CMBS loan documentation must do more to protect structures from suffering a material increase in debt as a result of energy efficient upgrades, Moody’s Investors Service said in a report on Monday.

Specifically, the rating agency is concerned that loan docs today don’t do enough to prohibit borrowers from taking on Property Assessed Clean Energy (PACE) loans. PACE allows property owners to finance energy efficiency and water conservation projects through property tax assessments. The loans are typically senior to the first mortgages included in CMBS.

In certain cases, mortgage lenders may want “to take on the additional PACE leverage if energy savings are substantial enough to outweigh the risk, and will benefit CMBS investors". However, Moody’s believes that lenders should take care “to always be in the position to make that credit determination”.

“PACE loans can materially increase a loan’s leverage and risk profile,” said Moody’s Senior Vice President Daniel Rubock in a press release. “Property improvement loans are typically junior to first mortgages on the property, but PACE loans, which are a type of property improvement loan, are senior and may significantly increase expenses, making the first mortgage loan riskier.”

Although CMBS documentation today prohibits the borrower from adding debt and prohibits “transfer” (a prohibited transfer includes creating any “encumbrance” on the property without the lender’s prior consent); Moody’s is concerned that PACE borrowers could argue that a PACE loan is not a loan but an “allowable tax lien." 

“Loan documents have to be specific about this because borrowers could argue that a PACE loan is a tax lien, and thus is not an unpermitted encumbrance on the property, which standard loan documents normally prohibit,” stated Rubock.

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