Tag Archives: Lending

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Another Take on PACE Lending

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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.

Turning to History for Lending Opportunities: Lending into Historic Tax Credit Developments

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Moody Mansion in Galveston

A historical and stable niche lending opportunity is found lending into historic rehabilitation projects. There are 10s of 1,000s of historic buildings across the United States. Many of them need a face lift or adaptive rehabilitation. Many of these historic structures are in key areas of town and carry a strong sentimental value for their communities. Lending for the rehabilitation and maintenance of these buildings can check several important boxes for community banks, often including community revitalization, positive press, high profile developments, community reinvestment act credit, catalytic investments, and more.

Federal historic tax credits provide a critical supplement for rehabilitating historic structures. They also provide for interesting niche lending opportunities. The Internal Revenue Code provides for an income tax credit of 20% of the rehabilitation costs of qualified historic structure. The tax credit may be used to offset federal income taxes. The federal historic tax credit may be taken over five years and unused portions may be carried forward for up to 20 years. The tax credit benefit may be transferred in a way by making an allocation of partnership income and credits to a third-party in return for an equity capital investment in the rehabilitation. This incentive was created to encourage the revitalization and reuse of historic structures that are often torn down to make way for less expensive development of newer improvements. Since its introduction, the federal historic tax credit has been used to aid the rehabilitation of over 40,000 structures in the United States.

Texas offers an additional powerful incentive for the redevelopment of historic structures. Texas historic tax credits of up to 25% of the rehabilitation costs of a qualified historic structure may be used to offset the cost of rehabilitating a historic structure. The credit may be used against franchise tax liability or insurance premiums tax liability. The credit is a useful tool for bringing cash equity into a redevelopment because the Texas historic tax credit may be freely transferred in return for cash. The Texas credit has been highly effective at encouraging the rehabilitation of historic structures in the State of Texas and may be used in conjunction with the federal credit. Over $2 billion in project costs have been supported by the Texas historic tax credits.

A number of other states also have state level historic tax credit programs or other redevelopment incentive programs that may be used alone or in conjunction with the federal historic tax credit.

Galveston Arts Center, San Angelo Auditorium, Tower Life Building

Both state and federal programs are frequently used to bring sources of cash equity into the rehabilitation and redevelopment of historic structures. That is, tax credit investors or purchasers are introduced to bring cash in return for the use of the credits generated by the rehabilitation. The capital injection can be used to pay rehabilitation expenses and does not need to be repaid like a loan.

The advantage and opportunity for traditional construction and permanent lenders is that a project with a 5-15% equity contribution by its owner can turn into a project with a 50-60% equity contribution. Up to 45% of the project costs of the redevelopment can be covered without introducing debt or other expensive sources of funding. Overall, using the historic tax credits reduces the debt service and stabilizes the project’s prospects for success. The credits can be used for many types of properties, including office, retail, industrial, special purpose, and, dare I say it in 2020, hospitality. For state only historic tax credit projects, this opportunity comes with little added complexity and can be treated much like another construction loan.

For construction and senior lenders lending into federal historic tax credit projects, the barrier to entry lies in complexity. Understanding the ins and outs of allocating federal income tax credits to a third party takes effort. The IRS code imposes restrictions on owners of buildings rehabilitated with federal historic tax credits for five years following completion of the project. This means that loan workout and foreclosure scenarios must be carefully planned in advance and may require more creativity than typical construction loans. Nevertheless, large and small institutions have been lending into historic tax credit projects for over 40 years and have developed adequate strategies for managing historic rehabilitation projects.  

For a construction banker willing to learn a new construction niche, making a bridge loan in support of a historic tax credit project carries a risk profile that is similar to construction lending and carries substantial benefits. Most of the cash generated by historic tax credits project becomes available upon completion of the project. For projects where the tax credits are is necessary to pay for the construction costs, a bridge lender may advance funds in anticipation of receiving tax credit dollars at the end of the project. The bridge loan may be secured by a lien on the tax credit proceeds and interests which control the proceeds. The proceeds from the transfer of tax credits would then be used to repay the loan at the completion of the project. The tax credit bridge loan does not require a lien on the real estate.

Advantages of tax credit bridge lending are a) this is a niche banking opportunity for which there are few competitors; b) the bridge lender does not need to compete with a senior lender for its security interest; c) repayment of the bridge loan is not dependent on the income from the project; d) once the construction is complete, the loan is repaid without any risk for the failure of permanent financing; and e) moderate cost overruns actually make repayment easier. The risks of bridge lending resemble construction lending. Risks to consider include construction completion, casualty risk for the structure, and non-payment of construction period interest. These risks and others can be adequately mitigated through insurance, interest reserves, underwriting, and other traditional risk management strategies. For an alert construction lender, historic tax credit bridge lending is an opportunity worth looking at.

As noted above, historic tax credit incentives have been used to finance the construction of over 40,000 buildings over more than 40 years throughout the United States. Most of these projects have had the support of bank financing, yet relatively few banks are involved in this area of lending. The longstanding success of these programs and limited competition make this a great niche banking opportunity.  

Driskill Hotel