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INSIGHT: PACE Financing—A New Health Care Capital Access Vehicle

08 August 2018 Bloomberg Law

Property Assessed Clean Energy (“PACE”) programs continue to expand across the country. Most recently, on June 12, 2018, Pennsylvania enacted legislation to bring PACE energy programs to that state. This follows the adoption of PACE legislation in Illinois in 2017 and Massachusetts in 2016, and adds to the 33 states (including the District of Columbia) that have similarly adopted PACE legislation in the effort to create new capital access for those in need of financing for energy efficiency, water conservation, and renewable energy systems, as well as for the costs of seismic remediation in California.

Although PACE programs have spread to some 180,000 homeowners, and within that population, certain activities have promoted consumer-based concerns and regulatory activity, only recently have loan sizes and access been such that commercial borrowers, and in particular those in the health care field, have been inclined to take advantage of the PACE program. Two recent financings, however, may begin to open the door to a much larger effort: A $40 million PACE financing to Seton Medical Center in Daly City, California, to assist with seismic remediation (a loan size which was reported to be four times the size of any prior PACE project financing, and the PACE financing in nine skilled nursing facilities (SNFs) in Ohio operated by Premier Health Care Management to reduce the upfront construction costs for new buildings and renovations.

This Article is designed to highlight the structure of PACE financing and its opportunities for the health care industry. For many, it may provide a new avenue for financing improvements, and in some situations, be a part of an overall capital plan that will expand the ability to access capital for those borrowers that may not be in a position to access existing arrangements due to covenant restrictions or a variety of other challenges.

What is PACE Financing?

At its core, PACE financing is a financing alternative to traditional lending vehicles designed to support funding for projects that support renewable energy, energy efficiency, water conservation, and seismic improvements (in California). It is a program that is enabled by state legislation, but is actually implemented at the local government level, which typically will adopt its own specific program consistent with the state enacted framework, to consider and approve PACE financings. It is available to property owners, and in some states, to lessees under a land/ground lease.

PACE financing is typically available for nonprofit and for profit borrowers, and programs exist for both qualifying residential (“R-PACE”) and commercial (“C-PACE”) properties. Recently, there have been challenges for many otherwise qualifying residential borrowers as the Trump Administration reversed a decision by the prior Administration with respect to insuring FHA mortgages where the property might have a PACE lien assessed on the property. That decision is an ongoing topic of discussion in Congress, where some Congressman have indicated a desire to pass legislation to reverse it.

The critical element of a PACE financing is that its repayment is secured by a property assessment and the loan payment itself is through property taxes.

PACE Financing Transaction Benefits

Because PACE financing is based on a property assessment structure, there are a variety of significant structural benefits. First, because of the nature of the property assessment structure, these loans are typically “non-recourse” financing, meaning that the borrower cannot be liable directly for the loan, and the lender may only pursue the collateral in the event of a default. Second, there are typically no required guarantees or the typical borrower covenants seen in a standard loan or Master Trust Indenture structure. Thus, the key issue will be property value, not necessarily whether there is current positive earnings or margin, or impact on rates as the result of an uncertain or changing management structure, or uncertain reimbursement from governmental entities.

PACE loans are also efficient—they are available to finance 100 percent of the cost of the improvements, and that includes all of the typical financing costs, as well as costs incurred for design, engineering, project development, appraisals, plans, audits, application fees, attorneys’ fees and other issuance and closing costs. Hence, there is no need for free cash or “up front” money to finance a qualifying project.

The repayment term of a PACE financing is likewise beneficial – it is typically paid over the useful life of the improvements.

Another benefit is that the loan does not have to be repaid upon a sale of the property or some other structural ownership transaction, since the loan is secured by the assessment which remains on the property after a sale. . While a buyer will not want to “pay twice” with a purchase price that includes the value enhancement the loan financed and then have to still have to repay the loan, that element will be a subject of negotiation, but not an outright major hurdle to completing a transaction.

Another potential benefit for owners leasing a PACE improved building to one or more tenants, is often the lease will provide that property assessments are “passed through” to the tenants. Because 100 percent of the qualifying project may be financed, in effect, this means that the full cost of the qualifying improvements may be passed through to the tenant(s).

