Financing and Benefiting from Implementing ESG in Real Estate

Today, implementing ESG and sustainability initiatives are crucial since the construction and operation of real estate account for 39% of total global greenhouse gas emissions. As a result, governmental policies are being implemented with net-zero targets set for all new buildings by 2030 and retrofitting of all pre-existing buildings by 2050. Additionally, the SEC has proposed climate-related disclosure requirements, which would mandate public real estate companies to disclose information about their climate-related risks, governance and management processes.

While the demand for real estate continues to grow, the need for environmentally conscious efforts and sustainable innovation have become ever more prevalent. Although ESG and sustainability efforts are essential, implementation is often viewed as daunting and placing an unwarranted strain on real estate companies' finances and operations. Furthermore, there's a misconception that real estate companies can either be profitable or sustainable when in fact these companies can not only recoup the initial cost of the investment, but it'll also increase their overall financial and portfolio position.

So real estate companies have several options to finance these initiatives, including conventional loans, capital contributions, green bonds, or crowdfunding. But another option is a PACE loan. So joining me today to discuss PACE loans is Bali Kumar, the Chief Operating Officer of PACE Loan Group. Hello, Bali.

Bali Kumar:
Hi. Thanks for having me.
Amy Menist:
Of course. So before we get started, would you mind giving the viewers some background on yourself?
Bali Kumar:
Happy to. Bali Kumar, Chief Operating Officer of PACE Loan Group. My background is very varied. I started my career out at Deloitte as a management consultant and then went off to law school and practiced law at a firm called Proskauer Rose. Later on I was tapped to run the Wayne County Land Bank, which is a quasi-governmental agency in Wayne County, Michigan, which is sort of metro Detroit. And then after that I was brought in to run the PACE program for the state of Michigan at a company called Lean & Green Michigan, which serves as the third party administrator for the PACE program around the state of Michigan. And currently I'm at PACE Loan Group. And so generally I think my varied background is just sort of identifying and solving creatively real-world problems and that's exactly what PACE financing does.
Amy Menist:
Wow, truly fascinating. Didn't know all of that. So thank you so very much for sharing. So can you actually explain what a PACE loan is and how it can be used?
Bali Kumar:
Absolutely. I always dumb it down and just say PACE is just a commercial real estate loan. There's a bunch of nuance, but at the heart of it, it's just commercial real estate finance. It was initially created to renovate existing buildings and bring aging building stock up to 2010, 2020 levels. That was like the birthplace of PACE and that's what people were thinking about when they created the statutes from a policy perspective.

Nowadays, it's a lot more than that. Nowadays, people are using it to retrofit and renovate existing buildings, but people are also using it just as commercial real estate finance to fill gaps in their capital stacks. If someone is building a new construction project and they're getting 55% loan to cost from a bank instead of putting down 45% equity or instead of raising a bunch of mezzanine financing, which is much more expensive than PACE, both equity and mezz. Instead, they can run an energy audit, see that they're doing some stuff that is above code and get PACE financing to cover all those costs. And so then a new capital stack would sort of look like maybe 55% senior lender, 15% PACE, and then 30% equity for instance. That's for new construction and gut rehab and adaptive reuse type projects. For renovation of existing buildings, if someone just needs a new roof, they can pay for the entire roof with PACE financing.

And then some folks are also using it, and this is something we discovered a lot more during the pandemic and now when economic times get turbulent, people are using PACE retroactively to reimburse themselves for work that they previously have done either in the last 12, 24, maybe 36 months, depending on the state. And they're using it, I mean you can call it a reimbursement, you can call it retroactive PACE, you can call it rescue capital. People have different feelings about each of those phrases, but that's another pretty creative use of PACE financing just to sort of reward yourself for the work that you did anyway on your building, on your building envelope, on the roof, upgrading lighting, having energy efficient HVAC, water conservation in certain states. So like low-flow showers and toilets and the like, renewable energy. Some folks are putting solar panels, solar-plus-storage, EV charging stations. In certain states, seismic retrofits. So PACE loans are pretty versatile.

Amy Menist:

Fantastic. So with that being said though, then, what are the PACE lending parameters? Can this be used also for commercial and residential or is it strictly just commercial? And how can this type of loan be more beneficial, I mean, in addition to what you just said, above and beyond what a conventional loan could offer?

