2023

PACE: The chameleon of CRE financing

by Rafi Golberstein

PACE financing is surprisingly flexible – and can fill financing gaps in any market condition. PACE gives developers a critical tool to add liquidity to any project. A common use of PACE is to fill the gaps in capital stacks for ground-up, adaptive reuse and gut rehab projects. Depending on the market, this can take various forms. Regardless, PACE makes deals pencil better, whether we are in a strong, or a weaker, more illiquid market.

Strong Markets

In strong markets, when construction financing is readily available, competition results in mortgage lenders increasing leverage or accepting more structured capital stacks. In this case, PACE acts as an “Equity Reducer and IRR JuicerTM”, substituting PACE instead of more expensive mezzanine financing and/or preferred equity. For example, in a strong market, a borrower might be able to obtain 70% LTC from a bank at 4% interest. To achieve a higher leverage, such as 85%, that borrower would typically look to mezz and/or pref equity, which would command 10%+ returns. PACE can fill the same hole in the capital stack at an interest rate of, say 6%, significantly reducing the cost of capital and increasing developer yields.

Weaker/Illiquid Markets

Financing is Expensive; PACE Reduces the Cost

In down or illiquid commercial real estate markets, the cost of capital increases and mortgage debt gets significantly more expensive. In this case, PACE can be deployed to blend down the interest rate and substitute more expensive financing in the deal. For example, if a mortgage is being priced at Prime + 1.75% or SOFR + 4.50%, the interest rate (as of June 2023) would be approximately 10%. PACE can be used to blend down that cost of capital; every dollar of PACE brought into the deal as a mortgage replacement (even if PACE is at 7.50% interest) is accretive and saves the borrower money.

Financing is Hard to Come By

In down markets, credit tightens, and capital market liquidity diminishes, making mortgage borrowing difficult. Unlike a strong market where a handful of lenders are bidding on each deal at relatively high leverage levels, borrowers/developers will see mortgage lenders significantly cut proceeds and simply want to lend less. In this case, PACE fills gaps in the capital stack, adding to the maximum leverage. For example, in a weaker market, a borrower or developer might only be able to obtain leverage of 50% LTC. That borrower could fill in the gap with PACE by adding 10 to 20% more leverage into the deal.