“There is a Stranger in My House” by Ronnie Millsap is a classic country song. Ronnie received a Grammy Award for Best Male Country Vocal Performance. 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…”
The new stranger in the house has to do with a new method of securing real estate loans. This new species of loans are referred to as Pace or “Property Assessed Clean Energy” and Hero or “Home Energy Renovation Opportunity”. These are loans created to facilitate the installation of energy and water efficiency improvements for real property owners.
While the loans are advertised as serving worthy goals, the danger of Pace/Hero loan programs is that they circumvent conventional loan and underwriting standards, and the recording of any security instrument at the recorder’s office. The legislature implemented regulatory guidelines where Pace/Hero loans show up as a super “priority liens”, with preferential security interest of the same priority level as property taxes. Property taxes, 1911 infrastructure bonds and other bond indebtedness such as Mello-Roos taxes, 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.
The purpose of these securitized loan programs is to finance energy efficiency upgrades or renewable energy installations for residential, commercial, and industrial property. Someone can use Pace/Hero to finance building energy efficiency improvements like insulation and air sealing, 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 loan are broad. Both programs are sold to the real property owners as “voluntary assessment contracts”, and amortized from 5 to 25 years, paid for by an increase in the property tax assessments. The lender will create an impound escrow account to manage the borrower’s payments for both the property tax and loan payments, referred to as “assessments.” The account will be adjusted on a monthly payment by the lender.
This is often a huge problem for the secured real property lending industry. Many lending practitioners have limited or no understanding of how “Pace/Hero” loans work.
A typical mortgage loan is secured by a trust deed recorded at the recorder’s office that will reflect a lien on the property. A 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 creditor has a charging interest against the property if the borrower of defaults. A lien refers to a monetary claim which may be attached to or recorded against one or more properties.
This body of knowledge and the process of recording and maintaining the documents become very important when establishing the priority of a lien. California law regards lien priority as “first-in-time, first-in-right”. California law also provides for exceptions for some types of liens whereby some liens are given “super priority” or “skipping power” to the front of the line. Government regulations permits certain liens to advance to the front of the line, so they become senior to, or super- priority to other liens.
A real estate lender could wake up and find themselves, and their private party beneficiaries, subordinated or junior to additional debt that no one agreed to or had any knowledge of.
Pace/Hero loans are supposed to save on energy bills and increase the property value while being paid for with an increased property tax bill, referred to as a voluntary assessment, so what’s the problem? Let’s list a few considerations:
1) Both current and future recorded liens are subordinated to Pace/Hero loans by operation of law.
2) Pace/Hero loan interest rates are 3-4% higher than traditional mortgages with up to 5% so-called administrative cost, including brokerage fees, and securitization fees. The subordinated lender could find themselves of having to pay for this in the event of borrower default.
3) Secured real property lenders are not given notice of the existence of a current or future Pace/Hero loans, because there is no requirement to notify the secured lender(s). Underwriting requirements are not like regular trust deed secured loans. They do not require appraisals, escrow, credit report, or title insurances. Pace/Hero loan 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” that never even shows up on public records. By magic, they have a priority lien.
4) The loans are funded with government resources, bundled, packaged and resold as a security investment on wall street. The government has gotten into the real property lending business and competes with private enterprise, but with a super-priority to perfect their security interest.
5) Since Pace/Hero loans are repaid through voluntary assessments-property tax payments, a current or future secured real property lender would only realize the existence of a Pace/Hero loan by scrutinizing the property tax bills frequently.
6) The maximum amount of annual property taxes combined with voluntary assessment payments, allowed by a Pace/Hero loan program can go up to 5% of the market value of the subject property. What this means that is you add up the annual property taxes and the payment on the Pace/Hero loan. That total amount cannot exceed 5% of the value. Upon review, this is a huge sum or high loan-to-value which could encumber the property in a superior or super-priority position.
7) Assume that an investor purchases a $1,000,000, 10-unit apartment property, and encumbers it with a secured first trust deed from a bank of $650,000 or 65% loan-to-value. The bank which makes the secured first lien has the opinion is that they have protective equity of 35%. A borrower’s payment is based upon a 5% loan amortized over 30 years. Principal and interest payments are $3,489.34 monthly, plus $833.33 for property taxes, or $4,372.34 monthly payments for PIT, principal, interest, and taxes.
