Should We Pick Up the Pace?

Michael Giberson

“PACE” stands for “Property Assessed Clean Energy.”  It is a financing tool through which cities sell bonds and then loan the proceeds to property owners to improve building energy efficiency.  The loans are repaid via a dedicated taxing mechanism.  A Milken Institute event on PACE financing described it in more detail:

In the PACE framework, cities and counties form financing districts that could issue bonds to provide financing for residential and commercial property owners to voluntarily retrofit buildings and make improvements such as installing solar, wind or geothermal energy systems.

Property owners would repay the loans over 20 years through a special property assessment, with the paper secured by a super-senior position, much like any property tax. Up-front costs for owners are dramatically reduced, which improves return on investment and the internal rate of return and doesn’t discourage them from opting in.

One bit of legal uncertainty surrounding PACE proposals is in that super-senior position.  Since the loan would become attached to a property that frequently is already mortgaged, in the case of default lenders become very concerned with who gets paid first from any proceeds from liquidation.  If PACE loans can achieve the super-senior position, then the bonds are safer investments, it lowers the city’s borrowing cost, and enhances the attractiveness of the program to property owners.  The legal question concerns whether, for already mortgaged properties, the law will allow PACE loans to jump ahead of the mortgage lender in priority.

On the finance side of things, the main issue comes in packaging bundles of small-scale, non-standardized city loan programs into something that can be sold in the municipal bond market. But there are a lot of creative financial types that are under-employed these days, so I trust “the market” will solve this particular problem.

Mitchell Schnurman’s column in the Fort Worth Star-Telegram discusses the PACE program’s California origins and growing interest among cities in Texas, he calls it a “game changer for a green economy.”

PACE financing has a couple of key principles. Most important, the improvements have to generate enough savings to cover the costs. That helps ensure that homeowners are making high-value investments.

Most programs exclude homeowners who are underwater on their mortgage. Leaders try to make sure that contractors are qualified, that the work is done correctly and that nobody is shortchanged.

There’s one more reason Texas leaders should get moving soon. To make the numbers work on energy efficiency, residents tap a slew of federal, state and local incentives.

With deficits rising, that money won’t be around forever.

I wouldn’t oppose the PACE idea on principle, though municipal management of lending programs make me a little nervous.  Lots of critics of Wall Street these days are calling for salaries and bonuses to be tied to long term performance in order to prevent short term manipulation of results.  How will municipal workers be motivated to be good loan officers?  Program management overhead should be recovered through the loan repayments, otherwise these costs become an indirect subsidy to participants.

On principle I worry about the after-the-fact revision of lender priorities.  And it seems like a misuse of the taxing authority of government to use it to support home and commercial property improvements, even though the “taxing” is limited to the properties involved in the PACE program.  Yet I’m not a specialist in these finance issues, so I am not particularly confident that my worrisome feelings properly identify substantive areas of concern.

I do object to the idea that government subsidies can “make the numbers work on energy efficiency.”  Seems to me that a proposed energy efficiency project is either a net value enhancer or a net value destroyer.  Subsidies can’t change energy efficiency facts, they only change who ends up paying for property owners to improve their property.  If it takes a subsidy to “make the numbers work,” the numbers don’t work.  But government subsidy is not inherent in the program, so this is not an “in principle” objection to PACE financing.

Much more information on PACE financing is available at PACE Now.


8 thoughts on “Should We Pick Up the Pace?

  1. I am against PACE if there are any subsidies involved. Then, PACE is only a way to accellerate handing out money for uneconomic uses.

    Motto: I would love to sell you some subsidized solar panels. How about this PACE loan to provide the financing?

    Assume no subsidies and a significant, real, financial return on energy saving technology. Then PACE is not needed. Capital will flow freely to support those savings within sound businesses.

  2. OMG! This is a disaster in the making. How can people who are underwater on their mortgages, unemployed, and can’t pay their real estate taxes, borrow more money? In California?

    The country is drowning in debt and these people think it would be a good idea to spend more. Lord have mercy.

    And no they cannot prime an existing first mortgage lien without the consent of the lender, even if will save the planet.