Bali Kumar:
So there are two types of PACE and they're all enabled by every state's Property Assessed Clean Energy Act, every state's PACE Act. We are only commercial PACE lenders. And commercial PACE has active programs in almost 40 states, or at least legislation has been passed in almost 40 states, but active programs, closer to 30 states. There are certain states that haven't created their program and gotten it fully up and running yet. So residential PACE, which we don't really need to talk about because that's not the subject that we're here for, only really exists in three states and they're working through some perfection of the program issues before that starts to proliferate onto other states. But yeah, we only do commercial PACE financing.

Commercial PACE loans are fixed and not floating, so the interest rate will fix at close and the fixed interest rate in the term can go all the way up to 30 years. Again, every PACE statute has different rules. So whereas in Minnesota you can only go out to a 20-years term fixed, in Michigan you can go out to 25 years, in California you can go out to 30 years. And so it's state by state. But the fact that it's long-term fixed interest is interesting to property owners and developers. Because treasuries have gone pretty crazy over the past 18 months or so, interest rates were in the fives and now they're in the high sevens, even in the eights depending on the treasuries. But we capitalize interest through the construction period so that way people aren't making out-of-pocket payments until after their building is up and running and earning income.

In terms of when people are constructing a capital stack, they care about their loan to cost. If it costs $10 million to build something and they're getting 5.5 million from a bank, maybe they need 15% LTC. What's interesting is what we care about more is loan to value. And so that has interesting interplay because we can do a project that is... And we can do up to 30% loan to value. There's a bit of a dance with the senior lender to see how DSCRs work. You don't want to destroy someone's debt service coverage by adding on PACE financing, but if we do something, say in California and it's 30% LTV, but if it costs 100 million to build something and it's worth 200 million afterwards, then 30% LTV could end up being 60% LTC.

But then in the inverse, if you're building something in Detroit and it's going to cost you, and these are made up numbers, so like Detroit is not this sort of market, but if you build something and it costs you 10 million to build and it ends up being worth 5 million, we would actually be able to lend half the amount of LTC. So it works both ways. And then you layer in PACE with the senior and combined, if the DSCR supports it, we can go up to 90, maybe even 95% LTC and really help the borrower get their project done.

Amy Menist:
That's fantastic. So my personal favorite part about a PACE loan is that it cannot be accelerated. So can you please explain for our viewers what that means and how it could be a key factor?
Bali Kumar:
Totally. PACE stands for Property Assessed Clean Energy, and I think the assessed part gets looked over because people focus on the clean energy part. But PACE is not a mortgage. We are a PACE Loan Group. Technically we're not even writing loans, we're writing special assessments to the property tax bill. And so PACE is a non-recourse voluntary special assessment. It runs with the land and if someone is buying a property with the intent to sell, they can walk away from the PACE loan and the buyer automatically assumes the PACE loan because it's on the property tax rolls. In real life, sometimes that's a deal point and someone might say, "All right, well, I'm going to need you to pay off the PACE loan." And so then they'll reach out to us and we'll do a payoff, but automatically it runs with the land. It can't be accelerated.

Amy Menist:
And with that being said, one of the best parts about the PACE loan for commercial real estate is that depending on how these lease agreements are drafted with the tenants, the PACE loan repayments can even be a shared cost with the tenants since it's actually put as part of an assessment to the property real estate tax bill. So can a PACE loan also then be used in conjunction with tax or utility company incentives?
Bali Kumar:
Yes. I'm going to speak to one point you passed or you made, and it's that through triple net leases, there are borrowers that are passing down all or part of the PACE assessment. That also can be a bit of a negotiation in advance because if someone is agreeing to pay the property tax bills and there's a massive PACE payment thrown on the property tax bills, if I'm the tenant, I'm pushing back a little bit and I'm saying, "Whoa, I didn't agree to that." But then the pushback on that pushback is, what we did was we made the building energy efficient, which means that your utility bills are going down and so net-net it's going to be basically the same. And so this doesn't really have much of an impact on you. So that's the triple net point.

And now going back to utility and company incentives and rebates, you can totally double dip. If there's free money out there, if utility companies are willing to give you some rebates or give you some incentives, you should be taking them. PACE will finance the entire portion of whatever is being financed. So if someone is putting in LED lights in their office building, and if they're going to get some sort of rebate or incentive from the utility company and maybe they get it after completion of installation, we finance 100% of that cost. And then if they get a 5% rebate, they just put that 5% rebate in their pocket or they pour it back into the business.

