There is a Stranger in My House is a country music classic sung by Ronnie Milsap and released April 2, 1983. The Song was written by Mike Reid. Ronnie received a Grammy Award for Best Male Country Vocal Performance. The song lyrics tells of a man who suspects that his wife is fantasizing about being with her secret lover. Sometimes a mind-numbing illusion whether real or not can get the best of people. My favorite line:
“there’s a stranger in my house
It took a while to figure out
There’s no way you could be who you say you are
You got to be someone else…”
There is a stranger in the house of the secured real estate lending industry. This stranger is real and is very dangerous to innocent real estate lenders who assume that they have a recorded and secured a collateral position on a property, such as first lien or second lien, until they discover otherwise. This “stranger” is a subset of real property financing options that is classified as a voluntary tax assessment as a unique form of encumbrance, rather than a secured loan transaction with a promissory note and a recorded deed of trust.
Two separate but similar programs are referred to as “Property Assessed Clean Energy (PACE),” and “Home Energy Renovation Opportunity (HERO)” assessments. Both programs are created to facilitate the installation of energy and water efficiency improvements for real properties where owners require financing to make substantial property upgrades. Terms and conditions on both programs will vary for each program administrator as authorized by state and local legislation. The first qualified program was instituted in Sonoma County CA in 2009.
PACE financing is not considered nor classified as a loan or loan program. The Wall Street creators of this financing scheme were able to reclassify them as a voluntary property assessment instead of a loan. This was apparently done as a method to circumvent federal and state licensing including material disclosures, fiduciary responsibility and to gain super-priority lien status over other recorded security instruments.
On October 4, 2017, Governor Brown signed AB 1284 (Chapter 475, Statutes of 2017). The bill renamed the California Finance Lenders Law to the California Financing Law. Once the change became effective it sets forth a licensing scheme for Property Assessed Clean Energy (PACE) program administrators. A “program administrator” is a person administering a PACE program on behalf of a public agency. (Fin. Code, § 22018.) A PACE program provides financing for the installation of energy-efficiency improvements on real property with funding repaid through property tax assessments, as authorized by specified laws. (Fin. Code, § 22016.) Most states which offer these programs have adopted their own regulations.
The term “mortgage broker” is replaced with “approved PACE solicitor” which is an organization authorized by a program administrator to solicit property owners to enter into financing agreements. PACE solicitor agents (like outside salespeople) are individuals employed or retained by a PACE solicitor to market to the public as a home improvement salesperson (California Finance Code 22017). Salespersons solicit property owners to convince them to make the decision to choose voluntary assessment contracts as a financing option.
Each program may have different disclosure requirements. These programs began with little consumer protections. Because of the potential “predatory” nature of PACE/HERO marketing strategies California passed Assembly Bill (AB 1284) established disclosure requirements, including “ability to pay” standards and disqualifying some applicants. California also passed Senate Bill (SB 1078) and (AB 2063). California now requires that a prospective borrower who intends to take out a voluntary assessment contract to receive a written disclosure of financing terms as well as a pre-signing phone call with a PACE administrator that verbally explains the terms of the financing.
While approved PACE solicitors promote this financing option as serving worthy social and environmental goals, the danger of these programs is that it allows for circumvention of conventional loan and underwriting standards and protections. The California legislature implemented regulatory guidelines where PACE/HERO assessments may unknowingly show up on public record as a super “priority lien,” with senior and preferential security interests of the same priority level as property taxes. Property taxes, 1911-1913-1915 improvement bonds, other bond indebtedness such as Mello-Roos, and Community Covenants, Conditions and Restrictions (CC&Rs), take priority over other recorded security instruments such as trust deeds, judgments, liens, and encumbrances, and memoranda relating to the security interest in the property.
Securitized bond pool programs were created to purchase financing contracts for energy efficiency upgrades or renewable energy installations including residential, commercial, and industrial property. These programs will probably grow in popularity because there is no requirement for skin-in-the-game and substantial equity positions that are common for approval of institutional lenders.