    What are these people smoking, and how can I get some?

  3. Andrew: PACE doesn’t require subsidy, although some counties are planning to use federal ARRA $ to buy down rates. But it works without subsidy. In fact, it could be a revenue generator for fiscally strapped cities.

    Your theory is great on paper, but I’ve seen several examples firsthand where capital did not flow freely to cost effective energy efficiency projects (IRR>40%).

    Why?
    1) No investment-grade credit rating as real estate is owned by special purpose LLC
    2) Lack of assets to use as collateral for a loan that don’t already fall under first mortgage–this is probably the most important barrier
    3) Limited # of lenders experienced in financing energy efficiency projects
    4) Limits/bans on adding debt that doesn’t support top line (revenue) growth due to balance sheet concerns
    5) Tenants pay energy bill, but owner can’t pass thru capex/finance payments
    6) Uncertain holding period for owner/tenant–we might not be here 2 years from now
    7) Aversion to using financing with rates that exceed internal cost of capital

    The PACE financing model is exciting because it addresses all of these barriers.

    Mike-you give a good summary of just one flavor of PACE: the pooled municipal bond model. But I recommend you broaden your definition of PACE and check out the program Los Angeles is planning. I think you’ll actually like it a lot more.

    Rather than issue bonds, the Community Redevelopment Agency of Los Angeles (CRA/LA) proposes to develop an “owner-arranged” tax lien financing model for retrofits of commercial properties, through which individual property owners can negotiate financing from commercial lenders on terms, scale and schedule that best suits the project, and secure repayment through a contractual assessment that sits in first position on the building’s property tax bill.

    They have 24 commercial lenders signed up to provide capital and due the lending due diligence…letting private sector take on that role (addressing your concern)

    and by the way, under the pooled municipal bond model, much of the lending management will actually be done by for-profit outsourcing companies that are forming to administer PACE programs.

    Finally, while the super-senior lien position legal issue appears like it could be a major barrier, many first mortgagees actually realize that it is in their best interest to provide voluntary consent (most programs will require mortgagee consent), because owners are left cash flow positive and better able to service their other liabilities and because these projects can significantly increase the value/marketability of the property under mortgage (green certifications, etc).

  4. Derek,
    You think the proper role of government is to be a big bank, backed by the full faith and credit of the taxpayers.

    How are Fannie Mae and Freddie Mac working out? They are just the most recent examples of failed government sponsored banks. Why should I expect every municipality to be better?

    The tax effects on municipal bonds are already a subsidy to the financing.

  5. Derek. Let me try again.

    The country is broke. California is broke. LA is broke. The people who live in LA are broke. They do not have jobs. Their houses are worth less than the amount they owe. They are not credit worthy. LA is not credit worthy. California is not credit worthy.

    When you are broke, you need to cut your spending, pay off your debts, and not borrow more money. Ideas for borrowing money are harmful to people who are broke.

    See small words. I hope that sinks in.

  6. There’s a similar program that’s been operating for about a year in Boulder, and all Colorado counties have the authority to start such programs. There’s currently a bill in the CO legislature to allow multi-county PACE programs.

    As to the concerns that PACE loans might be senior, I don’t see this as problematic to suddenly junior lenders so long as the income (or reduced expenses) from the energy improvement exceeds the payments on the PACE loan. The increased income would then make the mortgage loans safer, by increasing the borrower’s ability to pay.

    (The Boulder program requires an energy audit and improvements be included before financing solar, and since the returns from EE tend to be high, we can expect that nearly all of these loans are cash-flow positive.)

  7. Tom,

    That’s fine as long as the homeowners continue to have the ability to make their mortgage payments timely. However, should their household income decline significantly, the mortgage holder is definitely disadvantaged by the junior position.

  8. But it important to point out that only the delinquent unpaid tax assessment for that year is senior to the existing mortgage, not the entire project cost financed. That combined with the maximum lien to value ratio that most programs are setting means that the value of the PACE special assessment that is senior to the existing mortgage is likely to be <1% of the value of the property.

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