Christopher Hoeffel: Using C-PACE as a Form of Equity in the Capital Stack

Christopher Hoeffel is president and COO of CounterpointeSRE, Greenwich, Conn., one of the country’s leading C-PACE capital providers.

As property owners and commercial mortgage lenders work to build a capital stack for new development, or to “right size” the financing of an existing asset, there is often a need for more equity into the transaction. In the case of development, rising development costs have outpaced increases in rents, so the delta between cost and stabilized value has narrowed; lenders limited by Loan to Value (LTV) constraints can finance a smaller percentage of overall costs. In the case of refinancing, higher interest rates and stagnant values mean a loan that was 70% LTV at origination could be 80-90% LTV at maturity; and the DSCR (ratio of cash flow to debt service) could be below 1.0x.

Historically, property owners have utilized preferred equity or mezzanine debt to fill the gap between current equity and mortgage loan proceeds. These financing structures, being at the bottom, riskiest portion of the capital stack, are complicated, expensive and may erode the value of the property owner’s equity over time. Subordinate debt investors make these higher risk investments to earn high yields and to potentially “loan to own.”

Property owners with access to C-PACE can monetize their equity without selling an asset or diluting their ownership in order to raise proceeds for development, refurbishment or refinance. The financing structure is a low-cost alternative to subordinate financing that does not impact operations, does not add additional layers of management or oversight, is prepayable, and can transfer to subsequent owners without any external approvals. Since C-PACE poses little threat to a mortgage lender’s lien position, controls, rights and remedies, market participants might consider C-PACE proceeds as another form of owner equity.

What is C-PACE?

C-PACE (Commercial Property Assessed Clean Energy) financing allows property owners to fund up to 100% of the hard and soft costs related to energy efficiency, water conservation and structural resiliency infrastructure and to repay the funding over a long period of time, typically 25-30 years. Proceeds are funded by a private capital provider in coordination with the taxing authority of the relevant jurisdiction.  Repayments are made as voluntary special assessments on property tax bills, rather than through debt service payments that would be made for a loan. C-PACE sizing is based upon the stabilized value of the asset with some states capping this at 25-35% of property value. 

Because repayments are made through tax payments, generally as an expense paid prior to mortgage payments, the coupon is low. There is typically no acceleration of the C-PACE in the event of a default, because the only amount due at any point in time is the current year’s tax payment. And C-PACE does not need to be repaid upon a sale, the assessment runs with the land and can be transferred to the next owner. The advantages to a senior lender of C-PACE, vs. subordinate debt financing, is that the C-PACE capital provider has minimal ongoing involvement in the operations, sale or financing of the property itself and the C-PACE is tied to making improvements to the property that should increase collateral value. 

However, many senior mortgage lenders object to the use of C-PACE financing because they consider it to be senior to their loan, thus creating more risk and raising the attachment point of their mortgage loan. This, however, is a mischaracterization of C-PACE. Specifically, C-PACE should not be considered senior debt for a number of reasons:

• A C-PACE assessment is quite specifically not a loan. The obligation to repay is fixed, predictable, tied to the property, and repayments are only due during the period of ownership, not unlike repayment to a municipality for sidewalk or sewer upgrades that benefit a property.
• The mortgage lender still has a first lien on the asset and still gets paid first after municipal claims which might or might not include a delinquent PACE payment; the PACE assessment is not considered debt and there is no lien for the PACE proceeds. 
• A C-PACE assessment cannot be accelerated in the event of default. Lenders concerned that they are being “primed” by the full amount of the C-PACE assessment need not worry; the only amount due at any point in time is the current year’s tax payment. In the event of a default, the collections are typically made in the same manner as any delinquent taxes or special assessments.
• The delayed start of C-PACE repayment for two or three years may mean that a potential C-PACE default that might lead to foreclosure is not possible during the construction period. The senior lender retains the right to escrow the higher property tax payment that includes the C-PACE payment once on tax rolls and to include in reserves.
• The senior lender can eliminate any risk that a delinquent PACE payment can be senior to the mortgage before maturity. If C-PACE payments will come due before maturity of the mortgage loan, reserves could be increased to cover these payments. In this way, there will be no C-PACE default and senior lender retains all remedies and cures as well as priority position since there can be no delinquent payments that could prime the loan.
• C-PACE makes project safer for the senior loan over mezzanine debt as the delinquent payment does not trigger a fast foreclosure. If a payment is delinquent, C-PACE capital provider or municipality cannot seize control of the property for years. Most states have delinquent C-PACE and property tax enforcement mechanisms that are very owner-friendly, providing years for repayment of the delinquent payment. And the senior lender retains the right to cure the delinquent payment.
• C-PACE makes it easier to resolve issues over preferred equity and mezzanine debt. If the asset does not stabilize as anticipated; the senior lender retains controls. The municipality and C-PACE provider do not have a seat at the table and are not part of negotiations to work out new business or construction plan. Since there is no risk of quick foreclosure, the senior lender has extended time to work one-on-one with the sponsor without mezzanine lender or preferred equity partners in negotiations.
• Since the municipality and PACE capital provider have no financial covenants and little ongoing involvement in the property, there is no need for an intercreditor agreement. The municipality and C-PACE capital provider’s legal rights to foreclose are limited, delayed, and often follow property tax code.
• C-PACE is non-recourse and there is no dilution of equity ownership. Unlike preferred equity, or a mezzanine loan where the borrower equity is pledged, the borrower retains full ownership of the asset which is unaffected by the C-PACE assessment.
• C-PACE assessments have no “due on sale” provisions, so they do not need to be repaid if the property is transferred. Purchasers have an unfettered right to buy an asset subject to the assessment and to continue to make the tax payments. Conversely, if a purchaser wants to repay the C-PACE, they are always freely prepayable, usually with minimal penalties after the first couple years. C-PACE’s long term reduces take-out risk by providing additional options.
• C-PACE assessments fully amortize over the useful life of the improvements. In this case they are superior to ground leases (another equity monetization tool) in that the asset will not transfer to a lender/lessor at maturity. There is no risk of mortgage lenders losing their collateral or needing to negotiate a lease extension. Similarly, the payments are fixed at conception, so there are no “market reset” provisions.

While C-PACE does require periodic payments that will reduce cash flow available for debt service, it otherwise has no impact on asset value or property operations. This, coupled with its functional inferiority to a senior loan, make the risk profile more like equity than debt. As lenders look for property owners to contribute more capital into transactions, they should be open to considering C-PACE proceeds as another form of owner equity. It is an efficient way for borrowers to access trapped equity without pushing the senior lender down in the capital stack nor eroding the borrower’s equity, and motivation to perform, with high-cost junior debt. 

(Views expressed in this article do not necessarily reflect policies of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes submissions from member firms. Inquiries can be sent to Editor Michael Tucker or Editorial Manager Anneliese Mahoney.)