8) Assume for example that the 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 loan.
- All these improvements can be made for the reason of energy efficiency, water efficiency, and renewable energy.
- Replace aluminum frame single pane with double pane low E, pane windows.
- Abatement off and replace 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 finish and incandescent light fixtures.
- Replace finish plumbing and fixtures with low flow.
- Install solar panels on the rooftop.
- Replace hot water heaters and furnaces with energy efficiency models.
- Repair stucco, or lath and plaster and repair/replace deteriorated/dry rotted wood as required.
- Replace sheetrock with non-asbestos material.
- Repaint entire building with non-lead-based paints.
- Replace kitchen and laundry appliances with energy-efficient models.
- Replace exterior doors.
9) Let’s assume, as above, that a borrower wants to rehabilitate the 10-unit property and elects to get a Pace/Hero loan. The new loan is $400,000 at 6.5% amortized over 20 years. The amortized payment would be $2982.29 per month or $35,787.48 per year. Assume the current property tax is somewhere near 1% of the market value. Assume that the market value is $1,000,000. The property taxes may be about $10,000. per year. Adding $35,787.48 to $10,000 would equal $45,787.48 in annual payments for property tax and so-called voluntary assessments, meaning Pace/Hero loan payments. This reflects a monthly obligation of $3,815.62, or a total yearly of $45,787. As per the regulation, 5% of the market value of Pace/Hero debt is the maximum allowable on the $1,000,000, or $50,000. So, this example a $400,000 loan is close to a maximum loan allowable under Pace/Hero regulations.
10) The real property owner now has 2 monthly payments, The First lien of $3,489.34 plus the Pace/Hero assessment payment of $ 2,982.29, adding the monthly property taxes of $833.33, totals $7,304.96., not counting operating expenses. Maybe rents can be increased. But the property owner still has other operating expenses and vacancies to deal with. Operating expenses may be from 35% to 40% of the income.
11) The borrower did not understand the financial ramification of this and defaults on his Pace/Hero loan. The statutory default interest rate for Pace/Hero loans is 18% per annum. Assume that the borrower files a Chapter 13, and after two years the settlement of the bankruptcy occurs, the property is foreclosed by the secured lender and sold on the open market for $950,000. During that time the Pace/Hero loan has accrued 2 years of default payments of $144,000. The Pace/Hero lender places a demand, which has now become senior to the banks’ first trust deed, into the sale escrow for $544,000 plus an administrative cost of $20,000. When the escrow settlement occurs, charges reflect sales and broker costs of 8% or 76,000, the pay off the Pace/Hero loan of $564,000, leaving net proceeds to the secured lender of $310,000, for an original loan $650,000. 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. The secured lender could sustain a loss of $290,000 on what appeared to be a cookie cutter, first trust deed loan.
12) Using the above example, assume that the property owner had encumbered the property to 50% with an institutional long-term loan, and requested a private money second of 15% of value or $150,000. 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. The innocent 2nd trust deed holder may be unaware of the priority position and that its priority position was wiped out day one when the borrower got the Pace/Hero loan.
This paradigm, scheme, or fraud, no matter how you look at it, is now law. As lenders, we must change our front-end due diligence, loan processing, and underwriting guidelines. Lenders need to place a notice into their loan documents stating that if the borrower contemplates a Pace/Hero loan, the lender has a right to approve the loan terms and documents and that the Pace/Hero lender 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 base should 1% or less. If the taxes are questionably high call the borrower and question whether there is a Pace/Hero loan on the property.
The bottom line is that Lenders need a new disclosure, which all prospective borrowers sign, stating there is no Pace/Hero loan in place, and it does not contemplate one. This disclosure should be a separate document, so the borrower cannot argue to a judge it was buried in boilerplate language. It should also state that if the borrower contemplates a Pace/Hero loan, that the borrower will notify the lender. The lender may review the documents, approve the loan, and request that the Pace/Hero lender subordinate. If the borrower does not comply, the lender may call the secured loan due. The loan would be in default, with foreclosure proceedings to begin if the borrower refuses to comply.
Dan Harkey
Business and Private Money Finance Consultant
Cell 949 533 8315
dan@danharkey.com
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