By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group
(Steve ‘Buch’ Buchwald, New York, 3/25/2019) — In my previous article on Historic Tax Credits, we discussed one complicated financing structure commonly used by developers to capitalize their deals. In this article, we will discuss PACE Financing. I will do an article on several of these – a quick list includes Historic Tax Credits, PACE Financing, EB-5, and Ground Leases. Each of these specialty finance products adds layers of inflexibility to recoup equity, make refinancing decisions, account of cost overruns, and exit or refinance at attractive terms. My next article will be about EB-5, which was similarly popular a few years ago and now many developers regret the decision to take such an inflexible, difficult to deal with piece of capital just to save a few hundred basis points during construction on a small piece of the capital stack.
If you are in the commercial real estate development or financing business, I would be surprised if the term PACE Financing hasn’t crossed your desk by now. So…what is PACE? PACE stands for “Property Assessed Clean Energy”. Putting aside the minutiae of energy efficiency and what costs qualify, the key components to address are whether to employ PACE, where it lies in the capital stack, its security and repayment terms.
Before we explore what PACE really is, let me first address how it is pitched. PACE lenders have hired some amazing sales people and put out some extremely compelling materials about their programs. These materials paint a rosy picture – at the end of this article I will address how their materials could present a more balanced view – but borrowers are often drawn to low interest rate financing alternatives regardless of the potential costs and penalties down the road or across the rest of the capital stack. Like all new forms of financing, developers should be discerning and cautious. Low interest rate financing alternatives that look attractive on paper can have unintended consequences as the project progresses, particularly when it needs to be refinanced, recapitalized, or sold.
So how is PACE pitched? It is pitched as a long-term, low cost mezz alternative. Why pay 12% for mezzanine debt or preferred equity when you can get PACE for 7% fixed? However, looking behind the curtains, PACE cannot be compared to mezz in terms of security and its position within the capital stack. A PACE loan is a self-liquidating loan that is secured by a tax lien and is repaid through tax payments over a 20-year period. Like any tax lien, it is in first position, ahead of any senior lender, and it is literally on the state’s tax assessment roll. That is why some states allow PACE and some do not. But if PACE is the most senior piece of capital in the capital stack, why should it get a higher interest rate than the senior lender? Good question – it shouldn’t.
Putting PACE into your capital stack also has a potential cascade effect. If the senior is getting pushed up in effective LTV by the PACE loan, then it will either charge a higher spread on what should be a much larger piece of capital than the PACE piece would represent, effectively killing or more than killing whatever benefit it should provide over a traditional mezz loan, or it will reduce its leverage dollar for dollar at the same rate. Either way, that is not what is shown in PACE marketing materials where it looks as if the senior lender keeps its leverage the same at the same rate. Add on top of this a yield maintenance or hefty 5%+ prepay penalties that reduce in amount but go out a very long time, a reduced NOI due to the tax lien upon refinance, and other ancillary fees, one will generally find that PACE can be an expensive financing alternative, particularly as it pertains to recourse averse developers, developers with larger projects, and merchant builders or partnerships with fund LP capital that want to exit quickly.
To be clear, there is a place for PACE. If you are looking to develop a smaller scale property, desire to hold on to the property for a long time, are in a state that allows for PACE, and are employing local community or regional senior bank debt (typically partial to full recourse), then PACE may make sense. These lenders just care about their Loan to Cost and are underwriting to stabilized DSCR.
One of the perks of PACE is that the green energy aspect of it allows for a rationale to pass the tax lien on to tenants in commercial buildings through their lease or to guests at a hotel as an ancillary charge. While this does affect the end user’s effective rent or ADR, respectively, the underwriting can certainly pass muster for these local and regional bank lenders. Going back to the PACE marketing materials where the lender is pushed up in the capital stack and keeps their loan amount and rate the same – this is now a possibility – and the PACE works as intended (and marketed). It is no wonder then that almost every senior lender that has closed with PACE financing has this lender profile.
By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group
(Steve ‘Buch’ Buchwald, New York, 2/5/2019) — As it becomes more and more popular to gut renovate beautiful old buildings centrally located in various markets across the county, Historic Tax Credit transactions are becoming more common. Much to the chagrin of lenders, HTC deals have their own rules and, unfortunately, not all these transactions have identical structures. This further convolutes what is already a very complex and esoteric intricacy to commercial real estate transactions.
So, let’s back up. Historic Tax Credits can be either Federal Tax Credits, administered by the National Park Service (NPS), or State Tax Credits, administered by the state in question. These are based on qualified rehabilitation expenditures (QREs). While State Tax Credits can be relatively straight forward, the Federal Tax Credit rules often dictate complex org chart structures and create confusion among developers and lenders alike.
After a new set of IRS tax guidelines applicable to HTCs in 2014 were issued, the outright upfront sale of HTCs was prohibited and instead the tax credit investor had to become an investor in the transaction. The upfront payment was capped at 25% of the purchase price of the tax credits and the investor now had to have “skin in the game” throughout the construction period.
This resulted in two different structures:
The Single-Tier Structure – the structure whereby the tax investor is admitted as a partner of the property-owning entity and that entity is thus entitled to claim the HTCs.
The Master-Lease Structure – The property owner leases the property to an entity owned at least 99% by the tax investor. The master lessee in turn obtains a 10% stake in the property owner. While the property owner funds the QREs, it is permitted to pass the HTCs to the master lessee and thus to the tax investor through its interest in the master lessee.
If it sounds complicated, it is because it is. Even experienced lenders often balk at having to sign a subordination, non-disturbance and attornment agreement (SNDA) with the master-lease structure, claiming they will not subordinate to anyone. However, this is a must for HTC transactions since the SNDA prevents the collapse of the master lease structure upon foreclosure and, in turn, protects the tax credit investor’s rights to the HTCs. These tax credits can then be used by the investor over the five-year compliance period (20% per year) after obtaining Part 3 approval (the final NPS sign-off) post-construction. During this time, any take-out financing must also agree to sign a SNDA with the tax credit investor.
Another common point of confusion is how the HTCs can be used as a source of funding. There are generally three ways to capitalize a project with Federal HTCs:
A tax credit investor invests through the Single-Tier Structure and as a partner is entitled to the HTCs. This is straightforward as this investor would come in as a traditional LP partner. That said, this is incredibly rare and is not the standard for HTC commercial real estate transactions.
A tax credit investor purchases the HTC’s with the Master-Lease Structure and funds 25% of the HTC purchase at closing. Generally, these investors pay between 80 and 95 cents on the dollar and then 25% of this number (about 20-23% of the total HTC’s) can be used as a source of funds in the developer’s sources and uses. The remainder will typically come in over the course of the development, commonly at C of O, with some small amount held back until the developer obtains Part 3 approval from the NPS (typically 6 months or so after C of O).
With a tax credit investor structure similar to #2 above, the developer can then also obtain a tax credit bridge loan secured by the remaining payment stream from the tax credit investor that can be monetized up front. The amount of proceeds on the remaining 75% of the tax credit purchase net of the capitalized interest reserve and points on the tax credit bridge loan can then be added as an additional source of funds.
While these transactions are complicated, HTCs do significantly reduce the effective cost basis of renovation deals and thus are a necessary evil. Taking the time to properly understand the HTC structures can give developers a leg up on their competitors and lenders more deal flow and higher yields. Additionally, adding qualified professionals that understand HTCs to the development team including mortgage brokers, real estate attorneys, and tax credit consultants is a must for any developer that wants to tackle the complexities involved with Historic Tax Credit transactions.