PACE (or property assessed clean energy) financing is still in its infancy, but could be a huge growth market. It is a form of financing for energy efficiency improvements to buildings. It can also be used for water conservation measures.

In order for PACE financing to work, a state must first pass enabling legislation permitting PACE financing. Twenty-six states and the District of Columbia have passed such legislation. Under such legislation, local governments can establish or join a PACE district. Each PACE district has different guidelines with respect to the types of improvements that can be financed. Once a PACE district has been established, building owners evaluate potential projects and determine whether to seek PACE financing.

After a building owner decides to use PACE financing for an upgrade, then financing is arranged. Financing can be either public or private. If public financing is used, then the local municipality will typically borrow money in the capital markets by issuing bonds and then lend the proceeds to the building owner. If private financing is used, then the building owner will borrow money from an approved private source of capital, such as a bank or private equity fund.

After borrowing the money, the building owner accepts a property tax assessment on its property for up to 20 years and repays the loan through this special property tax assessment.

PACE loans effectively subordinate all other lenders’ security, because the PACE loan is repaid as part of the property tax assessment, which is superior to all other obligations. This results in the PACE loan subordinating existing mortgages on the property.

Residential PACE has been at a virtual standstill since 2010, because the Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, issued a statement indicating that the senior lien status of most residential PACE programs could not take priority over a mortgage guaranteed by Fannie Mae or Freddie Mac.

Commercial PACE is not affected because commercial mortgages are not guaranteed by Fannie Mae or Freddie Mac. Commercial PACE is not currently as widespread as residential PACE was poised to be, but it is expanding steadily. The development of commercial PACE programs did not begin in earnest until 2011. Sixteen programs in seven states have been launched as of February 2013. A number of new programs have begun operating in the last several months, and some states are considering passing PACE enabling legislation.

Funding Models

There are four basic financing models that exist in commercial PACE programs. All four models use the property tax assessment as the repayment mechanism. The difference among the models is the way in which capital is provided.

The models are grouped into two categories: the municipal-bond-funded model and the privately-funded model, each of which has two variations.

The municipal-bond-funded model is often used to finance upgrades to smaller buildings and is often chosen by cities with more small buildings than large buildings.

The municipal-bond-funded model is where a municipal bond is funded and funds are available on demand to finance projects as soon as applications are processed. Once all the bond proceeds have been disbursed, new bonds can be issued to create a new reserve. The ability to receive funds on demand and immediately determine the interest rate that applies to a loan is advantageous for borrowers who want to fund a project quickly and want more certainty about the overall project cost after the financing is taken into account. An example of this model is the Sonoma County Energy Independence Program in Sonoma County, California that has financed nearly 60 projects.

An alternative municipal-bond-funded model is where the municipal bond sale is arranged after enough projects can be pooled for the bond issuance. The demand for funds must exceed a certain level (usually a minimum of at least $2 to $5 million) before the authority will issue the bonds. This structure can lead to lower interest rates because transaction costs are lower, but borrowers may have to wait until there are enough projects to meet the minimum level the authority needs to issue the bonds. This structure also leads to some uncertainty for borrowers because the interest rate will not be determined until the bonds are sold. The Toledo PACE Program (in Toledo, Ohio) follows this model and has financed more than 50 projects with $12 million in financing.

The privately-funded model is more advantageous for financing upgrades to larger buildings and is often chosen by cities with more large buildings than small buildings.

The privately-funded model is where the projects are funded individually and the financing is either done in the open market (such as through a competitive bidding process) or through an owner-arranged program. This structure offers on-demand funding, but the transaction costs will vary and the interest rates will depend on negotiations between the borrower and the entity providing the financing. GreenFinanceSF, a program with a budget of $150 million in San Francisco, uses this structure.

An alternative privately-funded model uses a turnkey financing program with funding on demand. The program administrator will offer financing from one private entity. This model offers easy access to on-demand funding with negotiated interest rates. An example of this structure is Clean Energy Sacramento, a program that was launched in March 2013 in Sacramento, California.

Benefits of Commercial PACE

Unfortunately, there are various barriers to making improvements in existing buildings. The most significant barriers are lack of funding and an insufficient return on investment. Other barriers include uncertainty about the amount of savings that will be achieved and split incentives between landlords and tenants.

PACE financing is designed to overcome these barriers and is attractive to all interested parties, not just building owners, for a number of reasons.

PACE financing addresses the lack of funding because it can provide up to 100% upfront financing. Large projects can be undertaken with little or no money out of the owner’s pocket.

The problem of insufficient return on investment can also be addressed through PACE because investments made with such financing can be cash-flow positive from day one: the loan is repaid over a longer period, often over a term of up to 20 years. This is compared to terms of 10 years for commercial property lending and five to seven years for general real estate lending. Building owners do not have to wait years to break even on an investment made with PACE financing.

The interest rates on PACE loans are relatively low, often in the 6% to 8% range. One bond issuance in the Toledo PACE Program had effective interest rates of 5% to 5.5%.

