How CMBS lenders can stop worrying and learn to love C-PACE
Mixing C-PACE and CMBS sounds like a cocktail invented by Dr. Strangelove, but the intersection of these two financing vehicles creates unique opportunities and challenges for property owners, C-PACE investors and CMBS lenders. To date, more than 30 states have enacted commercial property-assessed clean energy statutes.
While legislative schemes and implementation vary by state, the goal is the same: to incentivize commercial property owners to invest in greater energy efficiency. As more states enact these programs, it is ever more timely to clarify the interplay of C-PACE financing with the rights of a first mortgage holder, especially a CMBS lender.
In a typical C-PACE transaction, a lender will advance funds to the property owner for investment in energy-related capital expenditures falling within the state-specific compliance guidelines. The C-PACE financing advanced to a property owner is then repaid from statutorily authorized property assessments paid along with and at the same priority as regularly scheduled real estate tax bills.
While a C-PACE loan cannot be accelerated in the event of a default, failure to pay a C-PACE assessment has the same effect as failure to pay real estate taxes, namely a priority lien on the real estate. The availability of C-PACE financing has been increasing year-over-year, and the first securitization of C-PACE loans occurred recently, indicating support among capital market investors for the C-PACE concept and structure.
The challenge of adding a C-PACE component to a property subject to a CMBS loan arises from the intentionally static nature of CMBS. One of the tradeoffs at the heart of CMBS financing is that property owners can get better loan proceeds in exchange for terms and conditions designed to promote stability of cash flows, asset values and sponsorship. Even a potentially accretive investment in the collateral property such as C-PACE can create headaches for a CMBS lender (and especially its servicer that lacks decision-making freedom under most pooling and servicing agreements) because of the cash flow and lien priority issues. This is largely why most off-the-shelf CMBS loan documents currently contain strict prohibitions against C-PACE arrangements, classifying them in some cases as a breach of the due-on-transfer clause of the mortgage loan documents, potentially triggering an event of default and recourse liability to the sponsor.
This perspective is understandable given the emphasis on stable cash flow structure with CMBS financing, but as the list of states enacting C-PACE programs continues to lengthen (and now includes New York, Florida and Pennsylvania), the incentives are stronger than ever for all CMBS loan market participants to work toward standardizing the documentation, language and process for combining C-PACE and CMBS.
An argument can be made to treat C-PACE assessments along the lines of real estate taxes or ground rents: assuming the magnitude of the assessments underwritten, the mortgage lender can structure around the priority lien issue by requiring the property owner/mortgage borrower to escrow funds with the mortgage lender sufficient to pay the assessments as they become due. To the extent the mortgage loan has a cash management feature (as is the case with most current vintage CMBS loans), a bucket can be added to the cash flow waterfall right behind taxes (and ground rent, if applicable) into which funds sufficient to satisfy the annual C-PACE assessment payments are deposited.
Additionally, failure to make the deposit, subject to sufficiency of property cash flow, could be included in the list of "bad acts" triggering recourse to a guarantor under the loan documents. Should funds from operation of the property be insufficient, the CMBS lender or servicer would be entitled to advance funds for the assessment and the mortgage loan documents could contain an express provision that any such advances would constitute protective advances under applicable law.
Finally, agreeing on a form of triparty agreement that recognizes the rights and obligations of the C-PACE lender, the property owner and the CMBS lender would facilitate closing transactions without adding excessive time or cost to the process.
These proposed structures and protections could be incorporated into loan closing documentation at origination with either specific C-PACE projects contemplated or as general conditions to effectuating a permitted C-PACE project at a later date by providing a clear framework for CMBS servicers to adhere to. This seems like an achievable and desirable end, especially given the anticipated continuing growth in volume of C-PACE financings.