A property owner can use PACE/HERO to finance building energy efficiency improvements like insulation, cool roofs, water efficiency products, seismic retrofits, and hurricane preparedness measures. PACE/HERO programs can also finance “green initiatives,” such as solar panels, which are promoted as a method for property owners to realize savings on energy costs.
The definitions of covered allowable purposes for this type of program are broad. Both programs are promoted and sold to the real property owners as “voluntary assessment contracts,” amortized from 5 to 25 years, and paid for by an increase in the property tax assessments. The property taxes due, usually twice per year will have a separate line item referred to as “voluntary assessments.” The amount of the increased outgoing cash flow for the obligation (voluntary assessment) and annual property taxes, together may be a real shock to property owners who agreed to participate in this financing program.
Many real estate brokers and mortgage brokers have no or limited understanding of how “PACE/HERO” financing programs work, nor do they understand the dangers reflected in potential subordinated collateral position of trust deed secured liens.
When a PACE/HERO loan is funded and closed the program administrator will record an “Notice of Assessment and Payment of Assessment Contract” which will reflect a lien of the property in public records with a date and time stamped instrument number. Recording and evidencing of the levy and contractual assessment that will run with the property. Anyone who orders a preliminary title report in the future should discover the lien as a matter of record. In many cases a borrower who contemplates a future loan will not disclose the PACE/HERO assessment obligation when applying for a new loan. Most real property lenders who discover the existence of one of these “voluntary assessments” will require that a portion of the newly contemplated loan proceeds be used to pay off this lien and release it as a lien on the property.
A typical real property loan is secured by a trust deed or mortgage with a date and time stamped instrument recorded at the recorder’s office that will reflect a lien on the property. The lien is a legal right referred to as a security interest given to a creditor to hold and possess as consideration for a loan. The secured creditor/lender has a charging interest against the property if the borrower defaults. A lien refers to a monetary claim which may be attached to and recorded against a property, or additional properties for the purpose of establishing additional collateral.
The process of recording, date, time, sequential number stamping, and maintaining the documents become very important when establishing the lien priority. California law regards lien priority as “first-in-time, first-in-right”. California law also provides for certain exceptions for some types of liens because by law these liens are given “super priority” or “skipping power” to the front of the line, not available to other recorded instruments.
A real estate lender and the corresponding private party beneficiaries could unintentionally find themselves subordinated or junior to a new PACE/HERO assessment obligation even if it was recorded after their transaction recorded. The lien remaining balance of a PACE/HERO assessment will remain intact if the ownership of the property changes hands. A new owner may or may not become aware that they will be responsible to pay the “ghost-like” obligation.
PACE/HERO financing programs are promoted as a method to save on energy bills and increase the property value while being paid for with an increased property assessment. The new assessment obligation is referred to as voluntary, so what’s the problem? Let’s list a few considerations:
1) PACE financing does not require any upfront cost or down payments. The property owner can finance 100% of the cost and creditworthiness is not a significant component of the approval process. There are no required monthly payments because the assessment obligation is paid when the property tax bills are paid. At the closing there will be an origination fee of 3-7% to the approved solicitor, program administrator fee, recording fee, and reserve fund fee. All the above will become part of the long-term assessment obligation.
2) Current and future recorded trust deeds or recorded mortgage liens and encumbrances are subordinated to PACE/HERO financing assessment obligation by operation of law.
3) PACE/HERO financing interest rates are 3-4% higher than traditional mortgages, including brokerage fees, securitization fees and an annual recurring administrative fee. Fee may be calculated on the total amount of annual assessment or the amount of outstanding loan obligation. The unaware subordinated secured trust deed lender could find themselves having to pay for this in the event of borrower default.
4) Underwriting requirements are not like regular trust deed or mortgage secured loans. They do not require appraisals, escrow, credit report, or title insurances. PACE/HERO financing obligation due diligence only requires an electronic valuation of estimated property value, a verification that the trust deed secured loans are current such as a recent payment invoice, and for the borrower to sign a “voluntary assessment contract.” By magic, they have a super priority lien.
5)The transactions are funded with government resources by approved PACE/HERO administrators, bundled, packaged and resold as bond pool offerings organized by Wall Street investment firms. The US government has entered the real property lending business and competes directly with private enterprise, but with a monopoly power and it has figured out how to demand super-priority lien status to perfect their security interest, and, of course gain preferential treatment. This is in no way a representation of free market private enterprise from my life experience, but rather an example of crony capitalism.
