By Bert Belanger, PACE Equity
Seemingly every week, a commercial real estate publication publishes a story warning that nine out of 10 markets in America need more affordable housing units.
Switching to an “all-bills-paid” mindset and utilizing Commercial Property Assessed Clean Energy (C-PACE) financing can help address this quandary.
Going Through the PACEs
In early 2021, after a 40-year career as a real estate lawyer, consultant and developer focused on affordable housing, I began “selling money.” By this, I mean that I was sourcing capital for PACE Equity, a Milwaukee-based private debt firm focused on providing C-PACE funding. Since C-PACE was new to my home state of Oklahoma, I was initially unfamiliar with its characteristics, but the practice of so-called “green building” was something I had experienced firsthand.
I hoped that my mixture of experience might make me a unicorn — a guy who knew how to meld obtuse government subsidized housing tools with C-PACE, all for the greater good. However, I have quickly learned that mixing C-PACE with government-assisted housing financing tools is a non-starter.
Why? Because cash flows within government-subsidized financings are thin by design, leaving no room for debt service beyond a small senior loan.
Real Deals and Real Savings
Back in 1992, as an affordable housing developer using low-income housing tax credits (LIHTCs), I discovered what I will call the utility-cost conundrum. This a reality that every commercial and residential landlord intuitively knows. In most lease structures, the tenant controls, consumes and pays for the costs of using water, natural gas and electricity, so the landlord has no financial interest in (or concern about) energy or water efficiency.
Then in 1996, I converted 12 brownstones dating to the 1920s into 96 one-bedroom LIHTC units, and I discovered HUD utility allowances. These allowances are intended to estimate the average monthly utility costs for apartment renters.
In the historic Paseo neighborhood of Oklahoma City, we gutted old buildings to the studs and created very tight units with blown insulation, new windows and energy efficient mechanical, electric and plumbing components. The key ingredient to success was that we chose to rent the apartments on a bills-paid basis.
I soon learned that the actual utility cost for each apartment within that development was less than 50 percent of the HUD utility allowance, with savings of nearly $100 per unit each month going to the bottom-line net operating income (NOI). Thus, even with a below market rent cap in place for our 96 units, we were able to enhance annual cash flow by more than $155,200.
That seemed to me to be real money.
Later, in an Oklahoma City commercial building retrofit completed in 2006, I installed a closed loop geo-thermal heat pump system, and my earlier lesson in energy cost savings was reinforced; while the per-ton installation cost of geo-thermal was nearly three times that of a conventional split system package unit, I saw a 60 percent savings in utility costs, once more using a gross-lease, bills-paid structure with each commercial tenant.
Again, real money.
Subsidies Are Not Enough
Today, I am pondering how these lessons might translate to making housing more affordable on a systematic basis. Here is what I have decided might make sense.
We have seen government-subsidized programs (e.g., HUD, USDA, LIHTC and other block grant or loan programs) generate hundreds of thousands of new and renovated housing units across the country, but this has not kept pace with the growing numbers of current and new households that will have to pay more than 30 percent of their income to house themselves.
Moreover, except where green building codes are imposed, this “workforce” or “attainable” housing stock is generally not energy (or water) efficient, nor resilient, and it will age poorly and deteriorate with time. The affordability of these units will undoubtedly worsen over time as well, as insurance and utility costs continue to rise.
A Better Approach
To bolster the supply of affordable rentals that will stay affordable and naturally occurring affordable housing (NOAH), there are several actions to be taken — not by the government, but by those of us in the multifamily industry:
- Align the interests of residential landlords and tenants on energy and water consumption through an all-bills-paid leasing structure.
- Incorporate green design principles in multifamily and build-to-rent projects. This includes solar and geo-thermal energy, water saving and recycling, low-emissivity windows, insulated concrete forms, structural insulated panels, sunshades and other modular systems, as well as sub-metering to identify over-consumption.
- Use C-PACE to finance more robust, resilient components over their full useful life on lower, fixed-rate terms.
- Leverage incremental utility-cost savings.
Some might wonder whether such an approach could impact the project NOI enough to make a difference. Consider a typical stick-frame, new-build multifamily complex of 200 units:
- Average estimated monthly utility cost of $200/month x 200 units x 12 months = $480,000
- Hard-cost budget based on traditional design = $41,000,000
- Incremental cost for geothermal and solar energy (3 percent of $41 million) = $1,230,000
- Impact on out-of-pocket utility costs: Assume (conservatively) that costs are reduced by 50 percent to $200. Under the bills-paid lease, 100 percent of the savings in out-of-pocket electricity costs flows to the benefit of the landlord; thus, NOI increases by $480,000/year. At a 7 percent cap rate, this amounts to a value increase of $6.8 million.
The Bottom Line
The C-PACE industry (and PACE Equity funding in particular) — with an emphasis on and shift to the all-bills-paid leasing structure — can help remake and rapidly expand the entire genre of NOAH, with developers and financiers collaborating to re-engineer both the physical design and the financial structure of rental housing. This has the potential to make a big dent in the nation’s affordable rental housing deficit. No government assistance or meddling is needed — only the natural workings of capitalism. Imagine that…