Vega is delighted to sit down and discuss C-PACE with expert Dan Castro, Chairman Investment Committee at Samas Asset Management. Samas originates C-PACE loans across the country and manages funds backed by C-PACE. Dan has a deep and broad perspective on the buy-side and the sell-side of the market, having been a banker, researcher, investor, fund manager, collateral manager, chief risk officer, chief credit officer, rating agency analyst, salesman, and strategist. He is a consultant and expert witness in fixed income and structured finance and focuses on ABS, MBS, CDOs, CMBS, SIVs, hedge funds, other funds, and related products.
Vega's Director of Business Development, Alison Palo, interviews Dan to gain his insights about the C-PACE landscape, new legislation, litigation risks, and more.
To learn more about retaining Daniel Castro as an expert, please contact firstname.lastname@example.org.
Alison Palo: Hi! Thank you so much for joining us today. You have intimate knowledge about PACE, and C-PACE in particular. Can you tell us a bit about what PACE is and how it works?
Dan Castro: Sure. It started in 2008 in California. They passed something called Assembly Bill 811, which allowed for voluntary placement of assessment liens to fund private property energy improvements. In 2009, they passed Assembly Bill 474 in California, which expanded the authority to include water efficiency measure measures, and the law was called “property assessed clean energy,” which is short for PACE. PACE programs typically provide funding for private property owner for energy efficiency, water efficiency, renewable energy, earthquake retrofit, and wind hardening product projects (hurricane protection), and those are all repaid through property tax bills.
First, I’ll discuss some PACE characteristics. PACE assessments are ranked super senior to any lien, any private debt such as mortgages, and they're with what we call pari passu, which means on equal footing to property taxes. This makes them really safe because you basically pay the PACE assessment with property taxes. I call it an assessment because that’s technically what it is, but it's a loan that you pay when you pay your property tax. And because it’s rare for someone to not pay their taxes, the PACE assessment also gets paid.
Next thing, PACE is what I call agnostic to eligible technology. What that means is there are over 900,000 projects that are eligible for PACE and the property owner can use any of those things to upgrade the properties. The terms of PACE loans match the life expectancy of the renewable energy, energy efficient or water mitigation asset originated. Financing terms go from 5 to 10 to 15, 20, 25, and 30 year terms and LTV’s never go over 25%.
Regarding the value ratio, depending on the term, rates right now go from about 4.25% and go up to as high as 8%. They are all fully amortizing over the term of the assessment and that's the way all PACE loans work, although my company and others are looking at potentially doing floating rate. Right now, they're all fixed rate, but there's nothing in the regulations that says you can't do floating. And that might be a little more interesting for some folks because most of the commercial real estate and commercial ABS deals are floating rate.
In case of enforcement of security, which means default, only the amounts in arrears are due. It's not like on a typical default where the whole thing is due. If the property changes hands, the new owner just takes over the payments of the debt service. This makes them even more safe because you know, you don't have the problem of coming up with all the money. You're just continuing the PACE assessment, the loan.
Right now, there are 37 States and the District of Columbia that have passed legislation since California first passed the law over a decade ago. PACE programs overall enable local governments to finance renewable energy, energy efficient efficiency, earthquake retrofit, wind hardening (hurricane prevention), and water mitigation projects (containing and preventing water damage from floods or water leaks).
The purpose of these programs is to promote energy efficiency and renewable energy, support green job creation, stimulate economic activity, all while achieving goals for carbon reduction and climate change. PACE programs are based on legal principles with an extensive history in the United States which permit the government to facilitate public purpose out through the use of special taxing authorities. The taxing authority relies on a pillar of the municipal finance system called a “land secured financing district.” Currently in the United States, there's over 37,000 land secure districts that already exist and they're very familiar to folks in the municipal markets because that's what are used in the in those markets.
The security for the loan is a special tax or a voluntary assessment levied on each property. The assessment in any tax lien stays with the property in the event of a sale. So, if you sell the property, the assessment just moves with the property. You're not actually selling the loan, it just transfers with property. This is a critical point because this is something that a lot of people don't understand. Most lending in the United States is what we call credit lending. This is where the lender looks at the company's credit profile and their ability to repay. PACE lending and base assessments are not based on credit. They're based on the value of the property, so as long as the property value supports the assessment, and the PACE assessment is never more than 25%. This means as long as you have a viable property that you can sell, you’re good. The problem is if you miss value the property. But there's a lot of protections in place that actually prevent that from happening.
Alison Palo: Can you tell us a bit more about the underwriting criteria and collections for PACE assessments?
Dan Castro: First thing is property owners must not have a late payment on their property taxes more than once over the prior three years and you can't have any liens or other state tax liens or lender debt out there. You can't have declared bankruptcy in the last seven years.
Mortgage related debt on the property plus the principal amount of the pace loan cannot exceed 95%. Costs may not exceed 25% of the market value of the property, but most pace loans are 5 to 15 percent. It's rare that it goes all the way to 25, but if they did go to 25 that that would mean that the LTV on the property before it couldn't be higher than 70%. So, if you have a commercial property with $2,000,000 of value, the most you can do on improvements up to half a million.
