Local laws will accelerate sustainable financing

Demand for C-PACE financing is set to increase as US cities introduce stricter environmental rules for real estate.

US city governments are becoming more concerned about the environmental impact of their buildings and a number have set in place ambitious legislation aimed at driving their cities toward decarbonization. As new rules come into operation, demand for Commercial Property-Assessed Clean Energy (C-PACE) financing from asset owners is expected to rise. However, lenders and borrowers will have to negotiate variations in state and city regulations to take advantage of this financing avenue.

C-PACE financing is not new, but use of it has accelerated in recent years. Industry body PACENation put the total of commercial transactions at $6.3 billion as at the midpoint of last year, up from $2.8 billion at the end of 2020. The increase is partially due to more states implementing PACE legislation; it is now up and running in 38 states and Washington DC, but also due to rising demand from asset owners looking to improve their buildings’ environmental performance.

Asset owners in cities across the country are more likely to investigate C-PACE financing as an increasing number of municipalities introduce strict environmental legislation that could lead to heavy fines. Municipalities such as New York City, San Francisco, Washington DC, Boston and St Louis are preparing to fine asset owners who fail to comply with new or updated local regulations.

Meanwhile, other cities are pressing ahead with more rigorous environmental standards. The National Building Performance Standards Coalition has 44 members at state and city level that have committed to design and implement building performance standards by Earth Day 2024 (April 22).

“The proliferation of these types of laws has multiple implications for commercial real estate, including new requirements for disclosure and energy efficiency, with potential fines for noncompliance. On the positive side, other longer-term impacts can include lower energy bills, greater tenant appeal and more resilience to heat waves due to higher energy efficiency,” says Natalie Ambrosio Preudhomme, associate director at Moody’s Analytics.

Setting standards

The rules vary from city to city, as do the fines that might be imposed. For example, Boston imposes stricter targets on all commercial buildings larger than 20,000 square feet, while Los Angeles’ legislation is focusing most severely on buildings that are larger than 100,000 square feet.

Alexandra Cooley, CIO and co-founder at Nuveen Green Capital, says: “Owners who choose not to invest in sustainability measures can face significant cost implications, including higher overall energy costs, fines for failing to comply with sustainability mandates, as well as decreased tenant and investor demand.”

Cities are also introducing stricter environmental regulations for new construction. A number, including Seattle, San Francisco and New York City have taken action to ban natural gas connections to new building construction.

However, these measures are facing legal challenges. Washington state had to modify its mandate to incentivize heat pump conversion, rather than making it mandatory, following opposition from the building and gas industries.

Michael Yaki, senior vice-president and senior counsel, policy and programs, at Petros PACE Finance, says: “We see jurisdictions starting to adopt ‘green building’ standards for new construction, requiring the use of sustainable or recycled materials, water recycling, adoption of ‘stretch codes’ and other means to minimize resource use and reduce carbon emissions.

“However, we anticipate additional cities are going to focus their attention on decarbonization efforts on existing buildings, encouraging building reuse and conversion rather than raze-and-rebuild.”

Flexible financing

The wave of legislation means property owners will likely prioritize measures to boost energy efficiency (although C-PACE financing is not limited to such), as most of the measures are linked to emissions reduction and eventual net-zero targets.

Cooley says: “C-PACE can be used toward measures which impact the energy or water performance of a property. This includes hard, soft and any associated costs connected to mechanical, electrical, plumbing, building envelope improvements and renewable energy sources.”

Examples of C-PACE-eligible measures include HVAC systems, heat pumps, LED lighting, facility controls, low-flow water fixtures, insulation, roofing, windows, doors and solar. Cooley says C-PACE financing, which is fixed interest and can be spread over 10-30 years, is ideally suited to making assets compliant with new regimes.

Typical C-PACE finance costs range from mid to high single digits, making it considerably cheaper than mezzanine or bridge financing options. It can also be used for development projects, depending on local legislation, lowering construction costs.