For the investment tax credit, I see a lot of folks who come to us and they say, "Hey, I want to do solar. I have this $2 million solar project. After I get my rebate from the ITC, then I only need 70% PACE loan or something because the 30% ITC will cover the rest and I can bridge myself out of pocket." But we say, "Well, we can just fund 100% of the solar cost. And then whenever you get the ITC back in your pocket, you put it back in your pocket, you use it to grow the business, acquire a new site, hire some new folks, keep it for debt service. Whatever you need that money for, it's there for you." And so I think a lot of smart folks are thinking about how to cobble together all the incentives and rebates and doing a lot of deep thinking on the IRA and how they can stack everything together and double or triple dip.

Amy Menist:
Fantastic. Now, and correct me if I'm mistaken, one of the great things about your loan is that you guys pretty much offer the funding essentially 100% upfront so that you guys can do the work that needs to be done, right?
Bali Kumar:
Yeah, we call it 100% financing. People put down a deposit so that way we can start doing with our due diligence and hiring legal. But honestly, all of the closing costs are capitalized into the loan. We capitalize interest through the end of construction and in a lot of cases through stabilization. So that way you take the loan, you do what you need to do with the building, and then when you start earning money on the building when you're fully leased up, then that's when you're in the best position to pay us back anyway. And that's when payment starts.
Amy Menist:
Great. Well, that's great. That's great for a business and to help their cash flow during this time period. So then how does a company actually go about applying for a PACE loan?
Bali Kumar:
I'd say reach out to us. Typically, what we need to look at is the project budget to see... People send over project budgets all the time and they say, "Hey, how much PACE would I even qualify for?" And we can look at it pretty easily eyeball like, okay, furniture, fixtures, equipment, that's not PACE eligible. It has nothing to do with your utility bills. We can see, oh, this thing in electrical or this thing in plumbing, and sort of do a quick back of the envelope calculation to say, all right, it looks like 15% of your costs would be PACE eligible and you can use that as a number to go forward.

We look at the proforma and the proforma would basically tell us, hey, based on what you think you're going to be making based on your net operating income, it doesn't look like you have that much space for that much additional debt service. And so then we can say, "Even though you would qualify for $3 million of PACE financing, it looks like you're only really going to be able to support $1 million of PACE financing."

We look at the sources and uses. That helps us know, all right, you're going to be spending $10 million building this project. You got $5.5 million from X bank and you have 1% equity and 49% mezz debt. And we can say, "Okay, well, you're not going to be able to do this deal." Or, I don't know. Those numbers didn't add up. 55%, 44% mezz debt and 1% equity. We'll say, okay, well, the senior lender's not going to let you do 1% equity, so that number's going to have to change. Mezz debt we know is more expensive than ours, so it's accretive to your cost of capital if we just minimize the mezzanine debt a little bit. What senior lender you working with? Okay, have you discussed PACE with them? Let's have that conversation if you haven't. Let's get that consent in writing or give them whatever credit enhancements we need to get them so that way we can assemble this capital stack as such.

We also can reach out to the program administrator because every state has a different program administrator and some states have multiples. In Texas, there are two program administrators. In California, there's four. In Florida there's four, but in Michigan there's one, and in Minnesota there's one. So just help them navigate that process, and then we underwrite the deal and we close.

Amy Menist:
Great. So out of curiosity though, because I know that this is very state by state specific, it could even be local legislation specific, is there a place that somebody could actually go to do a little bit of research before they give you a call?

Bali Kumar:
Yeah, I would say it might just make most sense to give me a call first because in order to figure out exactly which website and which rules and which program administrator, I know that stuff off the top of my head because we deal in this every day and we can answer questions that would take someone half an hour to figure out in two minutes. So I'm happy to take any phone calls and serve as people's resource.

I think one other super interesting thing about PACE that people are trying to still figure out how to underwrite is how PACE can pay for itself. And so a couple of states have a savings to investment ratio that basically says in Michigan, for instance, an energy model has to be done to show that the savings is greater than the investment. And then someone has to guarantee that. So that way someone doesn't come to your CFO and say, "Hey, I have this solar and these new LED lights and it's going to cost you $100 million, but you're going to save $40 million a year." Just to prevent that sort of scam.

