Investors eyeing $557 million of commercial mortgage bonds offered by JPMorgan Chase last month had to consider an unusual risk: The 103 office and industrial buildings that ultimately served as collateral might, at some point in the future, be encumbered by additional debt.
The loan on the portfolio gives the property owner, Workspace Property Trust, the right to incur Property Assessed Clean Energy loans to pay for energy efficiency upgrades.
Lenders often consent to borrowers taking on additional debt that is subordinate to theirs, since they are assured of being repaid first. But PACE loans create what is known as a super-senior lien. The funds are lent by municipalities and repaid through multiyear assessments against a property; if the borrower fails to make timely payments, any past due amounts take first priority.
In the residential mortgage market, this lien priority is controversial. One housing finance regulator, the Federal Housing Administration, has said it will insure mortgages on homes with PACE liens; another, the Federal Housing Finance Agency, bars Fannie Mae and Freddie Mac from acquiring mortgages on a property with a PACE lien. This doesn't stop a homeowner with an existing mortgage from getting PACE financing, but it can make refinancing or selling a home with a PACE lien more difficult.
In the commercial mortgage market, by comparison, borrowers often go to the trouble of getting a mortgage lender's consent before obtaining PACE financing. In the case of Workspace Property Trust, the PACE financing was pre-approved, so to speak. The original lender, a unit of JPMorgan, put language in the loan document that allows for future liens, but the current lender must sign off on any additional financing. Now that the loan has been securitized, this falls to the servicer of the securitization, dubbed JPMCC 2016-WPT.
Commercial PACE programs are available in 16 states, and to date some 106 lenders have consented to borrowers incurring such liens, according to PACE Nation, an industry trade group.
However, consent language has only appeared in securitized commercial mortgages very recently, according to Robin Regan, a managing director at Kroll Bond Rating Agency, which rated JPMCC 2016-WPT.
"We started seeing them this past summer," Regan said in a telephone interview. "There was another single-borrower deal, backed by the loan on the Shops at Crystals [in Las Vegas], and initially three or four conduits containing loans" where the borrower has the ability to incur a PACE loan.
Kroll Is 'Credit Neutral'
Generally, she said, borrowers must obtain lender consent for the financing. In some cases, PACE financing is also subject to confirmation that the additional debt will not hurt credit ratings. Some commercial mortgage loans also have caps on the permitted amount of the PACE loans, generally from $5 million to $7 million.
Kroll is "generally credit neutral" on the PACE financing, Keith Kockenmeister, another managing director at the rating agency, said in the same telephone interview. He said this view is based on several factors including the fact that loan-to-value ratios for PACE liens are generally low.
"It is an extra payment the owner has to make, so it impacts property cash flow, and it's in a superior-lien position," Kockenmeister said. "However, a lot of this concern is negated by the fact that [the lien] is at a lower leverage point."
And "in theory [PACE funding] is there to enhance the efficiency of operations. So from that respect, it's a positive," he said.
While some proponents hold that PACE improvements add to the value of properties, in addition to lowering utility bills, Kockenmeister said that this is "tougher to quantify and depends on several factors."
Kroll has yet to rate a CMBS deal where a property was already encumbered by a PACE lien.
Any PACE financing that Workspace Property Trust obtains on its portfolio will not be included as collateral in the securitization trust.
Lender Consent Key to Acceptance
Requiring lender consent was a prerequisite to the Texas lending community being neutral on commercial PACE when it came up in the state legislature, according to John Fleming, the general counsel for the Texas Mortgage Bankers Association.
Fleming said that the Lone Star State has had PACE statutes on the books for close to 10 years, but those statutes were defective and no one used them.
"The first viable PACE statute was passed in 2013 and is limited to commercial and industrial property, including multifamily property," Fleming said in an email. However, the PACE programs are just now coming on line in the state. "Only a few deals have been done," he said. "Not because of the consent issue, but because of getting new programs at the county and city level take lots of time."
Fleming said that lender consent "should be a prerequisite for any lien that could have priority over an existing mortgage lien." From a purely legal standpoint, he said, a lien is an interest in property and any law that erodes that property right introduces instability into the system.
"The existing lender underwrote the mortgage loan relying on certain debt-to-value ratios, debt-to-income ratios and anticipated cash-flow projections," he said. "PACE loans alter those basic underwriting expectations. A PACE loan should not be made without the existing lender getting the opportunity to evaluate the relative risk of this additional debt."
Fleming said that lenders "should seriously consider granting consent where it can be demonstrated by independent third-party verification that the PACE improvements add value to the collateral and the operation savings offset the annual PACE assessment. That is to say, the cash flow off the project is not impaired."
The Department of Housing and Urban Development's preliminary statement on consent for multifamily projects is a good starting point for a discussion on uniform criteria for consent in the commercial context, Fleming said.
Commercial PACE Provider Plans Securitization
While PACE financing is not included in the collateral for commercial mortgage securitization, these energy efficiency loans could eventually find their way to the securitization market on their own.
CleanFund, the largest provider of commercial PACE financing, plans to tap the securitization market early next year. It would be the first deal backed entirely by commercial PACE.
"We believe that commercial is going to ultimately be a more sustainable finance mode for PACE because of the ability to get buy-in from commercial lenders," said Greg Saunders, the company's chief executive. Also, "the commercial market is relatively underserved. There are a lot of companies flocking to the residential side, which is five times the size of the commercial market, in terms of dollar assets."
CleanFund's average transaction is $2 million and has a fixed-rate term of 20 to 30 years. However, the firm has made loans as small as $100,000 and as large as $10 million.
"We tend to underwrite our transactions to no more than a PACE lien to value of 20%," Saunders said. "When combined with a senior mortgage, we try to keep the CLTV [combined loan-to-value ratio] at 100% or less."
Saunders said that mortgage lenders tend to become more amenable to PACE when they understand that only the past-due amount may step in front of a mortgage in default, and that the average annual PACE payment is 1%-2% of a property's value.
"That's a minimal amount of potential seniority," he said.