Committee on Financial Services—likely would boost interest in commercial PACE programs, experts seem to agree. Residential PACE financing has essentially been on hold since mid-2010 when the FHFA made mortgages secured by participating homes ineligible for repurchase by the agencies.
Even if the proposed federal legislation, the PACE Assessment Protection Act of 2011, does not find its way to the president’s desk, that would not necessarily affect the budding commercial PACE programs being formed around the country, Probst predicts. But if the legislation does pass in a form similar to its sponsors’ proposal, chances are that development of commercial programs would accelerate, he says. “What happens in the next six months will be important,” adds Bloom.
Meanwhile, it appears the budding trend in a growing number of large cities toward energy benchmarking mandates could become a boon for commercial PACE programs.