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The capital stack: PACE finance vs. mezzanine debt

Michael Leahey

Michael Leahey
Managing director, PACE Equity Colorado

Commercial real estate capital stacks have become more complex in recent decades, allowing project sponsors and investors alike to fine-tune the level of risk they are comfortable tolerating, and get projects done – especially those with an environmental or community impact – that may not have been financeable in the past. One newer program, known as Property Assessed Clean Energy financing, is poised to seize a growing share of the commercial mezzanine debt market, while simultaneously encouraging energy-efficient development, realizing significant cost savings and improving building values.

PACE financing could be considered an evolution of mezzanine financing, which is itself an important and relatively recent evolution of commercial real estate finance. Mezzanine financing makes markets more efficient by bridging the gap between the secured and regulated world of primary mortgages and the riskier and more expensive world of equity. As an article in the July 5 Colorado Real Estate Journal stated, “mezzanine debt (is) taking a more prominent role within (the capital) stack” in Denver and nationally.

Mezzanine debt can be challenging to generalize, given the many types of providers, from sophisticated private equity funds and investment banks to independent local investors and even other developers looking to spread risk, and the wide array of terms. Mezzanine lenders typically lend between 10 and 20 percent of a project’s value, helping sponsors conserve equity, reduce weighted cost of capital and increase leveraged returns on a given project. Mezzanine debt sits behind the primary lender in the pecking order, typically in second lien position. Interest rates on mezzanine debt currently fall in the low double-digits, straddling the gap between the low rates on primary debt and the higher returns offered by equity. Beyond these points the mezzanine debt terms become complex and vary widely.

PACE, on the other hand, is relatively new and still evolving. It was created by policy entrepreneurs in California in the late 2000s to solve the most common problem in the world of energy efficiency – access to capital. Time and time again, energy-efficient and renewable energy projects would fail to move forward due to cost of funds, short-term thinking or the inability to obtain financing.

PACE was created to overcome these obstacles without requiring a government subsidy or guarantee. The program provides access to long-term financing, over and above the bank’s primary loan, for specific building measures that have a quantifiable positive impact on energy savings. These building systems include heating, ventilation and air conditioning, lighting, windows, roof, insulation/envelope, plumbing, solar and geothermal (among others).

Because these items generate energy savings, the designers of PACE realized these savings in the future could be used to reduce the cost of capital in the present. The key innovation, which allowed PACE to have a lower risk profile – and, thus, more sponsor-friendly terms than mezzanine debt, is repayment through the property tax assessment.

Property tax assessments have been used for over 200 years to cover public investments like schools, sewers and sidewalks. Since the energy-efficiency benefits of PACE financing stay with the property, the assessment used to pay for them run with the property as well – meaning that PACE financing is nonrecourse as well. An additional benefit of the property tax mechanism is that the relative security of these assets in the secondary market, backed by the property tax assessment, provide a flow of capital into funds that finance and develop PACE projects.

PACE is thus a public-private partnership between the state (which passes enabling PACE legislation), the county (which individually opt-in to the program), PACE providers (who bring private capital as well as project development and energy engineering experience) and owners. In more complex deals, other forms of public-private partnership capital such as tax-increment financing, public improvement/business districts, Low Income Taxpayer Clinic and U.S. Department of Housing and Urban Development money can be used alongside PACE financing.

Nationally, 31 states and the District of Columbia have approved PACE legislation, and 18 of those states have enabled PACE and launched programs. Colorado’s PACE program, which launched in fourth-quarter 2016 after years of policy development, has been enabled in 16 counties, covering 60 percent of the state’s population.

For new developments in Colorado, PACE can finance 10, 15 or 20 percent of the capital stack. The amount of financing available is capped by the total energy savings over the life of the building improvements, which can extend up to 20 years. The savings should essentially offset the repayment of the assessment – resulting, in some cases, in an effective cost of capital of zero.

That said, one misunderstanding of PACE is that buildings don’t have to be especially green to qualify – in fact, buildings just have to perform more efficiently than the average of their asset class. With building codes rising to higher standards than ever, most new development in Colorado will qualify. The more efficient the building is, however, the higher the financing available.

For certain projects, PACE has clear economic advantages over mezzanine debt. Overall, PACE financing is superior to traditional mezzanine financing in several key factors, including pricing, with interest rates, payback terms and, thus, cash flows superior to any other mezzanine financing alternative. PACE also provides a fixed rate, which can be a relief to project sponsors in a rising interest rate environment. For investors, PACE can diversify a portfolio heavy in higher-risk mezzanine or equity positions. In a world of investors seeking yield, the demand for PACE commercial paper will increase as well.

As interest in designing and developing commercial buildings that are not only economically effective but also environmentally efficient continues to grow, it stands to reason that the market for PACE should experience rapid growth – and capture a small but significant share of the mezzanine debt market. And with the U.S. economy growing at a slow but relatively stable pace – barring external shocks, of course – and cities like Denver leading the way in developing more sustainable buildings, external forces seem to support this growth hypothesis as well.

Efficient capital for efficient buildings – who can argue with that?


Featured in CREJ’s Sept. 20-Oct. 3, 2017, issue.

Edited by the Colorado Real Estate Journal staff.