Commercial real estate remains an area of unfulfilled solar potential. Most deployment in this sector has been constrained to properties where large, creditworthy entities own or have long-term leases and sufficient control of the property to support the credit requirements of solar project developers and their financiers.
Luckily, a range of financing innovations has recently evolved to open untapped solar sectors. One of the most promising is property-assessed clean energy (PACE), via which a loan on a solar system can be repaid via a property tax assessment. A PACE loan stays with the property, not the tenant, and offers the ability to underwrite a project with a short-term tenant or other unrated offtaker.
According to PACENation, an association dedicated to opening PACE financing, PACE financiers invested $252 million in 734 commercial buildings across 14 states. More than half of those projects have included renewable energy improvements. GTM wrote in December 2015 that over $1 billion has been invested in entities that finance commercial PACE, or C-PACE, projects, so there should be ample investment capital for good projects in PACE-friendly locations.
PACE must be enabled with state legislation and then generally undergo a county or municipal opt-in process. While 32 states plus Washington, D.C. have such legislation, only 16 states have active C-PACE programs.
Traditional financing structures -- third-party-owned power-purchase agreements (PPAs) and leases -- often don’t meet the differing needs of property owners and tenants, where capital improvements are paid by property owners and energy bills are paid by tenants, thus negating any incentive for property owners to invest in energy-saving technologies. This incongruity is frequently referred to as the "split incentive."
PACE works particularly well in commercial real estate because it leverages the general alignment of energy and property taxes: property owners pay both in owner-occupied buildings and under gross lease structures, and pay neither under commonly applied “triple net lease” structures where property taxes and similar assessments, insurance, and other utility and maintenance costs are the responsibility of the tenant.
A cost-effective solar installation combined with a PACE loan could provide immediate benefit to building owners and/or their energy and tax-paying tenants. By doing so, PACE could help open a new swath of the commercial building stock for solar deployment, not unlike how zero-down leases have transformed the residential solar market.
Nonprofits in particular are benefiting from the emergence of C-PACE. Nonprofits cannot monetize the tax benefits of solar and have a hard time meeting the credit requirements of traditional PPA structures. A leading provider of C-PACE in California recently funded a 292-kilowatt installation at a San Diego-based house of worship that will save an estimated $1.1 million over 20 years and $2.1 million over 25 years. The project includes third-party responsibility for providing solar production guarantees and managing the system O&M.
“Every dollar that a mission-based nonprofit saves on utility costs by going solar is a dollar that can be used to further advance the organization’s goals of helping the local community,” said Mahesh Shah, CEO of Figtree Financing, which led in arranging the financing. PACE Financing has helped houses of worship, private universities, assisted living facilities, and other nonprofits go solar.
Small and medium-sized for-profit businesses could also benefit significantly from PACE. These entities often own their real estate, operate local businesses, and may have the ability to monetize tax credits. However, they may not have the investment-grade credit and stable financials that other financing options have traditionally required. Small commercial buildings (less than 50,000 square feet) make up the vast majority of all building stock in the U.S., both by number of units and total square footage. Fully 94 percent of all commercial buildings are classified as small commercial -- and as a group they account for 47 percent of energy use in that sector.
PACE-financed “prepaid PPAs” are a variant of the innovation that combines PACE with the third-party ownership benefits of power-purchase agreements, the most common contract form between solar developers and commercial offtakers. Demeter Power Group was the first to pioneer this innovative combination through a PACE Lease and PACE PPA products. Prepaid PPAs enable PACE to tap the growing market for tax-equity finance and combine it with the secured underwriting consistent with property tax assessment. Demeter Power was a 2013 recipient of a Department of Energy SunShot Incubator Award.
Whether monetizing the investment tax credit (ITC) benefits through a third-party ownership structure or directly as the property owner, the returns can be extremely attractive with essentially no direct investment. PACE offers myriad other benefits as well:
- PACE loans are non-recourse (do not impact the creditworthiness of the current tenant)
- PACE loans are transferable upon sale of the property
- PACE loans do not accelerate (which would require the asset to be paid in full if there is a foreclosure or bankruptcy)
- PACE interest payments are tax-deductible
- PACE loans offer a cost of capital well below a real estate owners’ blended cost of capital considering equity hurdle rates prevalent in the industry
- Depending on the accounting treatment applied, the PACE loan may also be considered an off-balance-sheet form of financing for the property owner.
In sum, C-PACE offers an extraordinary opportunity to invest in solar and other property improvements, earn a highly profitable return, minimize the impact on a real estate owner’s balance sheet, and as well as on the ability to raise capital and reduce a tenant’s electricity cost.
The largest barrier to C-PACE for solar deployment remains with education of lenders, real estate owners, and the solar industry itself. Lenders are a critical target audience for two reasons: 1) as a source of PACE loans that are repaid through the property tax assessment; and 2) convincing the existing mortgage holder on the property to allow a lien senior to their position, referred to as “lender consent,” is a key issue in the industry.
Although some states do not require lender consent (California and Florida, for example), many of the institutional capital providers that are active in C-PACE and many property owners do require it. And Colorado’s new C-PACE program requiring lender consent appears to indicate states are heading in this direction.
Mortgage lenders are concerned that the PACE lien could jeopardize recovery of principal and interest on their asset should the tenants fall behind on payments, the real estate go vacant, or other stressed scenarios transpire. However, the solar project or other retrofit paid for by the PACE loan has a number of mitigating aspects that mortgage holders should consider.
“PACE improves the collateral quality of the property, improves the cash flow strength of the borrower by reducing their energy costs, reduces mortgage default rates (because properties are self-selected and screened to meet high-quality underwriting standards) and increases resale value,” said Stacey Lawson, president and CEO of Ygrene, one of the largest PACE providers.
Despite the exciting potential of PACE, education, consistency and best practices in underwriting would facilitate the critical trust necessary to scale the model broadly. Such best practices would include “providing a comprehensive package to each lender with PACE educational materials, an overall project summary for proposed energy production and savings, and a thorough analysis of other key elements that will impact building owners,” said Matthew Dawson, VP of market development for SolarCity. “Helping lenders understand the benefits of PACE and working to standardized PACE underwriting guidelines will be very important as we scale.”
In 2015, SolarCity, the market leader in residential installations and a top competitor in commercial installations, partnered with Renew Financial to offer PACE financing to small and medium-sized businesses that were difficult to otherwise underwrite.
Last year, SEIA launched the SEIA Finance Initiative, designed to open several untapped sectors for solar deployment, which identified C-PACE as one of the best mechanisms to open commercial markets -- and we're now working on outreach to the PACE financing, real estate and lending industries.
Mike Mendelsohn is senior director of project finance and capital markets at the Solar Energy Industries Association.