Cooley says: “C-PACE also allows property owners and developers to recapitalize ongoing, stalled, or recently completed construction projects. Through C-PACE recapitalization, property owners and developers can access low-cost, long-term, fixed-rate and non-recourse financing with no payment due for 24 months to fund cost overruns, replenish operating reserves and pay down existing leverage.

“While facilitating sustainability efforts, the program reduces property owners’ annual costs and provides significantly better financing terms than the available alternatives to fund construction projects. Another benefit of C-PACE is that it can be layered in with other forms of economic development financing, like historic and new market tax credits.”

One of the key advantages to C-PACE financing is that it can be transferred to the next owner, thus borrowers need not worry that they must deal with the full cost of sustainability improvements without taking advantage of the longer-term gains. Furthermore, in some jurisdictions, loans may be extended retroactively, allowing asset owners to refinance existing debt.

Cities impose stricter rules fines

If C-PACE financing is a carrot allowing asset owners to improve their buildings for a reduced finance cost, a number of US cities are preparing to wield a heavy stick in order to force compliance

Legislation focusing on building emissions has been introduced in a number of cities. For example, New York Local Law 97 requires most buildings of more than 25,000 square feet to meet new energy efficiency and greenhouse gas emissions limits by 2024, with stricter limits coming into effect in 2030. Fines will be $268 per ton of CO2 over the limit and $500,000 for providing false statements.

Meanwhile, Washington DC will require privately owned buildings larger than 50,000 square feet to meet new emission and energy consumption standards by the end of 2026 or incur a penalty of $10 per square foot, not to exceed $7.5 million.

Failure to comply with new rules will have material consequences. A Moody’s report in 2022 estimated that, by 2030, almost 3.3 percent of the $139 billion in debt contained in commercial mortgage-backed securities (CMBS) backed by New York commercial properties will face emission fines that will be greater than 10 percent of the collateral’s 2021 reported net operating income.

While C-PACE financing has huge potential for commercial real estate, borrowers and lenders must contend with a range of C-PACE regulations, depending on the state where they are operating. For example, New York has been lagging other major cities in the number of C-PACE financing deals closed, despite it having strict buildings emissions rules and a substantial number of large, older buildings.

Yaki says: “There are two issues we have pinpointed: first, the New York C-PACE statute is one of the oldest in the country and doesn’t cover water conservation, or resiliency improvements, like many other states do. That limits C-PACE’s ability to help property owners cover the gamut of efficiency or resiliency improvements they have to make.

“Second, and more importantly, the statute imposes a cost-benefit test that effectively eliminates most of new construction, since there are no ‘savings’ to input into a cost-benefit formula, since you are already building to code, and limits retrofits because everything has to pass a test without regard to what impact improvements will have on overall financial performance of a property.” That said, there is a bill in the New York State Assembly which could be adopted this year that would address concerns which include the cost benefit test and open up funding to sustainability and resiliency related projects.

Cooley says: “Legislative changes at the state level, along with policy changes being considered by[the New York State Energy Research & Development Authority], could dramatically increase program participation.”

In general, newer C-PACE regimes are better adapted to the needs of borrowers and lenders – indeed, some lenders have been involved in drafting guidance. Yaki says: “New Jersey will be launching its Garden State C-PACE program in the spring for both retrofit and new construction, and the clarity and specificity of the statute and the partnership we have with the state administrator has facilitated in a robust pipeline of projects waiting for program launch.”

In December, an S&P Global Ratings report noted a number of risks inherent in C-PACE lending, including the difficulty of appraising the value of sustainability measures. It also noted that the ability of C-PACE loans to be transferred on sale means assets could be sold to less creditworthy parties.

A final barrier to increasing use of C-PACE financing is the complications involved in setting it up. Not only must lenders and borrowers negotiate local PACE rules and environmental legislation, they must also work with senior lenders if they are present, as C-PACE payments limit cashflow, which could be used for debt servicing.

However, such is the forthcoming pressure on real estate owners, it is likely they will consider the time and cost worthwhile. “C-PACE is uniquely placed to help property owners cope with decarbonization and green building efforts,” Yaki says.