PACE bonds seeing more regulation, securitization in the market

The largely unregulated state-based residential Property Assessed Clean Energy (PACE) bond programs are headed for increased regulation and standardization that will likely boost their popularity among investors, according to market participants.

 

PACE bonds are taxable munis issued by local governmental entities that finance energy improvement upgrades to residential homeowners or commercial property owners.

 

The bonds, often unrated, are structured as limited-obligation special assessment bonds, backed by the special assessment payments and carry a tax lien that’s senior to all other liens, including mortgages.

 

Governments issue PACE bonds to directly finance projects or to lend bond proceeds to a third-party lender, who then finances the loans.

 

Historically PACE bonds have been largely unregulated, and loans have been based on the value of the property rather than the creditworthiness of the property or homeowner, said John Caleb Bell, a partner at Ohio-based Bricker & Eckler.

 

California, one of the largest PACE-bond issuing states, in 2018 passed laws tightening lending standards, linking a loan to a homeowner’s income, Bell said.

 

“California started with no consumer protections, then loan-to-value protections were put into place, and now you’re seeing those protections broaden into the actual ability of the homeowner to repay the loan,” Bell said. “That’s probably where we will land nationally on residential PACE,” he said. “By doing that, you’re creating a much more solid product.”

 

California’s tightened lending standards has sparked a steep drop in residential PACE bond volume, said Casey Dailey of the Western Riverside Council of Governments (WRCOG), which is the top issuer of residential PACE bonds in the state. WRCOG goes to market almost every week with residential PACE bonds, Dailey said.

 

Residential PACE bond volume at WRCOG fell by 70% from FY18 through FY19, Dailey said. The council closed 25,000 assessment deals in FY18 and is on track to close about 4,000 by next week’s end of FY19, Dailey said.

 

“Now there’s even more restricting controls from the underwriting standpoint due to the legislation, which WRCOG is supportive of,” Dailey said. “But there’s other factors as well,” for the drop, he said, citing more accessible capital for home improvements and increased competition from more PACE lenders.

 

Securitizations, which are increasingly common and don’t carry risk back to a government, are helping to standardize the PACE programs, Bell and Dailey said.

 

WRCOG’s residential PACE loans that are securitized for example, are all structured the same, carry the same standards under California law, and may even carry the same maturity.

 

“One of the nice things about securitization is the need for standardization of the underlying assets, which is fundamentally a good thing,” Bell said.

 

California is unique in that it has one of the most developed residential PACE programs, and because the state treasurer has set up a USD 10m reserve fund that acts as a backstop if homeowners are unable to pay. That fund has remained untapped, Dailey said.

 

On the commercial side, so-called C-PACE financing is growing fast, with securitizations becoming more common, Bell said. State-specific securitized C-PACE deals may come into existence if a state has enough deals, he added.

 

Most underwriting standards on the commercial side restrict PACE loans to no more than 20% of a building’s value. That coverage level, plus the senior lien on the loan, makes haircuts rare in case of a default, Bell said.

 

“You’d have to have 80% of the value evaporate to have a PACE lender take a haircut, so that’s why this asset class is developing,” Bell said. “Commercial PACE is increasing exponentially to a point where it’s becoming its own unique asset class.”

 

by Caitlin Devitt