Programs and Information

Feb­ru­ary 2010

PACE Pro­grams: His­tor­i­cal Prece­dent, Senior­ity and Ben­e­fits to Exist­ing Lenders

Pol­i­cy­mak­ers have looked at many options to help prop­erty own­ers pay for energy improve­ments in a man­ner that would elim­i­nate bur­den­some upfront costs and allow the financ­ing agree­ment to trans­fer with the prop­erty. One pro­gram that is rapidly gain­ing inter­est is the so-called “Prop­erty Assessed Clean Energy” (PACE) pro­gram. Both Con­gress and The White House have shown tremen­dous sup­port for the PACE model. This memo is intended to describe how PACE pro­grams ben­e­fit exist­ing mort­gage lenders and to address the valid­ity of senior liens asso­ci­ated with PACE finance. The major points are as follows:

1. PACE is a form of land secured financ­ing dis­tricts which are included in state law and have a long estab­lished and accepted his­tory.
2. The senior­ity of PACE liens is sup­ported by their sta­tus as “assess­ments” and the right
of state gov­ern­ments to advance as a valid pub­lic pur­pose.
3. If PACE liens are struc­tured as sub­or­di­nate, then PACE pro­grams would be unduly
bur­den­some to admin­is­ter and poten­tially pro­hib­i­tively costly. See Bar­clays Memo
4. PACE pro­grams pose sig­nif­i­cantly less risk to lenders and prop­erty own­ers than vir­tu­ally
any other tax or assess­ment dis­trict.
5. The value of prop­er­ties with PACE liens should increase due to the reduc­tion in the
prop­er­ties’ energy costs and the pos­i­tive net present value of the projects.
6. The Fed­eral Pol­icy Frame­work regard­ing PACE out­lines numer­ous under­writ­ing
stan­dards to fur­ther reduce the risk of default.
7. PACE lien senior­ity in fore­clo­sure is imma­te­r­ial: On a port­fo­lio of homes, each with a
$250,000 mort­gage, the PACE lien senior­ity in a fore­clo­sure sit­u­a­tion prob­a­bly amounts
to less than $100 per home and is more than off­set by the increased prop­erty value.

Land Secured Financ­ing Dis­tricts
For the most part, PACE pro­grams are sim­ply addi­tions to exist­ing state laws that already autho­rize the cre­ation of “land secured” financ­ing dis­tricts to pay for improve­ments in the pub­lic
inter­est, whether pub­licly or pri­vately owned.

Land secured financ­ing dis­tricts – which are crea­tures of state law and are var­i­ously referred to as assess­ment dis­tricts, pub­lic improve­ment dis­tricts and com­mu­nity facil­i­ties dis­tricts, among other terms – are a build­ing block of munic­i­pal finance and have been uti­lized for more than a cen­tury. They are used to finance projects which serve a pub­lic pur­pose, includ­ing street paving, parks, open space, water and sewer sys­tems and street light­ing, among others.

All land secured financ­ing dis­tricts oper­ate by plac­ing a senior tax/assessment lien on prop­er­ties which will receive a ben­e­fit from the financed improve­ment. The lien secures a tax/assessment pay­ment that is levied on prop­er­ties through the prop­erty tax bill. Tens of thou­sands of these dis­tricts already exist in this coun­try and are a stan­dard part of the prop­erty appraisal, under­writ­ing and dis­clo­sure processes.

Valid­ity of the Senior Lien
In most states, a gov­ern­ment can place a tax or assess­ment lien to advance a valid gov­ern­men­tal pur­pose. This is not a new power, nor one that is used infre­quently. Unless the pur­pose is deemed invalid or the law uncon­sti­tu­tional, there is no jus­ti­fi­able rea­son for
gov­ern­ment to be pro­hib­ited from exer­cis­ing this power.

Not only is the right of munic­i­pal­i­ties to place a senior lien to sup­port a pub­lic pur­pose sup­ported by decades of prece­dent, it is crit­i­cal to the suc­cess of PACE financ­ing. Given Stan­dard and Poor’s pub­lished cri­te­ria for bond rat­ings backed by spe­cial tax assess­ments, it is likely that a sub­or­di­nate PACE Assess­ment Bond will be rated below invest­ment grade yield­ing unman­age­ably high inter­est rates.
Fur­ther­more, there is no prac­ti­cal or cost effec­tive man­ner for County tax col­lec­tors, admin­is­tra­tors, fis­cal agents, or bond trustees to man­age a sub­or­di­nate PACE lien and cre­at­ing a new set of pro­ce­dures would be pro­hib­i­tively expensive.

