Property Assessed Clean Energy (PACE) Financing: Savior or Scam?
Right now, in the chambers of the Massachusetts State Congress, is a debate about a comprehensive energy bill that covers an array of energy topics. This bill went back and forth between the House and Senate, varying slightly. One key difference is the Senate’s removal of a major energy efficiency financing program called Property Assessed Clean Energy (PACE) financing. So you may be asking… what’s the Senate’s beef with PACE?
Well, it’s best to begin with describing what this PACE thing is. PACE financing is a method for financing clean energy investments that require a large amount of initial capital but pay for themselves over time. The financing is essentially provided by a municipality to the property owner; then paid back by the owner through an additional “assessment” to the property (i.e. an extra property tax) levied by the municipality, usually over 20 years. PACE financing comes in two forms, residential (R-PACE) for homeowners and commercial (C-PACE) for businesses.
The key difference with PACE is that the assessment stays with the property, not the owner. Therefore, if the property is sold, the tax assessment is sold with it. This important attribute allows for owners to invest in clean energy projects without having to stay with the property until the project pays itself back. They get "return" immediately.
Another very important piece of PACE is that the tax assessment is a senior lien on the property. Therefore, if the house is foreclosed on, the lien (the money for the project) is paid off before the mortgage. Essentially, the city gets their money back before the mortgage lender does (even if the mortgage lender loaned money first).
So that’s the gist. Next question: Why isn’t PACE a thing?
Turns out, it kind of is. The first statewide PACE legislation passed in California in 2008, with 31 states and Washington D.C. following suit since then. Hundreds of millions of dollars have been invested with both residential and commercial PACE financing. So if PACE programs are so popular, rely on a stable financing structure, and remove key barriers to energy investments, why is MA so resistant to the program?
The Rocky Road of R-PACE:
PACE isn’t always rainbows and butterflies. Let’s start with R-PACE programs, which were essentially dead as of 2010. That’s because the government’s housing financing agencies (Fannie Mae, Freddie Mac, and Federal Housing Administration) stated they would not insure or buy mortgages with PACE liens on them. They basically said that if a house is foreclosed on, they don’t want to be second in line to get money back.
In August of last year, the Federal Housing Administration (FHA) cleared things up a bit. They stated that PACE financing liens must be subordinate in order to receive FHA financing (aka FHA gets money back first in case of foreclosure). So the FHA is willing to insure mortgages with PACE loans attached only if the original mortgage lender is the senior debt holder.
However, if the lien is made second to the mortgage, the municipalities have a tougher time establishing PACE programs. The capital markets (the original lender for PACE) will not lend money at such a low rate to the municipalities. This is because the loan is not as safe, because the mortgage lender will get their money first, not the municipality. Because of this, the bonds will be less attractive and borrowing costs will increase, decreasing the feasibility of many projects and making R-PACE less attractive.
Ad from Southern California contractor. I don’t know about you, but it rings of subprime lending practices to me.
Further, there are issues of consumer protection and predatory lending. For example, there are numerous cases across California where homeowners cannot sell or refinance their property until they fully pay off the PACE loan, because mortgage lenders don’t want to provide financing for the new buyer with a lien on the property. In many cases, the homeowner did not know or understand that this could happen. There have also been cases of contractors going door-to-door to try and get people to sign up for these loans when the homeowner doesn’t fully understand the conditions. There are not extensive consumer protection measures in place for PACE like there are for traditional home loans.
Bottom Line of R-PACE:
As things stand now, mortgage lenders are combating R-PACE financing because they will not accept being second in line to receive money in case of foreclosure. On the other hand, capital investors will only provide affordable financing to municipalities if the PACE loans are senior liens (they get money first). R-PACE is complicated with too much ambiguity to be a promising and safe source of energy efficiency financing.
C-PACE: The Hillary Clinton of PACE financing
C-PACE is less risky, unclear, and unpredictable than R-PACE, but it’s still far from perfect. C-PACE financing has an estimated $250 million in projects, and is the type currently being considered in the MA state government. Commercial programs are considered less risky for a few reasons.
First, commercial borrowers are generally more reliable than residential and receive income from a wider array of sources. Further, additional liens on a commercial property usually require notification of the other creditors on the property, which is not the case with residential properties. This provides someone like a mortgage lender the opportunity to object to the PACE lien being added to the property.
