Colorado’s new Pace Program and how it effects Mezzanine Loans

Colorado’s new Pace Program and how it effects Mezzanine Loans

Commercial real estate capital stacks have become more complex in recent decades, allowing project sponsors and investors alike to fine-tune the level of risk they are tolerating, and get projects done that may not have been financeable in the past. One newer program, known as Property Assessed Clean Energy financing, is poised to seize a growing share of the commercial mezzanine debt market, while simultaneously encouraging energy-efficient development.

PACE financing could be considered an evolution of mezzanine financing, which is itself an important and relatively recent evolution of commercial real estate finance. Mezzanine financing makes markets more efficient by bridging the gap between the secured and regulated world of primary mortgages and the riskier and more expensive world of equity. As an article in the July 5 Colorado Real Estate Journal stated, “mezzanine debt (is) taking a more prominent role within (the capital) stack” in Denver and nationally.

Mezzanine debt can be challenging to generalize, given the many types of providers, from sophisticated private equity funds and investment banks to independent local investors and even other developers looking to spread risk. Mezzanine lenders typically lend between 10 and 20 percent of a project’s value helping sponsors conserve equity and increase leveraged returns on a given project. Mezzanine debt sits behind the primary lender in the pecking order, typically in second lien position. Rate of interest on mezzanine debt currently fall in the low double-digits, straddling the gap between the low rates on primary debt and the higher returns offered by equity. Outside of these points the mezzanine debt terms become complex and vary widely.

PACE, on the other hand, is relatively new and still evolving. It was created by policy entrepreneurs in California in the late 2000s to solve the most common problem in the world of energy efficiency – access to capital. Energy-efficient and renewable energy projects would fail to move forward due to short-term thinking, cost funds or the inability to obtain financing.

PACE was created to overcome these obstacles without requiring a government subsidy or guarantee. The program provides access to long-term financing, over and above the bank’s primary loan, for specific building measures that have a quantifiable positive impact on energy savings. These building systems include air conditioning, heating and ventilation, lighting, roof, windows, insulation, geothermal and solar.

Because these items generate energy savings, the designers of PACE realized these savings in the future could be used to reduce the cost of capital in the present. PACE’s key invention is repayment through the property tax assessment.

Property tax assessments have been used for over 200 years to cover public investments like schools. Since the energy-efficiency benefits of PACE financing stay with the property, the assessment used to pay for them run with the property as well – meaning that PACE financing is non-recourse as well. An additional benefit of the property tax mechanism is that the relative security of these assets in the market provides a flow of capital into funds that finance and develop PACE projects.

PACE is thus a public-private partnership between the state, the county, PACE providers and owners. In more complex deals, other forms of public-private partnership capital such as tax-increment financing, public business districts, Low Income Taxpayer Clinic and U.S. Department of Housing and Urban Development money can be used alongside PACE financing.

Nationally, 31 states and the District of Columbia have approved PACE legislation, and 18 of those states have enabled PACE and launched programs. The PACE program has been enabled in 16 different counties, covering 60% of the state’s population.

For new developments in Colorado, PACE can finance 10, 15 or 20 percent of the capital stack. The amount of financing available is capped by the total energy savings over the life of the building improvements, which can last up to two decades. The savings should essentially offset the repayment of the assessment.

That said, one misunderstanding of PACE is that buildings don’t have to be especially green to qualify. In fact, buildings just have to perform more efficiently than the average of their asset class. With building codes rising to higher standards than ever, most new development in Colorado will qualify. The more efficient the building is, however, the higher the financing available.

For certain projects, PACE has clear economic advantages over mezzanine debt. Overall, PACE financing is superior to traditional mezzanine financing in several key factors, including pricing, with interest rates, payback terms and, thus, cash flows superior to any other mezzanine financing alternative. The program also provides a set rate, which can be a relief to project sponsors in a rising interest rate environment. PACE can diversify a portfolio heavy in higher-risk mezzanine or equity positions. In a world of investors seeking output, the demand for PACE will increase as well.

As interest in designing and developing commercial buildings that are not only economically effective but also environmentally efficient continues to grow, it reasonable to say that the market for PACE should experience rapid growth – and capture a small but significant share of the mezzanine debt market. And with the economy slowly growing but relatively stable pace – barring external shocks, of course – and cities like Denver leading the way in developing more sustainable buildings.

Main Source – https://crej.com/news/capital-stack-pace-finance-vs-mezzanine-debt/

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