One bright spot in an otherwise dreary capital markets environment has been the continued emergence and success of PACE (Property Assessed Clean Energy) financing, a surprisingly adaptable funding source that has proved to be effective in varied market conditions.
PACE is a privately funded, long-term (20 to 30 years), low-cost, fixed-rate source of financing that can reduce equity, or senior debt, and boost returns. It is approved state-by-state and is available for properties and developments that have elements of energy efficiency, renewable energy, water conservation, flood mitigation and seismic retrofits. One of the unique features of PACE is that it is secured by a special assessment lien instead of a mortgage, meaning the assessment can stay with the property through various owners over its term.
PACE as an “equity reducer and IRR juicer”
In strong markets, when construction financing is readily available, competition results in mortgage lenders increasing leverage or accepting more structured capital stacks. In this case, PACE substitutes more expensive mezzanine financing and/or preferred equity.
For example, 18 months ago a developer might have been able to obtain 70% leverage from a bank at a 4% interest rate. To achieve a higher leverage, such as 85%, that developer would typically look to mezz and/or preferred equity, which would command 10%-plus returns. PACE filled the same slug in the capital stack at a lower rate, significantly reducing the cost of capital and increasing developer yields. Thus, PACE acts as an “Equity Reducer and IRR Juicer.”
Such was the case at The Grove, a new 222-unit senior living facility located within a mixed-use community in Austin, Texas. PLG funded this project in 2022 and the developer used PACE to increase its leverage by approximately 10%, effectively reducing cash equity and increasing proforma IRRs. The PACE had the added benefit of being associated with water and energy-efficiency improvements that are expected to generate $484,656 in annual savings.
When financing is scarce
But with interest rates now at levels never seen by the youngest generation of owners and developers, credit has tightened, and mortgage borrowing has become both expensive and difficult. If a mortgage is being priced at Prime + 1.50% or SOFR + 4.50%, the interest rate (as of August 2023) would be nearly 10%.
In these scenarios, PACE shifts its utility and becomes a “cost of capital reducer,” blending down the interest rate and reducing more expensive financing. For example, if PACE prices in the mid 7% range, every dollar of PACE that is used to reduce the mortgage is accretive and saves the developer money.
An example of this is a deal that PLG recently closed in Orlando, Florida. The developer was converting a vacant 151-room hotel to workforce housing. The mortgage lender, a regional bank, quoted the deal with a “not to exceed” loan-to-value requirement and priced its debt over prime. The developer realized that was an inefficient capital stack and introduced PACE. Ultimately, the developer opted to purse a combined $13.8 million PACE loan and $9 million mortgage. The total debt of $23.8 million stayed within the bank’s loan-to-value limitation but significantly reduced the developer’s cost of capital by using more PACE than mortgage debt.
PACE for liquidity
Another application of PACE is retroactive financing. Most states allow a one- to three-year lookback for PACE loans, meaning over the past 12 to 36 months a property has benefited from PACE eligible improvements (i.e., nearly any project built over the past few years). In those scenarios, owners can utilize their PACE eligibility and be reimbursed for the previously expended eligible PACE dollars, creating a liquidity event in an otherwise illiquid market.
In the case of the Four Seasons at RBC Gateway, a newly constructed hotel in Minneapolis, PACE Loan Group provided a $20M retroactive PACE loan to the developer, allowing them to capture liquidity and re-deploy those funds into other projects. In today’s environment, retroactive PACE is a smart way to create a liquidity event and use those proceeds to negotiate loan extensions and modifications for existing construction loans that are coming due.
Property owners of all property types can utilize PACE – but we know that it may be hard to understand. My tip is to ask questions, understand what your state allows and work with people who will dig into the details and stay only a phone call or email away. Watch out for broker reselling C-PACE. Instead, work with a firm that can has guaranteed capital and quick decision making — because C-PACE is a chameleon with the flexibility to fit almost any financing challenge.
Rafi Golberstein is chief executive officer of PACE Loan Group, a national leading direct lender providing C-PACE financing to commercial property owners with capital from funds managed by AB CarVal. Based in Minneapolis, the PLG team provides expertise up and down the capital stack, from origination and underwriting to loan servicing for PACE loans that can be used for renovations, ground-up construction, and seismic retrofits for any property type. PLG originates loans where PACE is available — in 40 states.