April2018

C-PACE–aPrimerforMortgageLenders

C-PACE–aPrimerforMortgageLenders

C-PACE–aPrimerforMortgageLendersBackgroundonC-PACEC-PACE(CommercialPropertyAssessedCleanEnergy)financingreferstopublic/privateprogramsthatusevoluntary,realestatespecialassessmentstofundthecostsofcleanenergyprojects.C-PACEcapitalissuppliedbycommercialbanksorotherprivatecapitalproviderstoprivatepropertyowners,incollaborationwithlocalgovernments.Theunderlyingvalueoflong-termC-PACEfinancingisthatthecostsofinstallingandfinancingequipmentistypicallymorethanoffsetbythesavingsonutility,operatingandmaintenancecosts.C-PACEcoversmostcommercialbuildings—industrial,office,retail,5+unitmultifamily,hospitality,self-storageandseniorlivingfacilities.C-PACEfundingistypicallyusedinretrofitornewconstructionofenergyefficiency,renewableenergyprojects,andwaterefficiencyprojects.C-PACEprogramsbeganin2009withsignificantactivityinCaliforniaandConnecticut.AsofJanuary2018,33statesandtheDistrictofColumbiahavepassedC-PACElegislationandthereareactiveprogramsin19statesplusDC.Over500countiesandlocalgovernmentsparticipateinC-PACEprogramsandmorethan1,200C-PACEprojectshavebeenfundednationwide,exceeding$580million.Since2009,C-PACEfinancinghasgrownatanannualrateof90%.TheClintonClimateInitiativeestimatesU.S.C-PACEpotentialat$100billion.TherapidlyincreasinguseofC-PACEfinancing,itsmarketpotential,andthefactthatspecialassessmentshavestatutorylienpriorityoverexistingdebtpointstotheneedformortgagelenderstobecomefamiliarwithC-PACEprograms.WhyC-PACEisPopularwithBuildingOwnersThetenureofC-PACEfinancingisbasedontheusefullifeoftheeligibleassetsbeingfunded,andcanextendupto25years.OwnersusingC-PACEfinancinggenerateadditionalpositivecashflowfromcomprehensivecleanenergyprojectswithlongsimplepaybacks,whichtranslatestohigherpropertyvalues.Andownerswithtriple-netleasedpropertiescanpassthroughthehigherpropertyspecialassessmentfeestotenants,whotypicallyenjoyreducedutilityexpensesthatexceedthehigherassessmentreimbursement.C-PACEisnon-recoursefinancing,underwrittentoaproperty’sassessedorappraisedvalue.C-PACEdoesnotaccelerateintheeventofanassessmentpaymentdelinquencyordefaultanditrunswiththepropertyintheeventofanownershiptransfer.BecausetherepaymentofC-PACEfinancingismadethroughpropertyassessmentpayments,andcannotbeaccelerated,ownerstypicallydonotclassifyC-PACEasdebtthatadverselyimpactsloancovenantsonaproperty.

C-PACE–aPrimerforMortgageLenders

WhyC-PACEisPopularwithLocalGovernmentForpublicofficials,C-PACEisn’tabrand-newconcept,asinmoststatesitusesthesameassessmentmechanismusedtofundbeneficialpublicinfrastructureprojects,suchassewersandsidewalks.C-PACEappealstolocalgovernmentbecauseitcreateslocaljobswithouttheuseofgovernmentfundsandwithnofinancialrisktotaxpayers(programadministrationcostsarecoveredbyfeespaidbythepropertyowner,andprojectfundingcomesfromcommercialbanksandprivatelenders).Todate,C-PACEinvestmentshavecreatedanestimatedeconomicimpactofapproximately$800milliononlocalcommunities.

TheCaseforLenderConsenttoC-PACEFinancing

Understandably,themostsignificantissueformanycommercialmortgagelendersisthatC-PACEspecialassessmentshavelienpriorityoverexistingmortgagedebt.However,moststatePACEstatutesrequiremortgageeconsenttoC-PACEfinancing.Historically,lendershaveacquiescedtonon-voluntaryspecialassessmentssuchasthosemandatedforBusinessImprovementDistricts.Lenderswithconcernsaboutpaymentsoffutureassessmentbillscanrequirethatfundsbeescrowedwiththemtomaketheannualorsemi-annualpaymentsandensuretimelypayment.Further,commercialmortgagesoftenhaveprovisionsforprotectiveadvancesforpaymentoftaxesorpropertyinsurancepremiums.Mostimportantlyformortgagelenders,C-PACEfinancingfundsprojectsthatimprovecollateralvaluebyreducingabuilding’soperatingcosts.Coupledwithlong-termC-PACEfunding,projectstypicallyresultincostsavingsthatexceedtheamountoftheC-PACEassessment,increasingcashflowandthedebtcoverageratio.Totheextentthatthisvalueiscreatedwithoutencumberingthepropertywithadditionalconventionaldebt,theloan-to-value(LTV)willbelower,thusimprovingtheriskratingforthemortgagelender.IncaseswhereC-PACEisusedtofundkeyinfrastructureresilienceprojects(e.g.,protectingtheassetagainstseismicorweather-relatedevents),C-PACEprotectsamortgagee’sunderlyingsecurity.Inaddition,improvementstotheenergysystemsofabuildingcanresultinhigherworkerproductivity,greatertenantcomfortandsatisfaction.Thishelpswithtenantretention,reducestenantattrition,andincreasesthecompetitivenessofthepropertyinthelocalmarket.LendersalreadyfactorpropertytaxesandassessmentsintotheirunderwritingmodelsandcaneasilyevaluatehowanincrementalC-PACEassessmentwouldaffectacreditdecision.C-PACEprojectstypicallycomprisenomorethan20%standaloneLTV,and80%-90%combinedLTV,asdictatedbyeachstatestatute.Inaddition,sinceC-PACEassessmentsdonotaccelerateuponarepaymentdefault,amortgagelender’sonlyexposuretotheseniorC-PACElienisforaC-PACEpaymentinarrears.SincetheaverageannualC-PACEpaymenttypicallyrepresentsjust1-2%ofthepropertyvalue,C-PACEcontributesminimal,ifany,incrementalrisktoalender.Todate,therehasbeennotbeenasinglereportedcaseofaC-PACEpaymentbeingcollectedthroughamunicipaltaxsale.

