Using PACE Loans with Traditional Mortgages

Many commercial banks have been trepidatious about permitting PACE loans alongside the bank’s senior mortgage position in commercial real estate financing. However, where underwritten and structured appropriately, PACE loans can work well as a secondary loan alongside a traditional commercial mortgage. 

Why PACE Loans?

Property Assessed Clean Energy (“PACE”) PACE loans are an effective way for property owners and developers to finance “green” energy-efficient improvements on their real property at a low, long-term interest rate with reasonable payments. PACE loans may be used to finance residential improvements, such as installation of solar panels. On a larger scale, PACE loans may also be used to finance commercial developments and rehabilitations that include energy efficient upgrades, like new windows, HVAC upgrades, and so on. PACE loans are flexible. They can be used alone, with traditional senior mortgage loans, and along with other types of funding, like publicly funded improvements, and tax incentives.

PACE lenders usually offer an attractive interest rate because the lender is in a great position to collect payment. After a PACE loan is funded, the borrower makes regular payments to a PACE administrator who forwards the payments to the PACE lender. The lender might be a government entity, a bank, or an independent lender. If the borrower fails to make timely payments on a PACE loan, the creditor may use the same process the tax assessor uses to collect the payment assessments. Just like a taxing authority, the PACE lender has a priority interest over a senior mortgage lender and can foreclose over other mortgage holders and lien holders. 

Overcoming the PACE Dilemma for Senior Lenders

Because the PACE lender has a priority lien over senior mortgage lenders, many banks have been reluctant to allow PACE lending as a part of funding real estate improvements.

However, because PACE payment assessments may only be collected annually over time, the downside risk for non-payment can be mitigated and controlled.

PACE Loan Payments Are Set at the Beginning and Can’t Be Accelerated

Tax assessors have had a priority interest in collecting real property taxes over mortgage loans for many years. Taxing authorities are entitled to foreclose on real property where the owner has failed to pay property taxes in a timely manner. However, unlike a mortgage lender, taxing authorities cannot accelerate the payment of the next 240 months of estimated tax payments to be paid immediately by the borrower.

The Senior Lender Can Control PACE Loan Payments

Because the amount of delinquent taxes in one or two years is usually a small part of the overall value of a property and the overall value of a loan, lenders can usually mitigate the risk of non-payment of property taxes by a) making sure the bank has the right to pay the taxes and add the payment to the loan and b) permitting the bank to foreclose or take control of the property if taxes are not being paid. The bank should also employ lockbox agreements to cover concerns about proper collection and forwarding of rents. To cover these points, the following provisions should normally be included in the bank’s loan documents:

1. The loan documents should provide that the bank may pay past-due property taxes and add the amount paid to the loan balance.
2. The loan documents should make the non-payment of property taxes as an event of default by the borrower.
3. The bank’s remedies upon a non-payment default should include the right to accelerate the loan payments and foreclose on the property.
4. The bank’s remedies upon a non-payment of default should also include the right to take control of the property as necessary.

Risks arising from non-payment of PACE loans may be mitigated in a similar way. PACE payment assessments may only be assessed one year at a time. The PACE lender may not accelerate the payments. For this reason, a senior mortgage lender may address and mitigate the risk of non-payment and foreclosure by the PACE lender much like the lender mitigates the risk of non-payment of property taxes. That is, by making sure the senior lender can make the PACE loan payments, adding the payment to the balance of the loan, and by making non-payment of the PACE payments an event of default like any other default.

The senior lender might also consider whether it would be useful to set up a reserve to cover initial payments or an escrow account to reserve funds for paying the PACE loan payments.  

Where PACE loan assessments are addressed like tax assessments, a senior lender can make a much more solid case for permitting a PACE loan to be part funding improvements on a borrower’s property.

Benefits for the Senior Lender for Permitting a PACE Loan

Allowing a borrower to use a PACE loan can improve the overall credit quality of a commercial development or rehabilitation. Some of the impacts a PACE loan may have are: a) reducing the LTV ratio of the senior debt, b) reducing the overall cost of capital, c) reducing lending limit pressures for large lending relationships, and d) providing a means for funding “green” fixtures, like solar panel installations and gray water applications that might not be suitable for some lenders.

Hopefully, taking a look at PACE loans from another perspective can open up additional lending opportunities for banks in regions where PACE loans are permitted.

Also published at Farleylawpllc.com.