News headlines are, by design, often arresting and sometimes alarmist, and one might be forgiven for reading the news with a wary (or weary) eye. So when, in the January 11th Wall Street Journal, a headline blared about a new kind of loan which cautioned of "the next subprime" crisis waiting to happen, we at Heron were initially skeptical.
The WSJ highlighted a financing structure that looks pretty appealing at first glance. The structure relies on partnerships between local municipalities, a private administrative agent, and local contractors who help homeowners and commercial landlords invest in energy retrofits for their properties by covering upfront financing, equipment and installation costs (typically through a bond issue to third party investors). Property owners repay this advance through an increase in property taxes for a fixed period of time—thus the name, Property Assessed Clean Energy or "PACE" financing.
PACE financing has caught the green bond wave and is growing rapidly, with cumulative financing approaching $4b at the end of 2016. At present, 19 states plus the District of Columbia have active PACE programs enabled by legislation, although California, as the early adopter, is far and away the most active.
Upon examination of our portfolio, we discovered that Heron was one of many investors with exposure to PACE bonds through one of our bond managers. Our bond manager provided a thorough fundamental analysis of the product and assurance that our interests, as an investor, were professionally evaluated.
However, the WSJ’s presentation of the residential homeowner’s perspective still had us concerned. Our team embarked upon a journey of inquiry beyond the immediate financial risk and return profile of the position into the net effect, across all stakeholders, of this emerging financing program. How would this affect the ability of people and communities to help themselves (or keep themselves) out of poverty? How should we think about the net benefits or detriments of the investment to people, place, and planet, and the tradeoffs between different stakeholders?
After a series of discussions and some amateur sleuthing, it was evident why PACE bonds appear especially attractive to environmentally conscious investors. According to the EPA, roughly 40% of the greenhouse gas emissions in the U.S. comes from electricity production (broadly) and the heating & waste management systems of commercial and residential properties. Experts suggest that retrofitting existing buildings is key to addressing climate change. PACE provides estimates of annual energy savings, water savings, and greenhouse gas emission reductions to gauge impact of the projects it funds.
Financially, the bonds receive a comparable yield to mortgages while occupying a senior lien on the underlying properties, which makes them attractive to investors who want a good return with low risk.
And on the surface, PACE loans make for an attractive option for homeowners as well: They are quick and relatively easy to obtain, while the expected energy savings and potential increase in the value of the home after the renovation are estimated to cover the cost of the increased tax bill. Lastly, the timing can be appealing: Since contractors such as plumbers and repairmen are the approved marketers, they can offer the loans to homeowners “in their time of need”—such as in that moment when the old pipes have burst and need replacing anyway.
A homeowner who is a sophisticated real estate investor, money manager, and mathematician might sit down to compare the implied interest rate of the increased tax bill to credit card debt (PACE would be better) or to a Home Equity Line of Credit from the bank (the HELOC would win). They might be able to think through whether the increased value of the home would be offset by the unwillingness of the buyer to pay a premium for a property with a tax lien. They might do an energy audit to be certain that the energy savings cover the price of the loan. And they might be disciplined enough to set aside the amount of the estimated savings for six months until the tax bill is due.
But what about the average homeowner who actually applies for these loans? The current sales practices bypass traditional underwriting procedures such as calculating debt-to-income assessments and similar ability-to-pay ratios. Skipping these investigations can lead to a big jump in the cost of homeownership—and potentially to the loss of the home. Those are the same kinds of protections that could have prevented the subprime mortgage crisis and which have been subsequently mandated for mortgage lenders by federal regulations.
That brings us back to our alarming WSJ headline. In this story, however, the mortgage lenders—formerly the 2008 villains—may join some homeowners as victims instead (along with the investors that buy their pools of mortgages). Why? Because the PACE tax liens take seniority over the residential mortgage. This is valuable for those who invest in pools of PACE loans, who will get paid back first, but bad for the mortgage lender who has very little transparency into how the value of their investment might be compromised by this additional debt burden on the homeowner.
Lastly, PACE can lead to awkwardness for the municipality that is partnering with the loan issuer: In the event a homeowner can’t repay, it’s going to be hard to win the trust and votes of folks after you’ve foreclosed on their friends and neighbors.
So the question remained: What should Heron do next? Do we divest entirely? Do we try to put certain parameters around which PACE loans are acceptable investments for our portfolio? Do we try to work within the system to change how PACE financing works?
We are starting by divesting from our residential PACE investments, but the journey does not end here. In the course of our investigation, we learned that the protections built into commercial PACE loans lead to a significant difference in how the benefits and risks are distributed. Commercial transactions appear to have generally positive results for everyone involved, while residential transactions expose the homeowners and their mortgage lenders to disproportionate risk.
So how do we build in better protection for consumers and mortgage holders? One place to start is with the Department of Energy’s Best Practice Guidelines for Residential PACE Financing Programs [PDF]. The guidelines explicitly call out best practices for PACE by “encouraging” energy assessments, “recommending” that the lender reviews the homeowner’s income, and “suggesting” that mortgage holders are notified of any tax lien placed on the home that is senior to the first mortgage.
One easy step would be to mandate such best practices, rather than “encourage” them. PACENation, an industry association, followed suit recently with its own consumer protection recommendations for residential programs. These are a step in the right direction, yet lack the enforcement teeth that a regulatory agency or government oversight would bring.
As impact investors, this has underscored the importance of not wearing impact-blinders, but looking at the total contribution or risk of our investments. Divesting from coal without investing in Appalachia can decimate communities; investing in job growth stories without looking at product lines can bring private prisons into your portfolio, and so on. As we’ve now learned, in the case of PACE, investing for the environment and jobs without taking the whole picture into account can mean putting homeowners at risk. No one can serve ALL missions, but we can all serve our missions while still being conscious of our effects on other stakeholders—and it's important that we do so.
Editor’s Note: On the day of publication for the above post, the Wall Street Journal published a second article, headlined “Renovate America Masked Borrower Debt Woes” (also by Kirsten Grind), which appears to confirm our concerns about the effects on homeowners. Referring specifically to the PACE bond issuer in which Heron was (until recently) invested, the article states: “The San Diego-based company enjoys the backing of municipalities and big-name Wall Street investors, thanks in part to its record of ultralow customer defaults. But Renovate America… has masked problems with some borrowers by paying off their debts if they struggle to keep up with payments, according to former Renovate America employees.”
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