Sallan Snapshot Photo ©amazon pixels


Snapshot Column AuthorSnapshot

Commercial PACE Financing: An Innovative Way To Scale Up The Building Retrofit Market In NYC

By: J. Cullen Howe

April 02, 2012

Energy efficiency retrofits of the urban building stock have great potential to achieve two important goals: reduce overall energy use and achieve significant greenhouse gas emissions reductions. The U.S. building sector accounts for approximately 40 percent of our country's primary energy use and greenhouse gas emissions, with the commercial building sector accounting for about half this amount.

According to a December 2010 report by Johnson Controls, energy savings of 22% could be cost-effectively achieved in the commercial building sector through retrofitting, resulting in the creation of hundreds of thousands of jobs and the avoidance of approximately 128 million metric tons of greenhouse gas emissions annually — equivalent to the annual emissions of 28 coal-fired power plants. Most importantly for building owners, these retrofits can reduce energy costs, resulting in an improved bottom line and an enhanced value in the marketplace.

Despite these benefits, a number of barriers exist that often deter commercial building owners from making energy efficiency improvements, including upfront capital costs, the frequent turnover of commercial real estate holdings (thus favoring short-term investments), split incentives between owners and tenants, and lack of collateral for investor security purposes. In addition, in many cases retrofit projects rely on internal rather than external funding, which means that these projects often compete for an owner's limited pool of capital with other competing priorities. Here in New York City, the New York City Energy Efficiency Corporation (NYCEEC) was recently created and seeded with $37 million in federal stimulus funds to finance energy efficiency and renewable energy projects. While a good start, given the size of the commercial building sector in New York City, much more capital is necessary to scale up the sector and make a measurable impact.

One promising solution to many of these barriers is tax-lien financing, more commonly known as Property Assessed Clean Energy (PACE) financing. This model is typically used by municipal governments to establish financing districts to fund municipal projects that serve a public purpose, such as new sewer systems. When deploying this model, a municipality sells revenue bonds to raise money for the project and then collects annual assessments from properties within the district to amortize project costs over a set number of years. PACE financing works in a similar way: local governments create special financing districts, and property owners within these districts voluntarily choose to perform energy efficiency retrofits or install renewable energy equipment. The funding for the projects is secured by a tax lien on the property, which is normally senior to all mortgages or other obligations, and the owner repays the amount via an annual assessment on its tax bill over a set period, usually 10-20 years. If the property is sold before the repayment period ends, the new owner assumes the remaining obligation.

The PACE model has been embraced by 27 states, including New York, by adopting (in most cases) enabling legislation that allows municipalities to create such financing districts. However, the Federal Housing Finance Agency (FHFA), which guarantees over half of all residential mortgages in the U.S., views the senior lien position of PACE loans as constituting an undue risk on these properties and, through Fannie Mae and Freddie Mac, has issued announcements to lenders stating that it will not purchase loans containing such liens. FHFA's stance has effectively shut down most residential PACE programs, at least for the time being.

Fortunately, commercial PACE programs, while just beginning to emerge, are not hindered by FHFA since the agency does not operate in the commercial lending market. Several financing structures have evolved to support commercial PACE programs. These include the "pooled-bond" model, the "owner-arranged" model, and the "warehouse" model.

In the pooled-bond model, applications for PACE financing are approved by the municipality during an aggregation period and then, when a sufficient pool of qualified applicants has been assembled, the municipality sells a revenue bond to fund the projects. The Florida PACE Funding Agency uses this model. In the owner-arranged model, the municipality acts as a conduit and property owners independently secure financing with a lender of their choice and negotiate rates and reserve requirements for the level of funding needed. The Los Angeles Commercial Building Performance Partnership program uses this model. In the warehouse model, an investor makes available a line of credit for a municipality to use in funding the PACE program with the intention of reaching a critical mass of funding that results in bonds or other securities issued to replenish the line of credit. A fund created by the Carbon War Room uses this model. Some commentators have noted that the pooled-bond model may be better suited for smaller projects (i.e. those costing less than $500,000) given that these projects are normally too small to attract private financing, while the owner-arranged model is appropriate for projects greater than $500,000 because the financing terms, schedule of performance, and measurement and verification of upgrades could be customized for each property.

While the owner-arranged model would appear to be advantageous to New York City given the relatively large size of most commercial buildings and because it offers the advantage of not having to wait until a bond is funded, a potentially significant drawback is that virtually all commercial mortgages have clauses requiring senior lienholder consent when an additional lien is placed on the property. However, given that a typical PACE lien will be for a relatively small amount in comparison with the overall value of the property, and the fact that in most instances PACE liens do not accelerate in the event of a default, obtaining senior lienholder consent should not be an insurmountable hurdle. Indeed, a number of commercial PACE programs that use this model are up and running, including programs in San Francisco, Los Angeles, and Melbourne, Australia. Requirements can also be put in place to protect senior lienholders, such as a maximum lien-to-property value ratio of 15% and a savings-to-investment ratio of greater than one to ensure that only cost effective measures are performed. In addition, public funds can be used to establish loan loss or debt service reserve funds, which add an extra layer of protection for lenders or bond holders in the event of late payments or defaults by property owners.

A commercial PACE program could work in tandem with NYCEEC to scale up the commercial retrofit market in New York City, such as by having NYCEEC provide credit enhancement capital to lower interest rates on retrofit projects. NYCEEC recently completed such a transaction at 125 Maiden Lane. Not only would it help to achieve the city's goal of increasing building energy efficiency through its Greener, Greater Buildings Plan, it would reduce fuel and utility-related operating costs for building owners that participated in the program, giving them a competitive advantage in the marketplace.

J. Cullen Howe is an environmental law specialist in Arnold & Porter LLP's environmental practice group, focusing on climate change, green buildings, and state and federal environmental laws. Along with Michael Gerrard, he is the editor of The Law of Green Buildings, co-published in 2010 by the American Bar Association and the Environmental Law Institute.

December 2022
Sun Mon Tue Wed Thu Fri Sat

Stay updated via Twitter, Google + or join our list.

Fulton Center transit hub oculus

We have made Snapshot articles available in .pdf format on Scribd.