Property Assessed Clean Energy
- Property assessed clean energy (PACE) programs are a way for property owners to finance energy-efficient renovations.
- Residential and commercial PACE programs have grown substantially over the past several years, though the securitization of these loans is still in the early stages.
- Looking beyond the standard lineup of asset-backed securities allows Diamond Hill to add value for our clients.
One of the unique aspects of the Diamond Hill fixed income team is our focus on securitized products including, but not limited to, residential and commercial mortgage-backed securities and asset-backed securities (ABS). According to the Securities Industry and Financial Markets Association (SIFMA), ABS is a $1.5 trillion market as of December 31, 2017, which has grown substantially since its emergence in the mid-1980s. The size of the ABS market peaked in 2007 leading up to the Financial Crisis and subsequently began a decline as issuance was greatly reduced and outstanding deals continue to pay down. Only more recently has the market begun to rebound as it expands beyond the traditional categories. One of the newer types of ABS is property assessed clean energy (PACE) bonds.
The Original PACE Program
PACE began in one of the most environmentally conscious communities in the United States: Berkeley, California. In November 2007, the Berkeley City Council took an innovative approach to assisting residents who were interested in adopting the green energy movement. Berkeley First was a new program to facilitate solar energy system installation by establishing a voluntary, long-term assessment on an individual’s property tax bill. Berkeley established the Sustainable Energy Financing District to fund the installation of solar electric systems and repay the financing through property tax bills over a preset time period of 20 years. As the innovator in this new field, the program delivered four distinct advantages to homeowners trying to reduce their reliance on fossil fuels:
- There was little upfront cost to the property owner.
- Capital costs would be repaid through a voluntary tax on the property, avoiding any impact to the property owner’s credit.
- Cost of the system would be comparable to financing through a home equity line of credit or second mortgage as the bond is secured by the home.
- Obligation for the loan transfers with the property.
While Berkeley First was restricted to solar installations and offered to a limited audience, it helped determine the viability of expanding the utilization of financing for clean energy. The program was initiated with 40 available slots for homeowners and all slots were filled within the first 15 minutes that online applications were open. Under the program, 13 projects were completed with roughly $336,000 in financing provided. This was considered a significant first step in establishing a model for clean energy financing.
How Does PACE Work?
In order to establish PACE programs, state legislation must be passed to authorize municipalities and local governments to design and develop programs to meet constituents’ needs. PACE programs are repaid and processed in the same manner as other local public benefit assessments such as sewers and sidewalks. Depending on the jurisdiction, assessments are paid either semi-annually or annually, become a portion of the property’s tax bill, and serve as a lien on the property. The payments, like taxes, are collected by the cities and counties running the PACE programs and the money is passed along to the lenders, with the local government collecting a fee. The fees collected by the local government can be substantial. As reported by the Wall Street Journal1, for the fiscal year ended June 30, 2017 the Western Riverside Council of Governments (WRCOG) in California collected $7.1 million in revenue from PACE programs. While each PACE program can be slightly different to meet the specific needs of the local population’s economic and ecological goals, there are certain aspects that are common in all PACE programs. The program and financing mechanism is strictly voluntary and can be combined with utility, local and federal incentive programs. The projects are permanent additions to the homes and transfer with the home at the time of sale.
Expansion and Government Intervention
With the success of the pilot program in Berkeley and additional success with programs in San Francisco and Boulder County, Colorado, the PACE movement was growing steadily. In 2009, the PACE program was adopted by the Obama administration, which announced new rules for PACE and also approved more than $100 million in grants to accelerate the expansion of PACE programs. In response to the White House’s action regarding PACE, Fannie Mae and Freddie Mac challenged the very concept of PACE and, in particular, the program’s ability to assume a superior lien position to the home’s actual mortgage (it is considered a tax assessment, which would be senior to all non-tax liens including mortgages). Both agencies issued new guidance that determined a PACE loan to be a violation of the property owner’s mortgage agreement, therefore creating a default event on the mortgage. They also announced that they would not purchase any mortgages on properties that had PACE loans, thus limiting the marketing and potential repackaging of mortgages on homes with PACE loans. The action from Fannie and Freddie stalled growth in the industry as local and state governments placed a hold on their PACE programs over concerns about the impact to homeowners.
With federal roadblocks limiting the expansion of residential PACE programs, commercial property assessed clean energy (C-PACE) programs began to flourish. C-PACE programs take the innovation of the PACE program and apply it to commercial, industrial, multifamily and nonprofit entities and assist in providing low-cost, long-term financing for environmentally conscious upgrades to facilities. The C-PACE industry has the ability to expand and develop without constraints placed upon it by the federal government. At the end of 2017, C-PACE programs are now operating in 20 states and an additional 13 states have active C-PACE-enabling legislation.
Despite the aforementioned efforts from the federal government to intervene in the residential PACE industry and halt its expansion, PACE programs have been approved in 34 states and Washington, D.C., and three states now offer residential PACE programs (California, Missouri and Florida). Even with a limited market, residential PACE has outgrown commercial PACE since inception, though at a similar trajectory.