However, C-PACE could still be somewhat dangerous because large commercial entities do not have some of the protections that homeowners and small businesses do. For example, when homeowners and small businesses attempt to get a PACE loan, they will often get a warning letter from the FHA or the small business association that describes what a PACE loan entails. Larger commercial entities do not get this level of protection so they could be more vulnerable to risky and unsubstantiated investments.
So PACE isn’t perfect, but better than nothing right?
PACE financing continues to spread across the country, touted as the way to facilitate energy efficiency financing. However, there are practical as well as philosophical qualms with PACE that should be considered.
Is this what you want? What you really, really want?
Primarily, there are problems with the validity of municipalities essentially subsidizing this program. The financing mechanism of PACE, which is a system of bonds being issued by a municipality in order to fund projects that are good for the community, is not new. This is a way projects such as new sidewalks, sewer lines, street lights, etc. have been funded for decades. However, those projects benefit the community directly, not an individual property owner on their private property.
Are energy efficiency investments really clearly benefiting the community? They lower emissions and therefore benefit humanity as a whole, of course, but should Boston’s citizens subsidize a gain on private property that often pays for itself anyway? Plus, why should bonds be issued for these projects when they could be issued for infrastructure improvements, firehouses, police stations, etc. that clearly and directly benefit tax payers?
In addition, the active role of government in this space should not be encouraged. If the market is demanding financing for energy efficiency investment, which is what PACE supporters suggest, then the market will provide investors. The private lending industry in the U.S. is very capable of covering this space, without putting municipalities’ credit at risk. PACE financing essentially allows the private sector to make money off the financing, manufacturing, installation, and operation of these investments without forcing them to be held accountable, because the municipality is the one who is ultimately responsible.
If there is money to be made in financing energy efficiency, the private markets will figure out how to do it. It’s their job, and they’re good at it.
Clearly, things aren’t clear.
Another potential issue, and one I believe could be huge if PACE loans increase, is the ability of the lending system (banks, municipalities, underwriters, etc.) to effectively rate the value of the projects. The projects are rated based upon the loan to value ratio of the property and the ability of the specific project to pay for itself (the credit of the borrower is NOT required).
The potential hiccup of this rating is that energy efficiency gains are notoriously hard to accurately model, and are often lower than expected. In addition, energy prices are more complicated, unstable, and unpredictable compared to something like home prices. Further, since a contractor gets paid for the work and is not often tied to performance afterward, there is significant potential for malpractice in this regard, leading to underperformance of the improvements. Finally, there is no industry wide standard for underwriting these loans, as each state and municipality has different legislation, which will lead to unpredictability and uncertainty.
I have an idea, let’s make it worse!
To make matters more interesting (read: scary), not only are the loans potentially poorly and unevenly rated, PACE loans are becoming pooled and sold in secondary markets. In fact, over $1 billion worth of PACE loans have already been securitized and sold as bonds. In other words, loans without clear underwriting standards, predictable payback, and in some cases collateral (if mortgage lender has senior lien status), are being pooled, rated, and sold to financial markets.
Investors will have no real way of knowing how good these investments are. The differences in legislation and standards across states alone will lead to a pool of loans with large disparities in the value of assets. Further, there is no publicly available data that indicates the performance of energy efficiency loans; therefore the loans cannot be accurately rated by rating agencies (S&P, Moody’s, etc.). How are the secondary markets going to rate these bonds?
Time to pace ourselves?
PACE financing is a neat idea, but ultimately relies on a process without clear standards or established practices while potentially forcing municipal governments to foot the bill. The pooling of loans makes the risk systemic across financial markets, without established transparency guidelines. It’s time to slow down on PACE and let other market players fill this gap.
As the energy efficiency market matures, the private markets will develop clear standards for these projects, while protecting the players involved and increasing efficiency in buildings. They can do this without reliance on PACE.
Some further reading....
- Overview of the PACE program from Dept. of Energy:
- Article describing MA energy bill. At the bottom, it highlights lack of PACE in Senate Version:
- Article talks about PACE Securities and program success overall (May 31st, 2016):
- Securitization of $123 million in PACE loans, article from June 2016
- California Realtors talking about problems with PACE in March 2016:
- Federal Housing finance Agency saying it can't support PACE, bad for market, article from last month:
- California Representative Matt Dababneh (D-Van Nuys) discussing the program in a June 2016 op-ed