Mar­ket Ram­i­fi­ca­tions
The mar­ket effects of PACE dis­tricts are no greater than those of tra­di­tional assess­ment dis­tricts, which have been imple­mented across the U.S. for decades. In fact, PACE pro­grams
pose sig­nif­i­cantly less risk to lenders and prop­erty own­ers than vir­tu­ally any other tax or assess­ment district.

1. PACE lien senior­ity in fore­clo­sure is imma­te­r­ial and is more than off­set by the increased prop­erty value: On a port­fo­lio of homes, each with $250,000 mort­gages, the PACE lien senior­ity in a fore­clo­sure sit­u­a­tion prob­a­bly amounts to well under $100 per home.
Alter­na­tively, on a $10 mil­lion com­mer­cial build­ing, PACE lien senior­ity in a fore­clo­sure prob­a­bly amounts to less than .5% of the property’s value.

• Note: In a fore­clo­sure, most state laws pro­vide that only the back tax lien pay­ment is sat­is­fied before the mort­gage note. The rest of the bal­ance is rein­sti­tuted post bankruptcy.

• Res­i­den­tial exam­ple: Assume you have a $300,000 home, $250,000 mort­gage and $20,000 (6% inter­est rate) 20 year PACE loan that is paid off $1,700 per year for 20 years. If the house is fore­closed on with 1 year of PACE pay­ments in arrears, then the 1
year of back pay­ment — or $1,700 – is paid ahead of the mort­gage, not the full $20,000.
So in this exam­ple, the mort­gage has $1,700 paid ahead of it (less than 1% of the value of the mort­gage). Far fewer than 10% of homes will result in fore­clo­sure (10% is where the sub­prime cri­sis peaked). For con­ser­vatism, assume 10% of all PACE homes in the
above sce­nario result in fore­clo­sure. This sug­gests that with a “port­fo­lio” of Fannie/Freddie mort­gages that have PACE liens, the impact is 10% x $1,700 or $170
(yes, one hun­dred and sev­enty dol­lars per home on aver­age). Real­is­ti­cally, prob­a­bly less than 5% of homes would result in fore­clo­sure, which results in an aver­age $85 of
senior­ity in fore­clo­sure on the hypo­thet­i­cal port­fo­lio of Fannie/Freddie mortgages.

• Com­mer­cial exam­ple: Assume you have a com­mer­cial build­ing worth $10 mil­lion and
that it has a mort­gage of $8 mil­lion and does a $500,000 PACE retro­fit (5% of the value of the build­ing as com­mer­cial retro­fits tend to be much smaller per­cent­ages of over­all build­ing value – 5% is con­ser­v­a­tive). Assume the PACE project is financed with a 6%, 20 year loan such that there are annual pay­ments of about $43,000. If the build­ing is fore­closed on after a year and there is a PACE pay­ment in arrears then this amount, $43,000, is paid ahead of the mort­gage. This rep­re­sents about .5% of the value of the
mortgage.

• Increased prop­erty value: Note that the fore­go­ing cal­cu­la­tions assume no increased value to the prop­erty result­ing from the PACE dol­lars that were spent. The PACE dol­lars spent add value and in the above exam­ples the retro­fit improve­ment dol­lars spent exceed the PACE senior­ity pay­ments by more than one thou­sand per­cent, or 10 fold.
So not only are the PACE senior­ity pay­ments imma­te­r­ial but they are more than off­set by the much larger monies spent on improvements.

• White House frame­work: The Fed­eral Pol­icy Frame­work also sup­ports the estab­lish­ment of pro­gram “Assess­ment Reserve Funds” which will pro­tect the bond­holder from late pay­ment of the assess­ment. Appro­pri­ately sized reserve funds will
pro­vide an addi­tional layer of pro­tec­tion to exist­ing mort­gage holders.

2. GSEs and lenders have been pur­chas­ing homes which hold assess­ment liens for decades: PACE pro­gram liens, if prop­erly exe­cuted, could at a min­i­mum be viewed sim­i­larly to
all other assess­ment, spe­cial tax or other land secured liens rather than as a new prod­uct that changes the fun­da­men­tal rela­tion­ship to the lender.
• One of the largest title insur­ance com­pa­nies in the coun­try issued writ­ten for­mal guid­ance regard­ing “Clean Energy Assess­ment Dis­tricts.” After their inter­nal review,
they con­cluded that “as a title insurer, we would treat the spe­cial assess­ment in a clean
energy assess­ment dis­trict the same way we treat real prop­erty taxes.”
• Prop­er­ties with PACE assess­ments rep­re­sent less risk to lenders since par­tic­i­pa­tion is vol­un­tary and financed improve­ments gen­er­ate sav­ings and increase prop­erty value.