Payments can be passed through to tenants (who usually reap the immediate benefits of an upgrade in the form of lower utility bills) in a typical lease arrangement where tenants pay for their shares of utility bills and property taxes. For example, if the owner installs a new energy-efficient heating and cooling system that lowers heating and cooling costs, then the tenants will have lower utility bills. The cost of the upgrade, if financed with PACE, will lead to a higher property tax bill, which is also usually passed through to the tenants as an offset to the lower utility costs.

Because a PACE assessment stays with the property, a building owner does not need to worry about repaying the loan if the building is sold before the loan is fully repaid. The obligation to repay the PACE loan transfers to a new owner upon the sale of a building. A more efficient building can also command higher rents and, by extension, an increased long-term property value. By one account, buildings with a green rating command an effective rent that is 6% higher than less efficient buildings and sell at a 16% premium.

While the accounting treatment is still an open question, there is the possibility that projects financed with PACE will not be entered as a long-term liability because property assessments are only a one-year obligation. If the full investment can be treated as off-balance sheet, then a building owner’s ability to take on additional debt for other projects is less likely to be affected.

Lenders like PACE loans (to the extent the privately-funded model is used) because they offer a low-risk investment opportunity. The lien securing repayment is senior in priority to mortgages and all other liens on the property (other than for taxes). The repayment mechanism (the loan is repaid when property taxes are paid) is secure.

Lenders holding the mortgage on a building receiving PACE financing also benefit from the PACE loan, despite the PACE lien having a higher priority than the mortgage. The upgrade financed with the PACE loan will usually reduce operating costs for the building, which increases the building’s cash flow. The PACE loan will not have an acceleration feature. Finally, a building that is more efficient is more attractive to occupants, which increases the value to the owners (including higher rent) and lowers the risk of default.

Municipalities like PACE because making buildings more efficient is a form of economic development that leads to higher tax revenues and creates jobs. One study predicted that every $1 million in building energy-efficiency improvements leads to $2.5 million in economic output, about $250,000 in state and local taxes and approximately 15 new jobs. Professionals are needed to develop and administer local PACE programs, and construction and technical workers are needed to implement and maintain upgrades.

PACE financing is no burden on a county’s or city’s credit or general fund. Unlike a typical economic stimulus program, the government is not spending tax dollars.

Energy costs and usage for local businesses are reduced. Less money spent on energy is more money that can be spent on other goods and services in the local economy, and a clean environment creates a more desirable place to live.

Issues and Opportunities

Commercial PACE financing is not without issues.

Lender consent is often required. Fortunately, the Federal Housing Finance Agency does not guarantee commercial mortgages, but most commercial mortgages forbid a borrower from permitting a lien to be placed on the property with a higher priority than the currently existing mortgage. In order to have the PACE lien assessed without triggering a default under an existing mortgage, the borrower will need the current lender’s consent. However, mortgage lenders generally consent to the PACE lien because of the other advantages from the energy-efficiency improvements to the building.

Another issue is the limited availability of PACE financing. While over half of all states have enacted PACE enabling legislation, only seven states have programs that are active. Even fewer have had a significant amount of activity. Most of the projects financed to date have been in California, especially Sonoma County and San Francisco. Outside of California, a number of projects have been financed in Toledo, Ohio, Edina, Minnesota and Boulder, Colorado. The other active, but recently launched, programs are in Connecticut, Washington, DC, Florida and Michigan.

For commercial PACE to grow significantly, two steps must be taken. First, more states need to pass enabling legislation. There should be little political opposition, because the typical partisan issues surrounding energy policy are not present with PACE financing. Second, local governments in states that have passed enabling legislation must establish (or join already established) PACE districts to allow PACE financing to occur.

Surprisingly, there may even be some help from Washington. Senators Jeanne Shaheen (D.-New Hampshire) and Rob Portman (R.-Ohio) are promoting a bill called The Energy Savings and Industrial Competitiveness Act that will encourage building retrofits. The bill passed the Senate Energy Committee in early May with strong bi-partisan support. It would provide grants to states to establish or expand programs that promote energy efficiency retrofits of commercial buildings, including PACE programs. It must still pass the House.

The market itself will also help expand PACE financing. Over time, more and more investors will be willing to participate in PACE financing. There is always a problem of persuading investors to be first movers. Large bond issuances will be possible over time as the pool of potential investors increases. Some market watchers believe that enough volume could exist in California within a few years to start bundling the currently privately-placed bonds to sell in the public market. The public market would offer lower interest rates and further increase access to capital.

Growth in PACE financings should lead to standardization in documentation and lower transaction costs.

Once the market is large enough, securitization of PACE loans could create a new asset class. The scale needed to make securitization work is probably in the $50 million to $100 million range. Once this occurs, loans could be bundled, sliced and sold to a variety of investors, including large institutional investors such as pension funds and insurance companies. These investors control very significant amounts of capital.

A larger pool of investors will lead to downward pressure on interest rates on PACE loans. This would further expand the PACE market by increasing the number of economically feasible projects.

Buildings in the United States consume more than 40% of the energy used and nearly 75% of the electricity used. Making these buildings more efficient represents an investment opportunity of nearly $280 billion. PACE financing is still in its infancy, but it could be the most efficient and promising way to enter this nearly untapped market.