Paying for Green Retrofits of Commercial Buildings with On-Bill Financing and ESAs

Building owners evaluating a green retrofit should consider on-bill financing or efficiency services agreements to finance the work.  These two financing strategies can help building owners pay the substantial upfront costs of energy efficiency upgrades.  What’s more, these creative financing models may also place within financial reach more efficient upgrades that may have a higher up-front cost, instead of lower-cost equipment that may not have the same long term benefits.  This article looks briefly at some of the economic reasons why building owners do not pursue green retrofits and then explores on-bill financing and efficiency services agreements as options to solve funding issues.

Difficulties in Financing Real Estate Energy Efficiency Measures

Commercial property owners typically set aside capital reserves for periodic replacement of major capital improvements, such as the replacement of a building’s roof, HVAC systems and repaving of parking lot.  Funds are less commonly set aside for energy efficiency upgrades, particularly in older buildings.

Landlords also typically don’t pass on the costs of energy efficiency measures to tenants.  Most commercial leases are drafted as so-called “triple net” leases in which tenants bear utility consumption costs directly, so landlords have less of an incentive to proceed with energy efficiency improvements. While “triple net” leases sometimes reserve the landlord’s right to charge tenants for the costs of green retrofits as a pass-through expense on an amortized basis, some landlords are also loathe to pass through such capital expenses under short term leases.

Finally, many landlords would prefer not to finance green retrofits through real estate secured debt.  Recognizing a return on investment for a green retrofit is delayed if financing costs are included.

On-Bill Financing:  Utility Companies and Property Owners Cooperate

Utility companies and building owners can work together to finance the improvements necessary to implement a green retrofit.  Simply put, the utility company advances the costs of the improvement work and is repaid from the energy cost savings by the building owner.  Financing is available to fund lighting, HVAC, electric motors, LED street and parking lot lights, refrigeration, food service equipment and water pumps.

Here is how the transaction is structured:  The utility company and the building owner reach an agreement whereby the utility will advance the funds required to complete the construction work necessary to retrofit the building.  The improvements are completed from the funds by the building owner, who hires a general contractor to perform the work.  The general contractor can be selected by the building owner, but typically must be on an approved list maintained by the utility.

Once the work is complete, the utility inspects the work.  Then, the funds advanced by a utility company are repaid by the building owner on a monthly basis at the time of payment of utility bills. The amount of the monthly repayments is structured to equal the difference between the amount that would have been paid for “business as usual” utility consumption prior to upgrade and the amount payable for post-retrofit actual utility consumption.  In California, utilities offer loans with a zero percent interest rate, there are no lending fees and no prepayment penalties.

Utilities today are offering loan amounts from $5,000 to $100,000 per premises with a maximum available credit of $1,000,000 per customer.  Repayment terms vary, but are typically 5 years.  After the loan is repaid, the benefits of the new equipment and the reduced energy consumption costs belong to the building owner.

Efficiency Services Agreements:  Private Financing of Larger Retrofit Projects

Efficiency Services Agreements, also known as Energy Services Agreements, (“ESAs”), are more complex arrangements that raise funds for major commercial or industrial energy efficiency retrofits, such as private universities, hospitals, corporate campuses, and other large scale facilities.  The improvement costs for such projects usually exceed $1,000,000.

ESA agreements are proposed by an ESA project sponsor to a property owner, who is the customer.  The ESA project sponsor offers to provide the customer with equipment and services to achieve the customer’s energy efficiency goals.

As part of the ESA agreement, the ESA project sponsor forms a single purpose entity (“SPE”) that will purchase and own the equipment on the customer’s property.  The SPE also contracts with an Energy Service Company (“ESCO”) to install and maintain the equipment and perform monitoring and verification services.

Once the equipment is installed and the energy efficiency performance of the systems is validated, the customer pays the SPE for the energy saved (so called “negawatts”).  The amount of the payment is calculated on the basis of demonstrated actual energy savings, either as a fixed dollar amount per kilowatt hour saved or as a percentage of the utility’s energy rates applicable to the customer.  The SPE then uses the proceeds received from the customer to pay for services provided by the ESCO and for debt service on the installed equipment.

