Environmental, social, and governance (ESG) principles have become increasingly crucial regarding how lenders, property owners, and investors invest in and develop commercial real estate. Specifically, the hotel sector has made significant progress in lowering utility costs, promoting sustainability in branding, and increasing energy efficiency.
Recently, a novel method of funding energy-efficient projects has surfaced: commercial property assessed clean energy or C-PACE financing. C-PACE financing was first created in California in the late 2000s, and it is currently offered through schemes approved bylaws in 38 states. The total monetary value of C-PACE loans that have been created has roughly doubled since 2018. This is mainly because hotel owners are trying to fill the gaps in their financial sources for new construction financing, property improvement plans (PIPs), and other projects motivated by ESG principles.
What are C-PACE loans, though? What unique advantages do they provide, and what should they think about if a hotel owner or operator wants to apply for a C-PACE loan?
How Do C-PACE Loans Work?
Real estate owners can use C-PACE loans, state-policy-enabled financing instruments, to borrow money for qualified projects featuring sustainable design and construction. Updates to elevators, escalators, and heating and cooling systems are among the less evident energy-efficient improvement projects. Other projects include solar panel installations and storm preparedness. It is possible to get C-PACE financing for remodeling or new construction. They can also be obtained and applied retroactively in many jurisdictions for qualifying projects finished in the previous two to three years. Proceeds from C-PACE that are applied retrospectively might be utilized for working capital, PIP payments, loan paydown or payback, or other property improvements.
Private third-party lenders are the source of C-PACE financing. However, in contrast to traditional finance, they are paid back by additional property taxes assessed on top of ordinary property taxes, and they are managed by development authorities or local governments as part of their assessment programs. Although program models may differ between jurisdictions, these payments often come as an optional real estate tax assessment. Like tax liens, a lienholder may eventually enforce the lien through a tax sale or foreclosure and get the actual property if a property falls behind on C-PACE assessment payments.
Advantages of C-PACE
Property owners can take advantage of unique benefits from C-PACE loans, such as the following:
- Cheaper than those of traditional finance: A component of capitalized interest that permits the borrower to postpone monthly payments for a number of years
- Repayment spaced out over a 15–30-year period using semiannual evaluations
- Acquisition and implementation of recently finished projects in a retroactive manner
- Usually not necessary to provide the comprehensive covenants or guarantees needed for conventional real estate finance
- Usually not accelerated upon failure to pay
- No need for guarantees or personal recourse
- Utterly transferable to a real estate buyer without the need for a formal assumption procedure
Given the advantages they provide and the state of the financing industry today, C-PACE financings are poised to become more commonplace. If a hotel owner is thinking about using C-PACE financing for their establishment, what should they bear in mind as operators and owners?
Hotel Owners Should Consider
A hotel owner can expect to ask their current mortgage lender for permission to switch to C-PACE financing. Like tax and assessment liens, C-PACE assessments precede mortgages and mezzanine loans. Therefore they frequently need approval from an existing mortgage lender. Although more and more mortgage lenders have approved C-PACE financings in recent years, some may still be hesitant due to worries about perhaps being “wiped out” in the event of a tax sale or tax foreclosure. To allay mortgage lender fears, borrowers may consent to create a reserve (as with real property taxes and other impositions) that guarantees money will be available to pay C-PACE assessments when they are due.
A senior lender setting up C-PACE assessment reserves to prevent tax foreclosure may also comfort certain hotel operators, especially those parties to long-term management agreements that offer strong nondisturbance protections from lenders in the event of a foreclosure. This is because obtaining a subordination and nondisturbance agreement (SNDA) from a C-PACE lender is typically impossible. According to state law, unpaid C-PACE assessments are usually enforced by a local assessing body; this procedure is probably not subject to modification by private agreements like SNDAs. However, since C-PACE loans are not accelerated, lenders continue to assert a minimal need for an SNDA (just as no SNDA is required for property taxes). Furthermore, depending on the jurisdiction, a tax lien foreclosure may take two to four years to complete, lowering the likelihood that a C-PACE foreclosure will occur without the hotel owner’s or its mortgage lender’s involvement. To reduce the risk of a C-PACE foreclosure, a hotel operator may wish to negotiate with a mortgage lender in SNDA talks if a mortgage loan is part of the capital stack. Some strategies include setting up reserves and paying C-PACE assessments directly from hotel bank accounts in a way consistent with paying other taxes.
Hotel owners and operators should also consider the possible effects of a C-PACE loan on the finances of their hotel management agreement. Parties should think about whether C-PACE assessments should be subtracted as well, for instance, if the HMA calls for an incentive fee to be given to the operator and property taxes are subtracted in the computation of this charge (i.e., if the incentive fee is dependent on profitability). A hotel owner can argue that C-PACE assessments ought to be subtracted from revenue like other real estate or ad valorem taxes. Moreover, a hotel operator might say that the energy-saving initiatives supported by these C-PACE loans eventually lower the hotel’s overall operating costs. On the other hand, an operator may argue that since C-PACE assessments, unlike required property taxes, are levied voluntarily due to a hotel owner securing C-PACE financing, they shouldn’t be subtracted from incentive fees in the same way that debt service payments aren’t.
In addition, hotel operators and owners could think about whether any of the C-PACE tax assessments might be (and ought to be) passed on to visitors in the form of an additional “green fee” that is added to hotel bills. If parties choose this course of action, the hotel operator should insist that such recovered sums shouldn’t be subtracted from its incentive fee in any case.
Conclusion
For certain property owners seeking to access extra money to design, develop, and remodel their real estate assets in line with specific ESG efforts, C-PACE loans present an appealing opportunity. To fully benefit from this relatively new lending model, hotel owners should think about bringing in legal counsel early on to grasp the details of the C-PACE programming that has been implemented in the state where the hotel is located, secure approval from mortgage lenders, and resolve any issues brought up by the hotel operator. Similarly, hotel operators can receive advice from legal counsel on the risk profile of their hotel being subject to C-PACE assessments and the impact that these assessments have on the hotel’s economics within the HMA.