3. PACE increases the value of prop­er­ties: Prop­erty value increases due to the reduc­tion in the prop­er­ties’ energy costs and the pos­i­tive net present value of the projects.
• PACE pro­grams increase a home’s value. A study in Appraisal Jour­nal found that for every utility-bill dol­lar saved annu­ally, due to an improve­ment, a prop­erty owner will gain $20 in prop­erty value. So reduc­ing a util­ity bill by $1,000 will return $20,000 in home
value.6, 7
• The White House Pol­icy Frame­work for PACE Financ­ing Pro­grams (Fed­eral Pol­icy Frame­work) estab­lishes pos­i­tive net present value criterion.7 By def­i­n­i­tion, improve­ments with a pos­i­tive net present value will increase the under­ly­ing value of the home prior to
the improve­ments, mean­ing that the under­ly­ing lender should receive more in fore­clo­sure than would be the case absent the improvements.

4. PACE pro­grams will decrease the risk of default: Improve­ments financed by PACE should have a Sav­ings vs. Invest­ment ratio > one. The fact that energy sav­ings will in most
cases exceed the financed cost of the improve­ments will improve the borrower’s abil­ity to pay,
help­ing to decrease bor­rower defaults and there­fore reduce lender losses.
• The length of the assess­ment may not exceed the use­ful life of financed improve­ments.
• The max­i­mum ratio of the lien to the prop­erty value should be lim­ited, gen­er­ally not exceed­ing 10% of the property’s mar­ket value.
• All own­ers of the prop­erty must approve the assess­ment, and the title should be free of ease­ments or sub­or­di­na­tion agree­ments that con­flict with the assess­ment.
• In order to be eli­gi­ble, prop­er­ties must be cur­rent on prop­erty taxes, have no out­stand­ing liens, have no notices of default for a spec­i­fied period, and be cur­rent on all mort­gage debt.
• The prop­erty owner can­not have neg­a­tive equity in the home.

Sources:

1. U.S. DOE, Press Release, Vice Pres­i­dent Biden Unveils Report Focused on Expand­ing Green Jobs And Energy Sav­ings For Mid­dle Class Fam­i­lies, Oct. 19, 2009,
http://www.energy.gov/news2009/8148.htm (last vis­ited Dec. 22, 2009); PACENOW. “PACE RETROFIT FINANCE WILL BE KEY COMPONENT OF OUR NATION’S “RECOVERY THROUGH
RETROFIT” Pro­gram.” Online video clip, http://www.youtube.com/watch?v=2HpwQff2tIA (last vis­ited Feb. 4, 2010).
2. See Let­ter from U.S. Sen­ate et. al., to Pres­i­dent Barack Obama avail­able at http://pacenow.org/documents/Letter%20to%20President%20Obama%20re%20PACE,%2011.10.
09.pdf (Nov. 10, 2009)
3. See N.Y. Con­gress­man Steve Israel, Roll Call: PACE Bonds Pro­mote Effi­ciency, Oct. 19, 2009,

http://www.rollcall.com/features/Policy-Briefing_Energy-2009/energy_environment/39556–1.html

(last vis­ited Dec. 22, 2009).
4. See, e.g., Daggett v. Col­gan, 92 Cal. 53 (1891); Bank v. Bell, 62 Cal. App. 320 (1932).
5. See Let­ter from Bar­clays Cap­i­tal, to PACE Work­ing Group, PACE: Prop­erty Assessed Clean
Energy Financ­ing – Cap­i­tal Mar­kets Financ­ing Issues Paper, (May 15, 2009), avail­able at http://pacenow.org/documents/5a.%20Barclays%20Memo.pdf (last vis­ited Feb. 4, 2010).
6. See Nevin, Rick and Gre­gory Wat­son, Evi­dence of Ratio­nal Mar­ket Val­u­a­tions for Home Energy Effi­ciency, Appraisal Jour­nal (1998),
http://pacenow.org/documents/EnergyEfficiency(2)_appraisal%20J.PDF (last vis­ited Feb. 4, 2010).
7. See Ken­neth R. Har­ney, Investor Report: Energy Effi­ciency, Realty Times (July 10, 2009),
http://realtytimes.com/rtpages/20090710_investorreport.htm (last vis­ited Dec. 22, 2009).