The SPE finances the initial purchase and installation of the energy efficiency equipment with funds obtained from private investors – both debt and equity.  Investors are repaid from customer payments (passed through the SPE, as described above), as well as incentives and rebates received from public utilities and governmental authorities, if available.

In some transactions, investors may demand a financial guaranty from the ESCO or the property owner as a credit enhancement.  In addition, investors may require the SPE to purchase insurance to manage the risk that the installed equipment, once commissioned, meets the promised energy efficiency targets.

ESAs have numerous benefits.  First, property owners may be able to finance energy efficiency improvements on an off-balance sheet basis.  Second, customers pay only for the actual reduction in their utility bills.  Third, the risk that the purchased equipment does not perform as advertised is shifted to the ESA project sponsor and/or ESCO.  Fourth, the operation and maintenance of installed equipment is the responsibility of the ESCO, who has the applicable experience and technical expertise.  Fifth, tax benefits may be available to the project sponsor or its investors, depending on the structure of the transaction and any available rebates and incentives.  Sixth, transactions can be structured so that “triple net” lease tenants are not adversely affected.

Conclusion

On-bill financing and ESAs are two available tools available to property owners considering a green retrofit.  For smaller commercial property owners, the zero interest on-bill financing offered by utilities is very attractive.  Larger green retrofit projects would appear to benefit from an ESA structure, because those projects have larger funding requirements.  Both funding mechanisms solve the problem of inadequate capital reserves, giving building owners the ability to install more energy efficient measures.

Where a commercial space is leased on a “triple net” basis, both ESAs and on-bill financing can be structured so that a tenant pays no more than its “business as usual” energy consumption cost.  Similar structuring considerations can benefit “base year” and “gross” leases, where the landlord pays all or a portion of energy consumption expenses.   Overall, today’s commercial property owners have more flexibility than ever in implementing energy efficiency upgrades for the benefit of their buildings, their tenants and the environment.

Real Estate Private Equity Choice of Entity Considerations

Selecting the appropriate investment vehicle for a real estate transaction can be crucial to the success of an acquisition, repositioning or development opportunity.  Why? Choosing the wrong form of entity can discourage participation by investors in a transaction or require expensive restructuring of the project entity.

This note briefly summarizes some of the issues a project sponsor and private equity investor may consider when choosing one of the two most frequently used forms of entity in real estate transactions: the limited liability company (“LLC”) and the limited partnership (“LP”).

  1. Number of Participants – Initial and Continuing

Most LLC statutes allow single member LLCs, so an LLC can be formed with one member and continue with one member if necessary through its life.

Limited partnerships generally require at least two members, the general partner (who must be fully liable for the obligations of the business) and at least one limited partner.  At formation, this issue is easy to control.

However, once the business is operating, if either the sole general partner or the sole limited partner withdraws from the limited partnership, the partnership could dissolve as a matter of law.  In California, a general partner can withdraw from a limited partnership at any time, whether rightfully or wrongfully.  A limited partnership agreement cannot eliminate that power.  While a general partner that wrongfully withdraws will likely cause the general partner to incur liability for damages if the withdrawal violates the terms of the limited partnership agreement, damages may not be a practical deterrent.  Damages can be speculative or difficult to prove and, depending on the structure of the deal, damages may be effectively limited to the distributions a party is entitled to receive.

Limited partners generally do not have the right to dissociate as a limited partner before the termination of the partnership.  However, there are exceptions.  For example, if the limited partner entity is terminated as a matter of law, or if there is a conversion or merger of a limited partner entity and the limited partner entity does not survive the merger, the limited partner is dissociated.  At that point, the limited partnership may terminate if a new limited partner is not admitted.  In a troubled deal or a bad economy, finding a replacement limited partner can be difficult.

  1. Extent of Involvement by Investors

A limited partner in a partnership generally has no personal liability for the obligations of the limited partnership.  However, private equity investors typically demand a substantial degree of control over the business decisions of the partnership, because they are contributing most of the capital required for the business’ operations.  If a limited partner intends to be extensively involved in the business, the limited partner could be rendered a general partner of the partnership by operation of law.  As a result, the limited partner could lose the cloak of limited liability, meaning that the limited partner becomes personally liable for the business of the limited partnership.