6) Since PACE/HERO obligations are repaid through “voluntary assessments-property tax payments,” a current or future secured real property lender or investor would only realize the existence of a PACE/HERO assessment obligation by scrutinizing the property tax bills frequently or ordering a new preliminary title report. A loan servicer of a trust deed secured lender may periodically check to make sure that the property insurance payments and taxes are current. and that the property taxes are current. The awareness (shock) of a new lien may become apparent when the property taxes show a substantial increase all at once, and a line item shows up as “voluntary assessment.”
7) A PACE/HERO program allows a total annual payment for property taxes and the annual assessment obligation to reflect a maximum of 5% of the market value of the subject property. What this means is that you add up the annual property taxes and the annual payments on the PACE/HERO assessment, that total amount cannot exceed 5% of the property market value. Upon review this is a huge sum or extremely high loan-to-value which could encumber the property in a superior or super-priority position.
8) Assume that an investor purchases a $1,200,000, 10-unit apartment property and encumbers it with a new purchase-money secured the first trust deed from a bank of $780,000 or 65% loan-to-value. The bank which makes the secured first lien has the opinion that they have a protective equity position of 35%. A borrower’s payment is based upon a 5% annualized interest rate loan amortized over 30 years. Principal and interest payments are $4181.21 monthly, plus $1,000. allocable for property taxes, or $5187.21 monthly payments for PIT.
9) Assume for example that the above subject property is a 10-unit apartment complex built in 1955-60. Here is an illustrative but not a conclusive list of needed upgrades that could be financed through a PACE/HERO financing program.
- All improvements can be made for the reason of energy efficiency, water efficiency, and renewable energy.
- Replace aluminum frame single pane and exterior doors with double-pane Low-E windows. Low-E windows have a clear coated material on the glass for increased energy efficiency through a technical process called fenestration.
- Abatement of and replacement of the asbestos roof covering, wall and ceiling insulation, floor tiles, sheet flooring, heat ducts/taping, and exhaust flues.
- Replace old galvanized steel, hot and cold-water lines with copper or acceptable PVC lines.
- Replace electrical and incandescent light fixtures with low voltage energy efficient florescent bulbs.
- Replace plumbing and fixtures with low flow water distribution
- Install solar panels on the rooftop.
- Replace hot water heaters and furnaces with energy efficiency models.
- Repair stucco or lath & plaster and repair/replace deteriorated dry rotted wood as required.
- Replace older asbestos containing sheetrock with non-asbestos material.
- Repaint entire building with non-lead-based paints.
- Replace kitchen and laundry appliances with energy-efficient models.
10) Let’s assume as above that a borrower wants to modernize and upgrade the 10-unit property and elects to get PACE/HERO financing. The new financing request is $400,000 at 8.5% amortized over 20 years. The amortized payment would be $3,471.29 per month or $41,655.52 per year. The PACE/HERO program administrator will add on an annual administrative fee, but I will use the payment only making for this example reflecting a total annual obligation of $41,655.52. Assume the current property tax is somewhere near 1% of the market value. Assume that the market value is $1,200,000. The property taxes may be about $12,000. per year. Adding $41,655.52 to $12,000 would equal $53,655.52 in annual payment obligations for property tax and the “voluntary assessment,” meaning PACE/HERO required payment. Even though these payments are due twice per year with the tax payments, the real monthly obligation of $4,471.29, or a total yearly of $53,655.52 for long-term cash flow planning purposes. If the borrower choses a monthly impound account, the increased amount would be required to include both taxes and annual assessment divided by 12.
PACE/HERO debt plus the property taxes cannot exceed 5% of the market value of the property. Also, some program underwriting standards for commercial PACE financing programs restrict the maximum voluntary assessment to 20% of a building value. So, in this example a $400,000 assessment contract is close to a maximum allowable for property taxes and annual assessment under PACE/HERO regulations and exceeds standards on the 20% of value question.
