Lending Freeze Pushes Demand For PACE Financing In Texas To New Heights

A state program that finances sustainable upgrades at commercial properties has seen a surge of demand over the last several months as cash-strapped developers seek alternative ways to pad their capital stack.

Texas’ Property Assessed Clean Energy program, known colloquially as PACE, offers low-cost, long-term financing for energy- and water-efficiency improvements secured through a voluntary assessment on the property. 

The program has been slow to get off the ground since its approval by the state legislature in 2015, but recent turmoil in the economy has energized PACE in a way no one saw coming.

“It’s been a little bit of a slow growth curve for PACE, mainly because developers have had a lot of access to capital since 2015,” said Lee McCormick, program administrator at Lone Star PACE. “What every single market has seen is that interest rates have gone up and banks have pulled back on their exposure on loans, and developers are really scrambling to get their projects financed.”

In the first two months of this year, Lone Star PACE closed $32M worth of PACE transactions; it closed $45M in transactions in all of 2022, which was a 350% increase over the $10M transacted a year prior, McCormick said.

“In the past, developers have had their capital stacks lined up, they’ve had their relationships with their bankers and their country club money, and to incorporate a new financing vehicle is just not that comfortable to a lot of people,” Lone Star PACE Chief Operating Officer Glenn Silva said. “Now, with talk about a recession, lenders are getting conservative, and PACE fills that gap in an excellent way.”

Lenders are incentivized to make PACE loans at lower interest rates because savings realized by the improvements offset the cost of financing, McCormick said. This is especially useful in an era when rising interest rates are putting the kibosh on many projects.

“Now everybody’s listening,” he said. “They’re not only surprised that it’s available, but they’re surprised at how cost-effective it is. It’s helping a lot of projects make it across the finish line.” 

A policy change that was rolled out in September unlocked wider access to PACE by allowing the financing to be used for projects on mostly unimproved greenfield sites. Prior to that shift, the tool was only available for already-developed buildings.

“It created clarity and a little more elbow room for developers to use it,” said Charlene Heydinger, president of Texas PACE Authority, a nonprofit organization that administers the program on behalf of local governments. “We’ve seen a distinct uptick in the use of PACE for new construction as a result of that.”

Texas PACE Authority had a record year in 2022, funding 17 projects across 13 cities for a total of $172M, which equaled the investment from the TPA in all previous years combined. One of those projects, the $40M Hotel Swexan development in Dallas’ Harwood District, was the largest PACE project in Texas, Heydinger said.

In the first two months of 2023, the TPA facilitated more than $30M in PACE investments.

“For a developer, all of the sudden interest rates are changing every half-hour, bonds are more complicated and harder to get,” Heydinger said. “So people are looking for alternative sources of capital, and here we are.”

PACE financing can comprise up to 25% of a developer’s capital stack, McCormick said. The loans tend to be an attractive alternative to traditional mezzanine financing because they are nonrecourse and have longer terms and lower interest rates.

All of these factors make PACE desirable from a capital development perspective, said Todd Harmon, the developer and owner of the revitalized Barfield Hotel in Amarillo, which used PACE to fill a capital gap between a conventional loan and historic tax credits.

Harmon is also tapping into PACE financing for a mental health facility in Beaumont and a hospital in Lubbock. 

“The end result is you have a cleaner environment and a lower carbon footprint, but it’s actually a great financing tool for raising your leverage on projects that would otherwise sometimes not get financed,” he said, adding that the Barfield building has an anticipated annual electrical energy savings of 73%.

Halfway through 2022, Countrywide Hospitality assumed 50% ownership of a partially constructed, 156-unit Aloft by Marriott hotel in Irving that had been stalled by the pandemic. Countrywide Managing Member Amar Patel said conventional lenders were hesitant to partner on the project, and to make matters worse, interest rates were growing increasingly volatile.

Countrywide eventually turned to PACE as a mechanism for securing a lower rate, which ultimately allowed the company to continue construction on the project. 

“In this environment, PACE definitely makes sense,” Patel said. “A big part of why we wanted to do it was because it was going to get our project financing across the finish line, but we also felt that we were going to be able to add that capital stack in at a cheaper rate and be able to contribute some of that cost to the project.”

Patel said some of his colleagues were skeptical of PACE financing because it sounded too good to be true, and it can be difficult to find a lender who has used the program before or is willing to try it for the first time. 

Farukh Aslam, CEO of Sinclair Digital and Sinclair Holdings, said PACE was a great fit for his Sinclair hotel development in Fort Worth because of his commitment to sustainability and the higher cost per square foot associated with historic preservation projects. He is also using PACE to finance a hotel project in Midland.

But finding a lender willing to work with PACE can be a challenge, which is why he prefers to partner with those who are already familiar with the program.

“Most lenders do not understand the PACE program, so it’s really about educating them,” Aslam said. “Right away when you tell them PACE will take a first lien ahead of your senior debt, that makes them nervous.”

Silva said this concern is why senior lender consent is required for the use of PACE and that the probability of foreclosures on PACE-assessed properties is nominal. The capital provider can only foreclose on installments that are past due, not the entire assessment, he added.

Since PACE’s inception, the program has created water- and energy-saving investments in Texas of close to $400M, but Heydinger said greater exposure is still needed for PACE to reach its full potential. Local governments must adopt the program before developers can tap into PACE, and only 42 cities and counties have done so.

“People can’t use a program they don’t know about, and our biggest challenge is getting the word out,” she said. “This is the greatest program not enough people have heard of.”

Whether PACE will remain as popular as it is now when interest rates settle and commercial lending returns to normal is still to be seen. But Heydinger said the state’s heightened energy costs — made more severe by the devastating Winter Storm Uri of 2021 — will prompt developers to look for cost-saving mechanisms long after a potential recession is over.

“Timing is everything. Even this challenge has turned out to be a blessing for PACE because it has made more people aware,” she said. “If energy prices weren’t increasing, I would be concerned that maybe PACE is the solution of the moment and we move on. But I don’t believe that’s the case.”