An LLC has much more flexibility in structuring entity governance.  An LLC operating agreement typically goes into great detail on management, voting rights, and the extent of each member’s participation of the LLC’s decision-making.  Unlike an active limited partner, an LLC member retains the cloak of limited liability despite the LLC member’s active and intense involvement in the operations of the company.

  1. Implied Duties

Partners generally have implied duties to one another, including fiduciary duties, duties of fairness and loyalty, duties of care, and the duty of good faith and fair dealing.  In some states, these duties can be limited or waived in the limited partnership agreement.

State laws may also impose on LLC members implied duties unless limited or waived in the limited liability company’s operating agreement.  Delaware, for example, allows great latitude in permitting the parties to define the scope of implied duties in their limited liability company operating agreement; however, LLC members may not eliminate the implied contractual covenant of good faith and fair dealing.

  1. Tax Matters

A limited partnership offers pass through tax treatment, which means the income, gains, losses, deductions, and credits of the limited partnership will be passed through to the partners for reporting on their personal tax returns.

A limited liability company will be classified as a partnership for income tax purposes, unless the LLC affirmatively elects otherwise.  A limited liability company that elects to be classified as a partnership will enjoy pass through tax treatment.

Some jurisdictions impose heavy entity-level taxes on limited liability companies but not on partnerships.  It is important to review the structuring of your transaction with your tax advisor to avoid tax pitfalls.

Loan guaranty waivers cannot be used to shield a bank from misconduct

A guarantor’s general waiver of defenses cannot be used to shield a lender from the lender’s willful breach of a loan agreement.

A guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement, a California appellate court held in California Bank & Trust v. Thomas Del Ponti.  A waiver of statutory defenses is not deemed to waive all defenses, especially equitable defenses, where to enforce the guaranty would allow the lender to profit from its own wrongful conduct.

The facts of the case were straightforward.  A developer obtained a construction loan from Vineyard Bank to develop a 70-unit townhome project with guaranties from two of the principals.  The developer contracted with a general contractor to build the project in two phases.  The project was on schedule for the first 18 months.  However, when the first phase of the project was nearly complete, the bank stopped funding approved payment applications, preventing completion and sale of the first phase units.  As a result, the developer defaulted under the loan.

The bank eventually reached an agreement with the developer, requiring the general contractor to finish the first phase so the units could be sold at auction.  The bank promised to pay the subcontractors unless they discounted their bills and released any liens.  The general contractor paid the subs out of its own pocket to keep the project lien free so the auction could proceed.  Nevertheless, the bank foreclosed against the developer.  In response, the general contractor filed an unbonded stop notice.  The bank (through its assignee California Bank & Trust) sued the developer and the guarantors under various theories for the deficiency following a trustee’s sale of the property.  The general contractor sued the developer and the bank for restitution and breach of contract.

In a consolidated case, the court found that bank breached the assigned construction contract and found that the bank breached the loan agreement with the developer, exonerating the guarantors.  The bank appealed, claiming that the guarantors had waived all defenses under the guaranty agreements.

The appellate court rejected the bank’s argument.  A pre-default waiver of the Bank’s own misconduct was not expressly waived in the guaranty agreement.  California Civil Code section 2856 permits a guarantor to waive certain legal and statutory defenses.  However, that section does not permit a lender to enforce pre-default waivers beyond those specified where to do so would result in the lender’s unjust enrichment and allow the lender to profit from its own fraudulent conduct.

In all suretyship and guaranty contracts in California, the creditor owes the surety a duty of continuous good faith and fair dealing. The court reasoned that it would be a violation of public policy to enforce the guarantors’ waivers of defenses to payment of the note where the bank willfully breached the loan agreement, causing the default.

Land Use Approvals in California Can Avoid CEQA If a City Directly Adopts a Voter Land Use Initiative

A city need not conduct an analysis of the potential environmental impacts of a proposed development if it chooses to directly adopt a voter-sponsored initiative for the project.