11) The PACE/HERO borrower is also required to pay an annual administration fee for the assessment added to the payment installment. The fee covers the annual cost to place the installment on the property tax bill, administer collection and disbursement and to administer the bonds issued to finance the instillation of eligible products.
12) The real property owner will also have operating expenses, rental issues, vacancies, and various ownership liabilities to consider. Property operating expenses may be from 35% to 50% of the income. Maybe rents can be increased to offset these additional financial obligations?
13) Suppose the borrower did not understand the financial ramifications of this voluntary assessment contract and defaults on his PACE/HERO obligation. The statutory default interest rate is 18% per annum. Assume that the borrower files a Chapter 11 re-organizational bankruptcy, and after two years a settlement occurs, the property is foreclosed by the secured lender and sold on the open market for $950,000. During that time the Pace/Hero financing obligation has accrued 2 years of default payments or $100,000. The PACE/HERO lender places a demand, which has now become senior to the banks’ first trust deed, into the sale escrow for $500,000 plus an administrative cost of $20,000. When the escrow settlement occurs, charges reflect sales commissions and closing costs of 8% or 76,000. the pay-off of the PACE/HERO defaulted obligation of $520,000, leaving net proceeds to the secured lender of $374,000. for an original loan $650,000. This does not consider arrearages of property taxes. Also, note that the secured lender had most likely $50,000 +/- of administrative costs to hire a lawyer to file a relief-of-stay in the bankruptcy to complete the foreclosure process. The secured lender could sustain a loss of $324,000 on what appeared to be a cookie cutter first trust deed loan.
14) Assume in another example that the property owner had encumbered the property to 65% LTV with an institutional first lien long-term loan and requested a private money second of 15% of value or $180,000. For the second trust deed lender to protect his/her interest in a foreclosure they would need to keep all other payments current, including the property tax/voluntary assessments, and first trust deed loan payments. An “innocent” second trust deed holder may have been unaware of the PACE/HERO lien priority position and that its priority position was wiped out day one.
In the above example of a second trust deed placement when a PACE/HERO obligation was later discovered the mortgage broker who arranged this loan would most likely be sued for negligence, negligent misrepresentation, fraud and constructive fraud.
This lending scheme, or program, no matter how you look at it, is now law. As secured real estate lenders, we must change our front-end due diligence, processing, and underwriting guidelines. Lenders need to place a notice into their loan documents stating that if the borrower contemplates a PACE/HERO financing obligation, the lender has a right to approve the program terms and documents and that the administrator will subordinate their position.
As part of best practices in loan processing, it is a necessity to check property tax records to determine if the taxes look unusually high. The property tax base should 1% or less with the help of proposition 13. If the taxes are questionably high and the lender discovers a line item on the tax rolls referred as “voluntary assessment” he/she calls the borrower and questions whether there is a PACE/HERO obligation on the property.
The bottom line is that mortgage brokers/lenders need a new disclosure, which all prospective borrowers sign, stating there is no PACE/HERO assessment obligation in place, and none is contemplated. This disclosure should be a separate document, so the borrower cannot later after a default argue to a judge that the language was buried in the boilerplate cluster of a trust deed. It should also state that if the borrower contemplates a PACE/HERO financing program, the borrower will notify the trust deed secured lender for approval.
A Borrower may request that a secured lender review the PACE/HERO financing documents and approve that the financing can become part of the property tax or additional assessment obligation. The secured lender could condition an approval upon an administrator of the program being willing to subordinate. If the borrower does not comply and obtains PACE/HERO financing anyway the secured lender may trigger the default provision of their own loan documents and call the loan due and payable. Triggering a due on encumbrance provision and proceedings to a foreclosure remedy is possible.
In a case where a secured trust deed lender approves the assessment contract to remain of record, the lender could require upfront and/or ongoing escrowed reserves to insure proper and timely payments of the taxes and assessments.
Taking out a second trust deed funded by private parties may be a less expensive alternative to a PACE/HERO financing program. When the upgrades are completed an institutional refinance may be obtained.
Dan Harkey
Business and Private Money Finance Consultant
Cell 949 533 8315
dan@danharkey.com
I intend this article for educational purposes only and is not a solicitation.
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