How to Add Green Updates to Your Building With Minimal Cost

When developer Michael Tomko rehabbed the historic 145 Rich Street office building in downtown Columbus, Ohio, a few years ago, he determined that the old chiller, boiler, roof and elevators still had some useful life left. However, tenants quickly expressed their desire to have state-of-the-art offices with more modern and energy-efficient building systems.

Reluctant to make a big capital expenditure so soon after completing the rehab, the founder of the local Tomko Company offered a solution: He would use a $711,000 Property Assessed Clean Energy (PACE) loan to upgrade the HVAC system and other infrastructure, and tenants would pay for the costs as part of their operating expenses. In return, the tenants would enjoy lower energy bills.

"The tenants loved it because they got improved infrastructure, and some of the costs were offset by energy savings," says Tomko, who is currently using $4.5 million in PACE loans for a similar historic renovation of the Hayden office building a few blocks away. “They're getting a better experience in the building."

PACE is a decade-old loan program that pays for energy and water conservation upgrades to create more environmentally sustainable and resilient buildings. The program's promoters contend that it beats using conventional debt typically used to fund such improvements because PACE is often cheaper, it has a fixed interest rate versus an adjustable rate, and its loan terms are generally 15 to 25 years instead of three to five. Tomko's Rich Street PACE loan featured an interest rate of 5.5% and a term of 14.5 years.

The biggest distinction between PACE and conventional debt, however, is the fact that a PACE loan becomes an assessment on the property's real estate tax bill. Consequently, landlords can pass the costs of improvements directly to tenants operating under triple net or modified gross leases largely found in office and retail properties, which typically obligate tenants to pay taxes and other operating expenses.

Among other energy projects, Indianapolis-based mall owner Simon Property Group used $3.4 million in PACE financing seven years ago to install a more efficient HVAC system and roof at the Great Lakes Mall in Mentor, Ohio. Costs were passed through to tenants, according to the Lake County Ohio Port and Economic Development Authority, which helped facilitate the PACE loan. Simon transferred the property to Washington Prime Group, its real estate investment trust spinoff, in 2014.

"Tenants tend to be okay with this method of financing because they get the benefit of energy savings out of it," says Caleb Bell, a partner with the Bricker & Eckler law firm in Columbus, who specializes in PACE deals. “The owner gets the benefit of getting long-term financing and can pay for improvements without the cost coming out of pocket."

Hotel operators can pass through a PACE assessment to guests, too. A room bill breakdown at the two-year-old Hotel Indigo in downtown Kansas City, Mo., includes a PACE assessment surcharge of 5.9%. The developers converted a historic but vacant office building into a 118-room boutique hotel and used $2.4 million in PACE financing to pay for LED lighting, HVAC systems, environmental control systems and other infrastructure.

"Ultimately the goal for hotel developers is not to grab extra revenue, like a resort fee, but to see how much of the assessment they can get back," says Rob Shear, CEO of PACE Sage Capital, a PACE loan originator in Overland Park, Kan., that structured the Hotel Indigo financing. "It's purely about the business model and fulfilling PACE's public policy goal to enhance energy and water conservation."

Shear further notes that developers can effectively drive their PACE loan interest rate to zero if they can recoup around 40% to 45% of the assessment cost.

While directly passing through all or a portion of PACE costs to commercial property tenants or hotel guests is compelling, landlords and developers may not be able to—or want to. Some hotel operators looking for a competitive edge may be reluctant to add an extra fee, and certain hotel brands may prevent passing through such costs, Shear and Bell say.

Similarly, office or retail tenants that are in a strong negotiating position may be able to limit their operating expenses, Bell says. Even in cases where landlords or developers are able to pass through PACE costs, they'll still be on the hook if a PACE assessment extends beyond the lease term of a tenant that doesn't renew. Still, Tomko says, the benefits outweigh the risks.

"You do have some exposure on the back end," he says. “But when you use PACE to put a 30-year roof on or install a chiller with a long warranty, you're getting capital expenditure savings in addition to energy savings."