Strategically Green - New Financing Vehicles Target Energy Efficiency Retrofits
By: Abigail C. Johnson, president, Abacus Property Solutions, LLC
Only a very small portion of existing buildings – particularly older inventory – has undergone energy efficiency retrofits. So what’s the holdup? The short answer is money — or lack of money — to allocate to energy efficiency projects.Energy-related retrofits play second when competing with necessary capital budget items and/or when the ROI of the energy project is below the internal cost of capital. Many times, energy-related projects — regardless of payback period — are lumped together and therefore, shelved together.
A recent example is where the facility engineer recommended “no brainer” efficiency projects such as replacing 1970s-era fluorescent fixtures and metering the cooling tower makeup water. However, despite the benefits and quick payback period (less than two years), the asset manager put all energy-related projects on hold due to capital constraints.
New Faces on the Block
When internal funds are unavailable, financing for energy-related capital projects has been traditionally via real estate lenders, equipment financing companies and energy service companies (ESCOs). Over the last few years, a number of financing alternatives have emerged that address the primary roadblocks to energy efficiency financing: upfront costs, insufficient ROI and uncertainty in savings estimates. These include: Property Assessed Clean Energy (PACE) financing, Energy Service Agreements (ESA) and On-bill financing.
PACE financing (also referred to as “tax-lien financing”) enables building owners to access low-cost financing for energy efficient upgrades via an assessment on their property tax bill. Programs typically have financing terms from five to 20 years, up to 100 percent loan-to-cost, for improvements ranging from $2,000 up to $2.5+ million. As a tax lien, PACE has priority over all mortgages and requires existing lender approval. To use PACE, the building must be located in one of the 27 states (and Washington, D.C.) with enabling legislation and in municipalities offering the program (e.g., Los Angeles). Key benefits include:
- Eligibility as a pass-through expense in triple net leases;
- Ability to transfer assessment on a property sale;
- Long amortization allowing for deeper measures with longer payback periods; and
- Potential treatment as a non-capitalized expense.
Despite these significant advantages, there is an ongoing perception that PACE is risky from many viewpoints:
- Lender: PACE priority lien in case of default
- Seller: Lowers value due to additional operating expense
- Tenant: Additional pass-through expense
Abacus Property’s perception is that these fears are overblown because the measures would result in incremental savings and building value, and the reduction in annual expenses would be in excess of the annual PACE assessment. In addition, in the case of a default, PACE assessments do not typically include an acceleration clause.
An Energy Service Agreement (efficiency power purchase agreement) is a contract between a building owner and third-party project financing company. Lenders develop the project, fund all construction costs, manage the installation and provide ongoing measurement and verification. It is a “pay for performance” solution where the lender captures the total energy savings in the building and charges back the historical utility costs to the owner. It has similar advantages to PACE and may be used in conjunction with PACE financing. Unlike PACE, ESAs:
- Can be executed throughout the United States;
- Fund large portfolios;
- Are not considered liens on the property, as they can be terminated at property sale; and
- Usually only work for large individual buildings or for a portfolio of buildings, with typical minimums of $750,000 in total retrofit costs and/or $1 million in total annual utility expenses.
However, in the case of ESAs, the primary benefit to the owner is increased investment yield through lower basis and operational savings after expiration of the agreement. With PACE, the owner accrues the benefits of energy savings immediately after project completion -- particularly attractive for full-service leases or owner-occupied buildings.
On-bill financing is a financing vehicle where the utility provides the upfront capital for specific energy efficiency projects and is paid through savings via a charge on the customer’s monthly bill. Although costs and benefits vary among utility providers, on-bill financing provides a similar value proposition to the PACE and ESA models. Like PACE, on-bill financing is dependent on areas served by the utility.
Beyond the Horizon
These new financing vehicles offer promise because they address key issues that have hindered energy efficiency financing thus far, such as:
- Minimizing upfront capital costs;
- Extending financing periods;
- Addressing the split incentive between owner and tenant;
- Reducing investment risk; and
- Offering potential for off-balance sheet treatment.
However, meaningful commercial lending activity for energy efficiency measures/retrofits is still needed, where appraisers and lenders incorporate the value of energy efficiency as well as the risk of inefficiency in standard underwriting practices. New initiatives, such as the one underway by Professor Nancy Wallace at the University of California Berkeley, specifically addresses energy efficiency and commercial mortgage valuation. Stay tuned!
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