As financing of energy-efficient projects through property assessments becomes more widespread, concerns and misconceptions regarding its use and oversight have become more common. Morningstar Credit Ratings LLC explores three misconceptions it has heard from market participants regarding the residential property assessed clean energy (PACE) sector.
Misconception #1: Not Using FICO is Worrisome
Lien-to-value ratio is the key credit-risk consideration, because PACE lending is tied to the asset and not to the creditworthiness of the property owner; thus, leverage ratios are more relevant risk indicators than borrowers’ FICO scores. An expectation to see FICO scores in residential PACE eligibility criteria may exist because of the similarities between PACE assessments and mortgage loans. Indeed, both share the same collateral, the same obligation to pay and the ultimate consequence of property loss if the contractual obligation is not met. However, a critical difference is that the obligation to pay a PACE assessment remains with the land, not the homeowner.
While FICO scores are not part of the underwriting criteria for most PACE programs, major originators collect borrower FICO data. To estimate mortgage defaults in PACE securitizations, Morningstar considers each borrower’s FICO score, mortgage balance and combined lien-to-value ratio, as mortgage defaults may disrupt payments on PACE obligations. Morningstar has not observed any major PACE originators pursuing originations to borrowers with weaker credit. Indeed, borrowers associated with GoodGreen 2016-1 Trust, rated by Morningstar in November, had a weighted average FICO score above 700. Besides, a FICO score reflects only the current homeowner’s creditworthiness, and the score may materially change when property ownership changes.
PACE assessments typically have a term of 15 to 30 years, and over that period multiple property owners may be required to make PACE payments because the PACE obligation remains outstanding until paid in full. For this reason, PACE is called an assessment or special tax rather than a loan. When analyzing PACE securitizations, Morningstar assumes each assessment will go through multiple default cycles to address the potential deterioration of a FICO score and the possible liquidity interruptions when property ownership changes. In addition, Morningstar may review historical weighted average lien-to-value ratio and the weighted average FICO score of property owners included in an originator’s PACE portfolio to identify any trends and may compare them against those of peer PACE originator portfolios.
Misconception #2: PACE Sharply Increases Risk to the Underlying Mortgage
While a PACE assessment raises a property’s lien-to-value ratio, any increased risk to the underlying mortgage is likely minimal. The PACE assessment is usually small in proportion to the mortgage, and the improvements that PACE finances often enhance the property’s value and contribute to cost savings.
While most PACE assessments enjoy priority of payment over the mortgage lender, the magnitude of any loss to the lender is likely to be limited. When a property owner defaults on a PACE payment, only the overdue amount, and not the entire balance, is due. This outstanding delinquent PACE amount has priority of payment over a mortgage loan. As noted, the remaining PACE obligation passes through to the subsequent property owner when a property is sold. In addition, if there is a mortgage on the property, the mortgage servicer is likely to advance PACE payments so the lender can control the disposition of the property to protect its interest.
Misconception #3: Industry Lacks Oversight
Government oversight of PACE programs offers various consumers protections. While private companies administer most PACE programs, local governments typically set guidelines and policies, including eligibility criteria, fee structures and interest rates. California and Florida, two of only three states that currently offer residential PACE financing, have had courts validate their programs. Morningstar believes that the PACE program’s oversight by government authorities and the evolving consumer-disclosure framework will increase transparency and consumer protection.
For example, Gov. Jerry Brown signed Assembly Bill 2693 (PACE Preservation and Consumer Protections Act) into California law. The law, effective Jan. 1, 2017, introduced more safeguards, including providing consumers with complete financing terms in advance of signing any documents, full disclosure that an owner may be required by the mortgage lender to fully pay off the PACE assessment before refinancing or selling the property, and allowing homeowners to cancel the contract within three business days of signing. Separately, the Department of Energy in November published best practice guidelines for residential PACE programs, which outline procedures for state and local governments as well as originators to follow. Likewise, the guidelines suggest a “more rigorous” approach to protect consumers, including verbal confirmation of PACE terms with property owners.
In addition, the industry has sought to enhance consumer protection. PACENation, the industry association, recommended consumer protection policies before the PACE Preservation and Consumer Protections Act became law in California. Originators have taken voluntary measures, such as requirement of consumer calls to verify their understanding of the key financing terms, to address consumer-disclosure concerns. Morningstar views government authorities and the industry working together to improve consumer protections as credit positives.