C-PACE–aPrimerforMortgageLenders

ARoadmapforLenderConsentAlenderpresentedwitharequesttoacknowledgethataprospectivePACEassessmentwouldnottriggeranon-monetarydefaultinitsexisting1stlienfinancingshouldconsidertheseunderwritingcriteria:

• Howwillcashflow(eitheratthepropertylevelorforthepropertyownerglobally)andtheDSCRbeaffectedbythecombinationofPACEfinancingexpensesandprojectsavings?Aqualifiedengineerindependentoftheapprovalprocesscanreadilydeterminethecost-benefitofaprojectandwhethertheprojectedsavingsinutility/maintenance/othercostswillmorethanoffsetpaymentsfortheC-PACEspecialassessment.

• Aretheimprovementsdiscretionary-e.g.,installationofmoreefficientlightingsystemsorsolarPV-andgeneratehighercashflow?Oraretheymandatory-e.g.,thereplacementofafailedrooforHVACsystem–andprotectassetvalueandamortgagee’sunderlyingsecurity?

• WhatistheincrementalpropertyvalueincreasethatresultsfromthePACE-fundedimprovement?Lendersmayrequireacurrentappraisalofthepropertytobeimproved,toupdate“asis”and“asifcompletedandstabilized”valuations,andtoverifypropertyownerequity.Theprojecteddecreaseinoperatingcostsdividedbytheproperty’smarketcapratewillprovideagoodestimateoftheincreaseinpropertyvalue.

• HowmaterialistheC-PACEassessment?TheaverageannualC-PACEpaymenttypicallyrepresentsjust1-2%ofthepropertyvalueandcontributesminimal,ifany,incrementalrisktoalender.

• Willtheimprovementstotheenergysystemsofabuildingresultinhigherworkerproductivityand/orgreatertenantcomfortandsatisfaction?Thishelpspreventtenantattrition,andincreasesthecompetitivenessofthepropertyinthelocalmarket.

• Whatisthenatureoftheborrower’srelationshipwiththelender?Relationshipsdomatter.EspeciallywhenaC-PACEprojectinvolvesalong-termcustomerwithoutanypaymentdelinquencies,andtheprojectmakesgoodbusinesssenseforthebuildingowner.

SummaryStateandlocalgovernmentshaveidentifiedC-PACEasanimportantfinancingtooltoincentivizepropertyownerstoimplementcleanenergyprojects.WhilemortgagelendersmayfindlegitimatereasonstoobjecttoaproposedC-PACEprojectincertaincases,surveysbyPACENation,anationalnot-for-profitorganizationrepresentingallPACEmarketparticipants,indicatethatthemajorityofprojectssubmittedtolendersarebeingapproved.Standardizationofreviewandapprovalprocedureswithinlendinginstitutionsandthelendingindustryisexpectedtoacceleratethistrend.

C-PACE–aPrimerforMortgageLenders

Inmanyurbancentersacrossthenation,therearemanycommercialbuildingsthatneedupdatingtoremaincompetitivewithnewornewlyrenovatedproperties,andtoprotectleasespreadsandoccupancyrates.Suchpropertiesoftenhavesignificantequityandadequatecashflowtocovercommercialmortgagesthatmayhavebeeninplaceforyears.ThesepropertiesarestrongcandidatesforC-PACEfunding.TheyarealsocandidatesforrefinanceofexistingmortgagesifthosemortgageholderswillnotapproveC-PACEfundingfortheseproperties.PACElegislationisauthorizedataStatelevel,butC-PACEregulationsareenactedlocallyandvaryfromonejurisdictiontoanother.Whilethiscanbeproblematicfornationallenderswhodonotwanttocontendwithlocalprogramvariations,ithascreatedamarketopportunityforlocalcommerciallenders,orprivatecapitalproviderswhocanmorereadilytailortheirlendingtolocalconditionsandfundtheirclients’C-PACEprojects,