A clever new finance product is making it easier and cheaper for property owners to retrofit old buildings to improve their environmental efficiency.
Environmental Upgrade Agreements (or “EUAs”) enable environmental upgrades to be funded without the need for large amounts of upfront equity. EUAs have already been introduced by Melbourne City Council, City of Sydney, and Parramatta City Council, and several other local governments are planning to adopt EUAs.
The focus of EUAs has largely been upgrades to commercial buildings, but they can also be used to upgrade industrial buildings, data centres, and even residential buildings of 20 or more units.
HOW DO EUAs WORK?
The process is fairly simple. Upgrade activities eligible for an EUA include improving energy or water efficiency, reducing waste and greenhouse gas emissions, recycling, pollution prevention or reduction, renewable energy projects and reducing car use by encouraging activities like walking and cycling.
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The Building Owner, Finance Provider and Council all enter into the Environmental Upgrade Agreement under which:
- the Building Owner borrows funds from the Finance Provider to fund a set of environmental upgrade initiatives. This sets out the conditions of the loan (term, principal, interest, etc);
- the Finance Provider makes funding available without taking security over the property and without obtaining recourse to the Building Owner. The repayment obligation rests with the Council, although Council is not obliged to make payments until it has received an equivalent amount from the Building Owner;
- the Council agrees to strike an Environmental Upgrade Charge which corresponds to the repayments due to the Finance Provider (being the principal plus any interest). The Council collects the payments from the Building Owner in the same way that it collects rates. The Council then passes on the funds to the Finance Provider and charges an administration fee;
- if the Building Owner fails to make payments, the Council must enforce the payment using its powers of enforcement, generally in the same way that it can enforce payment of Council rates. This only applies to current arrears. There is no acceleration of the repayment, however the Council may charge penalty interest on the Building Owner for non-payment of amounts owing to the Council; and
- in some circumstances, the Building Owner will be able to recover some or all of the Environmental Upgrade Charge from tenants as a contribution to outgoings.
WHAT ARE THE ADVANTAGES OF EUAs OVER NORMAL PROPERTY FINANCE?
There are a number of reasons why a retrofit supported by an EUA is beneficial to Building Owners.
- Competitive lending terms. Because of the extra layer of security offered by the involvement of the Council, Finance Providers are able to offer competitive lending rates and provide funding over a longer term.
- Unsecured borrowing. The Finance Provider has no recourse to the Building Owner, the repayment obligation rests with the Council. The Finance Provider has no rights to accelerate its debt against the Council, and the Finance Provider is dependent upon the Council providing the enforcement procedures. Consequently, there is no need for a mortgage or charge on the land.
- No implication on Loan to Value Ratio (LVR). Because the Building Owner is not the Borrower, and does not grant security for the purpose of existing borrowing, EUAs should not negatively affect the existing LVR (and in most cases will improve it). However an EUA may still trigger a negative pledge as mentioned below.
- Ability for the Environmental Upgrade charge to run with the land. On the sale of the property, the purchaser can elect for the Environmental Upgrade Charge to continue to run with the land, or alternatively elect for the vendor to prepay the Council (at a discount to face value) and have the Environmental Upgrade Charge released. The Council would then be obliged to fully repay the Finance Provider.
- Ability to recover costs from tenants. Generally, capital expenditure for building upgrades is not recovered from tenants. However, if the lease outgoings provision is drafted broadly enough to include recovery of an Environmental Upgrade Charge, then the landlord can recover these charges.
There are a number of reasons why a retrofit supported by an EUA might be attractive to an existing tenant.
- Higher NABERS rating. Some larger, more sophisticated tenants have their own sustainability targets, are conscious of the mandatory nature of the National Australian Built Environment Reporting System (NABERS), and are actively seeking retrofits for their own corporate purposes (e.g. to avoid having to relocate to premises with higher star ratings under NABERS);
- Economic incentive to retrofit. Tenants subject to net lease arrangements are liable for energy costs. Therefore, if the savings from the retrofit (in terms of reduced energy or utility costs) is at least equal to the cost of the Environmental Upgrade Charge over the term of the lease, there would be an economic incentive to allow the retrofit to occur via an EUA. Tenants subject to gross lease arrangements are not liable for the energy or utility costs associated with their tenancy (and are therefore cost neutral), however they will receive the benefit of improved premises at no additional cost.
WHAT ARE THE DISADVANTAGES OF EUAs OVER NORMAL PROPERTY FINANCE?
There are arguably some disadvantages to Finance Providers in relation to recovery including:
- Possible delay in payment. If they are relying on the sale of the property to discharge the debt owing from the Council, the Finance Provider may have to wait for some time while Council works through its recovery processes;
- No security interest. The Finance Provider will need to accept that it has no security interest in the land (not even an interest to support a caveat); and
- Cannot accelerate payment. The Finance Provider will not be able to accelerate repayments in the event of default or insolvency or if there is an event with a material adverse effect in circumstances where a normal mortgage would have allowed this.
Even though an EUA is an unsecured product, mortgage borrowing covenants (such as a negative pledge) will generally be broad enough to prohibit entering into an EUA without consent from the existing Finance Provider – and an existing mortgagee may not yet offer this product and may resist funding from a competitor. However, as the retrofit inevitably increases the value of the property, many commercial property lenders should be happy for the improvement in LVR.
WHAT IS THE FUTURE FOR EUAs?
An EUA is a very new environmental finance product. The first EUA was signed in October 2011 to fund the retrofit of 460 Collins Street. Since then, the City of Melbourne has signed another three EUAs and the City of Sydney has recently signed its first formal EUA.
Due to the number of stakeholders involved, and the higher level of documentation required for the financing, the parties involved will need to be committed to the process and adopt a sophisticated approach to negotiations.
The Finance Provider will need to know the credit metrics and default statistics of local governments. The Council will need to have systems in place to manage the additional payment stream, as well as a stock of buildings in its jurisdiction that could benefit from EUAs.
Realistically, therefore, early EUAs are likely to involve Australia’s major trading banks (as they have the track record in lending to local governments) and the larger, more creditworthy councils. However, as more EUAs emerge, there may be greater scope for more councils and banks to get involved.
Building Owners that will benefit the most from EUAs will be those A-REITs that have older stocks of CBD buildings in their portfolio. EUAs can assist A-REITs in increasing the value and attractiveness of their portfolios through favourable funding arrangements, without disturbing existing financing arrangements.