The Eligible Borrowers and the Qualifying Projects

In general, for profit or non-profit property owners with eligible or qualified projects can be borrowers for commercial or industrial property improvements. (Certain residential projects may also qualify.) Commercial and industrial normally includes all types of commercial or industrial property, including all manner of health care facilities, retail, industrial, hotels, theatres, multi-family properties with five or more units, and the like. The properties must be listed on the tax rolls, be current on their taxes (if any), and be free and clear of delinquent liens.

The precise nature of the eligible improvements will be found in the applicable state enabling legislation. The PACE financing obtained by the Ohio SNF operator was reported to be used to install solar panels, insulation, LED lighting, HCAV system elements, kitchen equipment and thermostats, as well as other energy efficient upgrades. The Seton financing was for seismic remediation.

In general, PACE financing, as the new Pennsylvania legislation illustrates, is used for energy efficiency, water conservation and renewable energy projects. [Title 12, Pa. Consolidated Statutes 4103]. These projects include those that replace or supplement an existing energy system that utilizes nonrenewable energy with one that uses an alternative energy source, i.e. a system that uses energy generated from such things as solar, solar thermal, low-impact hydropower, geothermal, biomass, fuel cells, waste coal, or coal mine methane. In addition, the Pennsylvania statute includes demand-side management of customer consumption or distributed energy generation systems. These projects may replace or supplement an existing nonrenewable energy system, facilitate the installation of an alternative energy system in an existing building or a major renovation, facilitate a retrofit to meet high-performance building standards, or involve installation of equipment to facilitate or improve energy efficiency or conservation. In the water conservation area, the project must simply “reduce the usage of water or increase the efficiency of water usage”.

Thus, in an older health-care facility, there is considerable latitude as to the variety of projects that may qualify. This can run from elevators, air compressors, occupancy sensors, dishwashers and commercial washers/dryers to reconstituting the grounds with more drought resistant landscaping to save water. And, while new building construction may not qualify for PACE financing, qualified projects do include the installation or modification of a permanent improvement that is a clean energy, water conservation, or renewable energy project that can be a component of a major renovation.

In some states, PACE programs also extend to power purchase agreement settings. This means that if there is an arrangement in place where a third party owns, operates, and maintains a permanently affixed power plant for the property owner, and the owner purchases power from that plant, the third party may also finance the acquisition of equipment with PACE financing.

Typical Loan Terms and Structure

A PACE financing typically is limited in size to 20 percent of the value of the property which secures the loan. As previously noted, the overall loan size, however, may include the “fully loaded” project costs, and there will be no required down payments or up-front project contributions. The financing is non-recourse debt. The financing may be paid off over the weighted average useful life of the project, which may, depending on the project, run from 20-30 years.

The security consists of a special assessment or charge on the real property. This will be similar in nature to other municipal or local governmental levies to finance street paving, sewer systems, or street lights, except in this case, it may only be imposed with the consent of the property owner. In some cases, there may be an assessment reserve required.

Critically, it will have first lien priority status over mortgage or other recorded liens, and be on a parity status with other taxes and assessments. Initially, this means that existing loan documents will need careful review to ascertain the extent of any prohibition on additional lending above a certain size, or prior liens. But often, the existing terms do allow for loans up to a specific percentage of the overall debt or equity of the borrower, or there is no prohibition on non-recourse loans or governmental assessments. For this reason, in some states notice to existing lenders is required, and in some states, in addition to notice to the existing secured lenders, consent is required, even if under the loan documents, this would be a permitted lien.

In those states where consent is required, there are compelling arguments as to why the lenders should consent, notwithstanding the priority lien status of the assessment. This is an alternative source of capital that must go directly into the building for improvements that may be long overdue and add value to the facility, without the existing lender being required to provide additional funds at a time that, for a number of reasons, may be problematic. And, in the event of a sale, existing financing may be required to be retired, but the PACE financed funds need not be repaid then. PACE financing requirements in some states, and for certain projects, may require that there be a demonstrated savings or “ROI” to be funded (which may have to be certified by a consultant), such that the savings are sufficient to retire the loan. In those instances this may mean that the cash saved in reduced operating costs increases the ability to fund the existing financing, or simply assist the borrower in avoiding defaults under a debt/capital test, while still providing project capital.

Conclusion

Use of PACE financing is expanding. It is broadly available in the states in which it has been authorized. While it does have a number of technical requirements associated with it, PACE financing provides a great deal of flexibility for health-care facility owners to add to their capital availability when it comes to upgrading, remodeling or renovating their buildings to bring them current in terms of energy and water infrastructure. This novel financing approach is, for all of these reasons, worth considering.