Instead, you get an energy audit done and you show it's going to cost you $5 million to install this stuff and with a reasonable utility escalation because the cost of energy goes up every year. So a reasonable rate is like 3%. So to say, all right, you're paying this much in your energy bill, this solar array plus these LED lights will decrease your energy bills by this amount. You grow that amount by 3% every year because the cost of energy goes up, it's going to cost you 5 million to install, but by the end of the 20, 30 years of your PACE loan, you will have saved $8 million.

There's other ways where PACE building upgrades pay for themselves. There's water conservation. If you're flushing one gallon instead of three gallons every time, that's a huge water savings. O&M, we're working on a project right now where just by bringing the currently existing building up to 2023 standards, it's going to save them hundreds of thousands of dollars a year in O&M because every time something breaks, which is all the time, they have to bring in an engineer, they have to have another person on staff. There's just so many O&M costs that they're going to be able to get rid of.

And then there's like accounting savings. Some folks are saying, "Well, I'm just going to accelerate depreciation on this." Then that results in some savings or with their incentives and rebates, like layering all that in. So there's just so much savings that everybody should just be upgrading their buildings or building above code.

Amy Menist:

Well, thank you so very much, Bali, truly informative, and I could absolutely see how this could be a fantastic financing option for real estate companies. So I kind of want to take what you said and build off of that a little bit as well and just kind of further drive it home a little bit for some of our viewers.

Like you were commenting before, there are tax incentives such as the 179D commercial building energy efficiency tax deduction, and the 45L energy-efficient home tax credit. So, for instance, the 179D is a federal deduction that can be applied to ground up energy-efficient construction projects as well as to energy-efficient retrofitting of preexisting buildings. So this 179D applies to all types of energy-efficient commercial buildings and to residential rental buildings that are a minimum of four stories tall. Whereas the 45L tax credit is a one-time federal tax credit that promotes the construction of energy-efficient residential homes. Now this credit is available to builders and developers and others who build homes for sale or for lease.

And additionally, to build off of what Bali had commented earlier, real estate companies can utilize the cost segregation studies so that they can actually generate these additional tax savings and accelerate the income tax depreciation deductions and maximize their real properties' financial returns by generating significant cash flow savings.

So now that we've discussed how real estate companies can afford to finance these ESG and sustainability initiatives, I'd like to also just explain and further clarify how this can improve a real estate company's overall financial and portfolio position on a long-term basis.

So first and foremost, as Bali had commented, the company will realize immediate utility cost savings. By decreasing the usage, you're decreasing your cost of those utilities. Additionally, the higher the performing the building, the greater it's going to attract and retain tenants, thus further improving the rental revenue.

Second, ESG is shaping and influencing real estate valuation. Investors today use a variety of tools to determine future opportunities and ESG policies are getting higher on their due diligence checklist. As such, when investors see ESG and sustainability in a real estate company's portfolio, they believe the investment is safer because they believe that the company's more attentive, proactive, and responsive in mitigating its risks. This can all often result in a lower overall cost to borrowing.

Third, implementing ESG and sustainability initiatives can help decrease the amount spent on insurance premiums and expenses relating to repairs and maintenance due to severe weather-related events or repairs and maintenance or O&M. So, for example, a company could also take into consideration like climate forecasts and environmental risk zones as part of its ESG strategy prior to developing the real estate property.

So fourth, real estate companies can comply with local ordinances regarding decarbonization, thus avoiding hefty fines and penalties. For instance, New York City enacted Local Law 97. Starting in 2024, the law places carbon caps on most buildings greater than 25,000 square feet. Failure to comply results in fines that could exceed $1 million per year for heavy polluters.

So lastly, companies can improve their asset value and overall position by meeting these carbon and energy reduction targets. As Bali had commented earlier, it's based off of the fair market value. So by implementing these ESG and sustainability initiatives, real estate companies can create an immediate increase in real fair market value and mitigate against potential decreases in their fair market value associated with failure to comply and to meet these new net-zero laws.

So in conclusion, real estate companies can improve their bottom line and their portfolio position by implementing ESG and sustainability initiatives. I'd like to give a special thank you to Bali Kumar for joining us today. And if you'd like to discuss your company's ESG and sustainability initiatives or whether or not you qualify or if you have interests on the PACE Loan Groups, feel free to contact us. Thank you so very much.

Bali Kumar:
Thank you.

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