C-PACE: Creative Alternative to Value Engineering
It is pretty much a 100% problem. As construction cost proposals come in, the project budget is 2%, 5%, 10% higher than expected, particularly on new construction and gut rehab. What happens next?
Almost always, the developer proceeds with Value Engineering to close the financing gap.
Value Engineering is another way of describing giving up something in the design that was important enough to be there in the first place. What the project sponsors “give up” may be a special design feature, square foot shrinkage, or other visible changes. However, the most common Value Engineering measures reduce the performance of the “invisible” parts of the design, often found in the HVAC, mechanical systems and building envelope.
A new way to offset deep Value Engineering is to apply C-PACE financing to help close the financing gap while keeping the performance and features that the building design called for. This is the sponsor and developer’s way of having their cake and eating it too!
C-PACE
Commercial Property Assessed Clean Energy or C-PACE has now been widely used throughout the US as a creative financing mechanism that greatly mitigates this or any other gap in financing. In WA, one of the nations’ newest programs rolling out, the State added Resiliency as a key objective of C-PACE financing. Thus, programs in that state are named C-PACER.
C-PACE takes energy related costs of the project — typically estimated to be 15% — 20% of the new construction budget — and moves them into the property tax of the project. This voluntary property tax assessment then spreads the cost of more high-performance energy measures across a long payback cycle — typically 20 years. This long payback period tends to match the long-life cycle of the energy measures and on-site renewable energy.
Shift Project Risk to Tenants — Resolve Split Incentives
Consider who benefits from higher performance energy designs and lower energy costs? The Owner? Developer? Tenant?
In fact, most investor-owned commercial real estate faces a nuance described as the “split incentive”. The incentive for high performance energy systems, lower energy costs and on-site renewables is with the tenants. But traditionally, the costs are with the Developer / Owners (unless owner occupied, where the owner is the tenant).
C-PACE can effectively mitigate this nuance. C-PACE in the capital stack of new construction or gut rehab actually reverses the split incentive. It shifts the energy performance portion of the project risk from developer / owner to tenant, where — in many ways of looking at it — it belongs.
The developer or investor / owner of a commercial building, particularly a multi-tenant building, has almost no “gain” from the higher performance energy systems in their design. The Tenant however will benefit from lower energy costs for the life of the building — even as tenants come and go. Therefore, placing both the cost and benefit of high-performance energy systems into the building’s property tax shifts that portion of the capital stack — and project risk — to the tenant lease. Because it is a straight amortized long payback period, typically 20 years or more, the tenant will often achieve savings through reduced electric costs that exceed the increase in annual property taxes. This means it is possible — in fact common — for C-PACE financed projects to be net positive each year. It is also rational that long life energy improvements should in fact be attached to the property tax not unlike improvements in sidewalks, public lighting and other site enhancements.
Impediments to C-PACE
One challenge for using C-PACE in the capital stack is that the senior lender must provide consent since the C-PACE assessment is the same as all property tax in priority over the senior debt. However increasingly senior lenders recognize the dramatic reduction in this priority since only the current year’s small fraction of the total amount is in priority, same as all property tax. Additionally, the senior lender benefits by shifting some project risk to the tenants and by being vested in a property with lower operating costs and higher NOI.
C-PACE vs Value Engineering
C-PACE has become increasingly popular as a new creative financing component for new commercial construction. It can be considered a tranche of funding to fill any gap. However, it makes particularly good sense when the project faces cost overrun to mitigate or share the burden typically placed on value engineering alone.