CUMULATIVE PACE FINANCING (2010-2017)
Headline Headaches and Growing Pains
As with any new industry the PACE market has experienced growing pains, most of which were exacerbated by news headlines. The Wall Street Journal raised the profile of the industry as well as concerns about the business model upon which PACE is built. The aforementioned January 2017 article alleged that contractors were serving as loan brokers for PACE deals but were not properly trained to do so. Since PACE loans are based on the value of the property and not on the credit history of the borrower, individual credit ratings are of less importance compared to other segments of financing. Contractors, fueled by referral fees from lenders, began to aggressively market PACE bonds to assist in landing jobs.
As a result of some of the earlier issues that arose in the PACE industry, new disclosure laws have been put in place to align PACE loans more closely with mortgage lending terms. In 2016, Department of Energy released its Best Practice Guidelines for Residential PACE Financing Programs. The document provided best practices for:
- Eligibility measures and property-owner eligibility
- Consumer and lender protections
- Education and disclosure
- Establish maximum assessment amounts
- Documentation improvements
- Disclosure standardization
- Property appraisals (pre- and post-improvement)
- Quality assurance, data collection and evaluation
The winds of change continue to swirl around the industry. In 2016, the Department of Housing and Urban Development (HUD) declared that the Federal Housing Administration (FHA) would begin insuring mortgages that carry liens created by PACE programs. This decision was revoked at the end of 2017 by the Trump administration, citing concern around the impact of PACE liens to the Mutual Mortgage Insurance Fund as well as the lack of consumer protections.
Benefits Beyond the Financial Markets
In a paper published in March 2018 titled, “Assessing the PACE of California Residential Solar PV (Photovoltaic) Deployment,” results of a study on the impact of residential PACE programs on the deployment of solar energy systems was released. The study was funded by the U.S. Department of Energy’s Office of Energy Efficiency and Renewable Energy. This report, while not the first studying the impact of PACE on PV deployment, was the first to encompass the impact of large, statewide programs. The study covers the time period from 2010 through 2015 and examines PACE impacts from two different standpoints: large cities only and all cities in California. Some of the high-level results offer a compelling argument for expansion throughout the entire country. Specifically, in Californian cities with a population of 65,000 or more, the PACE programs are credited with a 12% increase in PV deployment. When expanded to include all Californian cities, the increase in PV deployments measures roughly 7% as a result of PACE availability. The paper also noted that during the study period, PACE programs in California funded $1.8 billion in clean energy improvements, with 37% of the investment spent on renewable energy including rooftop PV systems.
Securitization for PACE and C-PACE
Though PACE programs, both residential and commercial, have grown substantially over the past several years, the securitization of these loans is still in the early stages. Unlike most other ABS deals, the collateral associated with a PACE transaction is not a loan or lease, but a voluntary tax lien agreed upon by the residential or commercial property holder in order to finance energy efficient improvements.
The first securitization of residential PACE bonds, HERO 2014, was completed by Renovate America on behalf of WRCOG by utilizing both state and federal legal channels. Due to the ongoing legal wrangling between the FHA and the PACE industry at the time, less than 40% of the mortgages linked to the residential properties in the deal were financed by government-sponsored enterprises. This initial $104 million deal was rated AA by Kroll and delivered a coupon of 4.75% with significant excess spread, overcollateralization, and a liquidity reserve of 3.0%. The transaction was not broadly distributed but rather focused on specific investors. This initial foray into securitization was followed by the second PACE securitization seven months later, which was issued on behalf of WRCOG and the San Bernardino Associated Governments (SANBAG). According to industry group PACENation, the size of the residential PACE securitization market has grown from the first two deals in 2014 totaling over $230 million to nearly $1.5 billion just three years later.
The first securitization for C-PACE was completed in September 2017 by Greenworks Lending. This was a private deal arranged by investment management firms and, while not publicly available, illustrated the feasibility and appetite for such deals.
The Diamond Hill Fixed Income Team is able to exploit some of the pricing inefficiencies associated with the PACE securitization market by applying our bottom-up research analysis and a deep understanding of the structure of the deals and companies that bring them to market. Meeting with firms like Renovate America, Ygrene, Renew, PACE Funding and others provides insight into the issuing firm’s history, philosophy, background, and financial stability. We combine the qualitative aspects of understanding a company with the quantitative methodology of breaking down deals to their basic components to truly understand how they are structured and where risks may reside.
Capacity discipline also plays a very important role in the ongoing management of our fixed income strategies. Our smaller size allows us to take advantage of deal issues that larger firms would not consider, as the size of the deal would be a negligible addition to a very large strategy. At Diamond Hill, portfolio managers are solely responsible for determining the capacity estimates for their strategies. The key consideration in estimating a strategy’s capacity is to determine what asset size may hinder our ability to add value over a passive alternative. Portfolio managers have the authority to close their strategies before they reach an asset size where they believe that they can no longer add sufficient value.
1“America’s Fastest Growing Loan Category has Eerie Echoes of Subprime Crisis” The Wall Street Journal, January 10, 2017.
Originally published on April 27, 2018.
The views expressed are those of Diamond Hill as of April 2018 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.