Understanding the Implications of C-PACE and Triple Net Leases

Commercial Property Assessed Clean Energy (“C-PACE”) allows property owners to borrow money for energy efficiency or renewable energy projects and make long-term, low-cost payments via an assessment on their property tax bill. This financing agreement is tied to the property, not the property owner, meaning the repayment obligation may transfer with property ownership. But what happens when a tenant agrees to a triple net lease (NNN)? Who is responsible for the C-PACE loan—the tenant or the property owner?

C-PACE

C-PACE is a unique loan from private investors or government programs that enables property owners to finance renewable energy improvements on commercial properties. C-PACE is only available for commercial properties owned by entities such as corporations, limited liability companies, partnerships, real estate investment trusts (REITs), or any property owner other than a natural person. The eligible renewable energy improvements depend on the specific C-PACE program chosen. Some programs allow financing for non-energy projects such as water efficiency, seismic retrofits (earthquake proofing), wind resistance, and flood mitigation, while others strictly adhere to energy efficiency or renewable energy projects. Energy efficiency projects generally aim to reduce energy consumption, such as upgrades to heating and cooling systems. Renewable energy projects typically include the development of solar thermal systems, energy storage, ground and air source heat pumps, and high-efficiency, low-emission wood heating systems. C-PACE funding is currently available in 38 states and the District of Columbia.

C-PACE eligible upgrades can be 100% financed with no money down and are repaid as a benefit assessment on the property tax bill. The repayment term matches the useful life of the improvements, typically over 10 years. The property owner pays for the completed work through a property tax assessment, and the local municipality remits the repayment to the lender. The assessment transfers with any sale of the property and can be passed on to tenants – but, should they? Usually, the savings generated from the energy efficient improvements will exceed the additional property assessment amount.

Potential drawbacks from C-PACE financing include lender approval/pushback: unpaid C-PACE assessments can create a senior lien on the property, requiring lender consent for any property with a mortgage, adding time and cost to the financing process. Unpaid assessments can also limit refinancing options. Properties with C-PACE assessments can be more difficult to sell, as new owners must agree to pay the additional assessment on the property tax bill. Additionally, C-PACE financing is only available in locations with PACE-enabling legislation, including statewide enactment and local municipality participation.

Triple Net Lease

A triple net lease, as opposed to a gross lease, is structured such that the tenant, in addition to base rent, is responsible to pay essentially all of the property owner’s expenses to operate the property, such as real estate taxes, insurance, maintenance expenses, and utilities. Triple net leases are common in commercial real estate, particularly for retail uses and warehouses. Since tenants are responsible for their energy/utility bills under these leases, any savings from energy efficiency upgrades benefit the tenants. While this is advantageous for tenants, it leaves property owners covering the entire cost of these improvements without receiving any financial return. This dilemma, known as “the split incentive,” gives property owners little motivation to invest in energy efficiency projects. Because of this unfavorable situation, property owners have been hesitant to pursue such upgrades, and, as a result, leased commercial properties have historically lagged other properties in terms of energy efficiency.

Hence where C-PACE becomes relevant. C-PACE solves the split incentive problem and uses the triple net commercial lease structure to the owner’s advantage. Typically, a property owner repays any of its financing directly to its lender, but a C-PACE assessment can be passed through to tenants. In triple net leases, tenants of the commercial building pay their share of property taxes. The property tax bill includes the C-PACE assessment, which means tenants are covering the cost of the C-PACE assessment.

This combination of triple net lease and C-PACE assessments is challenging due to the nuances involved. Tenants may not always be aware that they are contributing to the payment of the C-PACE assessment. Nonetheless, they theoretically benefit from reduced utility bills resulting from the energy efficiency improvements funded by the assessment. However, if tenants are not aware that they are indirectly paying for the C-PACE assessment and the "savings" are delayed, they may feel blindsided by the unexpected charges. The complexity is further compounded by lease agreements that may explicitly exclude “PACE assessments” from the definitions of “Taxes” or “Operating Expenses.” These exclusions create financial ambiguities, which may lead to potential conflict. The effectiveness of C-PACE funding in solving the “split incentive” depends on the transparency of the lease terms and the tenants' understanding of the cost-benefit dynamics of C-PACE.

Who is paying the loan?

C-PACE is a win for property owners. They get to reap the benefits of energy efficiency upgrades without paying any of the costs out-of-pocket – resulting in lower energy bills, reduced operating expenditures, and higher valuations. The property can be marketed as “green,” which can be an advantage for rent premiums. Additionally, recent upgrades serve as a selling point to attract buyers. Meanwhile, tenants who have entered into a triple net lease pay the C-PACE funding assessment instead of the property owner.

Before entering into a triple net lease for a commercial property that has received C-PACE funding, it is crucial for tenants to assess the pros and cons. In most scenarios, there should not be an added cost to the tenant if the C-PACE energy project is effective. Most C-PACE programs require energy efficiency improvements to have a savings-to-investment ratio greater than one - meaning tenants should be able to make each C-PACE repayment with the funds saved from lower energy bills—and still have cash left over. Tenants also reap the benefits of improved buildings with brand-new HVAC systems, windows, chillers, and other features.

Next Steps

For more information on C-PACE and Triple New Leases, please contact Rafael Pignataro (716.848.1222), (Sujata Yalamanchili) (716.848.1657), or any other member of our Real Estate Practice.

Disclaimer

This client alert is a form of attorney advertising. Hodgson Russ LLP provides this information as a service to its clients and other readers for educational purposes only. Nothing in this client alert should be construed as, or relied upon, as legal advice or as creating a lawyer-client relationship.