Next thing, most people don't understand how PACE collections work. The county accepts the property tax bill payments via mail, over the phone, credit card, electronic funds tax should transfer, etc. The county doesn't accept partial payments and PACE assessments don't qualify for installment plans. First, installment taxes have to be paid before the county will accept the funds for the 2nd installment. So, if you're delinquent they collect immediately. The county sends the assessment funds to the Trustee or payment agent (servicer) according to the rules in each state. This is why knowing the different procedures in each state is very important.
Alison Palo: Can you tell us about the recent legislation regarding PACE?
Dan Castro: Yeah, for me there are a few key takeaways. There's something called the “solar investment tax credit.” And historically that started at 26% and over the course of three or four years it drops by a percentage point from 26 down to 22. I think it's at 23 or 22 right now, and it’s popping up to 30%. So that's a nice jump for solar, and that is very positive.
Then there's also something called the “production tax credit,” which is related to generating electricity from wind, so windmills and other wind related things and that one is getting bigger.
And there's also in the legislation of bonuses that are dependent on the area. If it's in a distressed area you get a bigger credit than in a non-distressed area. This is typically how Congress does things.
And then maybe the most important thing here is tax credits are now directly transferable. In the past, there are companies that the tax credit if, for example, they're not making profit in that year or startups don’t generate profit for awhile. But, now they're transferable. And that's really important in particular for customers who get the proceeds to offset the cost of the system, so they can monetize that if they want.
This is a game changer and our investors are very excited about this tax credit transferability because it makes it eligible for a lot more people to participate.
Alison Palo: How do investors use PACE to meet ESG investment goals?
Dan Castro: Well, different people have different views on what ESG investment goals are, but, investors look for companies or investments in any of the three forms of environment, social, and/or governance. The goal is to get a long-term returns while also helping with climate change or governments etc.
But two critical things. One is there's a lot of focus on right now on the equity side because a lot of the equity investments are mischaracterized as “ESG positive.”
However, PACE is a fixed income asset and distinct from the equity side of ESG investments. By definition, the energy efficiency, the water mitigation, the hurricane, all of that stuff is ESG eligible. And that’s my big take away from that question, that you don’t need to worry about eligibility like you do on the equity side.
Alison Palo: Over the past decade R-PACE has become subject to significant public criticism, suffered a decline in participation, and even termination of the program in some municipalities. Do C-PACE face similar challenges or how and why are they different?
Dan Castro: Well, a couple things. First, residential PACE are typically small projects on homes, not like commercial projects that can be you know millions of dollars if it's a big building, big hospital. On a home, it might be $5,000-10,000 or maybe $20,000, depending on what what's being done. So due to the small project nature of the projects, there's never been an economic review of the equipment that the property owner selected by the consumer. Next, many installers charge remarkably high rates and inflate the bills. The financing is also much higher relative to C-PACE just because the economies of scale.
For C-PACE, you are required to review the economics and the equipment is stalled on every single project. For example, we've got engineers on staff to evaluate the viability and cost. Homeowners typically don't do that analysis.
The next thing is on the residential side is that Fanny, Freddie and Ginnie Mae don't allow PACE financing. Well, they've financed most of the houses in the US, so that's a problem.
Consumer protections are part of the R-PACE ecosystems, but the consumer protections don't help with the things I just mentioned a minute ago. You know all that stuff kind of escapes the consumer protection.
Finally, the senior management originating R-PACE don’t have mortgage origination experience. They are just guys were working with contractors. You know, they're hawking solar panels and new air conditioners and solar glass, all that kind of stuff. So, they don't really understand how mortgage origination works. And that's a problem because you really should understand what the underlying security is on a home.
Alison Palo: PACE assessments have been booming. What are the challenges and risks you foresee that may give rise to litigation?
Dan Castro: Well, a few things come to mind on the litigation side. First, I mentioned that 37 states and DC that have passed PACE legislation and each of those is unique. There's a lot of similarities in the legislation across states, but there are probably about 5 to 20% of differences that can be significant. One great example is some states require that you must face the borrower as an investor while others don't. This may result in challenges in the servicing if there is an event of default. So that's one potential thing where there could be litigation.
There could be challenges by a future lender on a property around lender consent. In some states it's not required, or it's not required below a certain size. For example, if the assessment is under $1,000,000 (which is actually my target market) you didn't need to get senior lender consent. But in some states, consent is always required. This is a potential problem there if somebody wants consent or if there's a sale to another lender. One of the solutions if a lender refuses to give consent is to refinance a property with a lender that will give consent.
Finally, there's always a risk that a contractor screwed up installed equipment improperly, or it was faulty. There's always the risk of litigation there, but typically that's going to be between the contractor and the property owner, not really the PACE market per se. A possible exception is for PACE assessments in a securitization.
Alison Palo: I understand that R-PACE has few consumer protections at the federal level and inconsistent protection among states. How are C-PACE assessments regulated and are there any federal protections?
Dan Castro: There is a huge difference between the commercial market and the residential market because commercial borrowers are considered sophisticated. They have to know the financials, they have to understand how their mortgage works and all of that. That, and so that's why the C-PACE market doesn't have those protections. So that's why you don't have that level of protection.
Alison Palo: Thank you so much, Dan!
Dan Castro: Thanks, for having me.