For developers of projects that are popular but likely to be challenged by a small minority, the California Supreme Court’s decision in Tuolumne Jobs & Small Business Alliance v. Superior Court is good news.  A popular project can skip the preparation of an Environmental Impact Report (EIR) or other environmental document pursuant to the California Environmental Quality Act (CEQA).  This strategy saves time and money in two ways.  First, developers can save months – sometimes years – waiting for a city to prepare technical studies analyzing the environmental impacts of proposed projects.  These studies are almost always prepared at the developer’s expense.  Second, if there is no CEQA document, there is no CEQA litigation.  The cost and delays that result from CEQA litigation are avoided.  As a result, project opponents have one less arrow in their quiver to try to delay or kill a project by filing a CEQA lawsuit.

The facts of the case are straightforward. Walmart Stores, Inc. (Walmart) operated a store in the City of Sonora.  Walmart sought to expand the store in order to convert it into a “Supercenter,” which would sell groceries and be open 24-hours every day.  The city circulated for public comment a draft EIR for the expansion.  After a hearing, the city’s planning commission recommended to the City Council that the EIR be certified and the project approved.

Before the matter was heard by the City Council, a citizen served the city with a notice of intent to circulate an initiative petition. The “Walmart Initiative” proposed to adopt a specific plan for the contemplated expansion. The City Council postponed its vote on the EIR and project approval while the initiative petition circulated. The petition was signed by more than 20 percent of the city’s registered voters, qualifying it for the ballot.

Under California law, when a city council receives a voter initiative petition with sufficient signatures, the city is required to do one of the following: (1) immediately adopt the initiative without change; (2) immediately submit it to a special election; or (3) order the preparation of a report within 30 days, which the city council uses to decide whether to adopt the initiative or submit it to a special election. In Tuolumne, the City Council ordered that a report be prepared to examine the initiative’s consistency with previous planning commission approvals for the Walmart expansion. At its next meeting, the City Council considered the report and adopted the proposed initiative as an ordinance without further complying with CEQA.

The Tuolumne Jobs & Small Business Alliance sought a writ of mandate, claiming, among other things, that the City Council violated CEQA by adopting the ordinance without first conducting a complete environmental review.  The trial court denied the CEQA claim.  The Court of Appeals reversed, holding that when a land use ordinance is proposed in a voter initiative petition, full CEQA review is required if the city council adopts the ordinance rather than submitting it to an election.

The California Supreme Court disagreed. CEQA does not apply to a city council’s action to adopt a voter-sponsored land use initiative. The language and legislative history behind the Elections Code statutes did not support the proposition that the city was required to comply with CEQA before adopting the voter-sponsored measure.

The project opponents argued that “developers could potentially use the initiative process to evade CEQA review, and that direct adoption by a friendly city council could be pursued as a way to avoid even the need for an election.” While that may be true, the Supreme Court was not convinced: “The initiative power may be used to thwart development [too]. . . . The process itself is neutral. The possibility that interested parties may attempt to use initiatives to advance their own aims is part of the democratic process.” What’s more, California’s election laws offer another protection from overreaching by the city: the referendum power. If voters disagree with a city council’s adoption of a voter-sponsored initiative, they can file a referendum petition and a vote to block the enactment of a land use measure.

The Tuolumne case can be an effective tool when both a city council and the public support a popular development project. However, a well-thought-out legal and political strategy is crucial for success. For example, a city must still hold a public hearing before adopting the voter measure, affording the public an opportunity to be heard. How city council and the developer prepare for this hearing is important. Wise city council members will order a report to help develop a record in support of their decision and to show that they have considered countervailing arguments. In addition, environmental protections are still afforded by California’s other environmental laws and regulations. It is crucial to develop a plan for project approvals that must be obtained from other regulatory agencies that may have permitting authority over the proposed project. Indeed, CEQA compliance may still be required in order to obtain permits or approvals from state agencies or other governmental authorities. Developers do not get a “free pass.” Before using the Tuloumne strategy, developers should consult counsel to understand the legal and political risks.