While touted for nearly a decade as a pathway to provide for the expansion of renewable energy and other energy-efficient upgrades in the U.S. housing sector, Property Assessed Clean Energy ("PACE") programs have generally not been thought to have met their full potential. One important impediment to the expansion of PACE has now been removed, however, with the U.S. Department of Housing and Urban Development's guidance (the "Guidance")1 issued on July 19, 2016 to allow for the Federal Housing Administration ("FHA") to insure residential home mortgages which are subject to senior PACE liens meeting certain specified conditions.

While banks, hedge funds and other investment firms have long had interest in PACE as an asset class, the Guidance is expected to spur renewed focus in PACE bonds and PACE-related financings. In this client alert, we examine issues most relevant to parties considering providing financing secured by PACE assets and/or purchasing PACE bonds. Given the many existing PACE programs and expected development of new programs, it remains important that potential investors and finance providers carefully analyze the specific terms of a program before moving ahead.

GENERAL TERMS OF PACE PROGRAMS

PACE programs are currently in existence in approximately 30 states, but California has seen the predominance of residential PACE activity. PACE programs arise at the state and local government level as a mechanism to finance the installation of energy efficient improvements to properties located in designated areas, such as new windows, lighting and plumbing and heating systems or the installation of solar panels. Such retrofits are conducted by program-approved contractors under programs often administered by private third parties. The programs are designed to incentivize homeowners to undertake energy-efficient improvements, the cost of which can then be amortized over time rather than paid upfront; designed properly, the cost savings realized from the improvements over the life of the property should exceed the cost of installation.

The municipality or district will fund the cost upfront as a loan and in turn a special assessment will be added to the property, akin to a property tax assessment, to provide for repayment. The property assessment will be in place for typically up to 20 years and will attach to the property (i.e., a new property owner will be responsible for remaining payment obligations, but, of course, receives the ongoing benefits of the property improvements); upon foreclosure of a property, the remaining assessment is not accelerated, such that only current amounts and amounts in arrears (together with any penalties) would be payable. Like tax assessments, property assessments for PACE improvements will typically share a first-lien priority, ahead of any mortgage. The municipality will in turn generally issue limited obligation improvement bonds secured by pools of PACE assessments, effectively transferring the cost of the PACE installations to third party investors, similar to other municipal financings.

The senior status of PACE liens has been a primary impediment to the expansion of PACE programs. Prior to the Guidance, the FHA would insure only certain properties for which a PACE assessment was subordinated to the related mortgage and, as noted in more detail below, the Federal Housing Finance Agency ("FHFA") has long prohibited financing of mortgage loans for which a PACE assessment has lien priority over the mortgage.

THE NEW GUIDANCE

The Guidance represents the culmination of a nearly year-long process undertaken by the FHA to assess PACE financing. Under the Guidance, residential properties subject to a senior PACE assessment will now be eligible for FHA-insured mortgage financing if a number of criteria are satisfied: (1) the PACE assessment must be collected and secured in the same fashion as other special property assessments under applicable law, (2) only past due, scheduled PACE assessments may be realized ahead of the mortgage on the property—the PACE lien may not be superior with respect to the entire outstanding amount of the PACE assessment, (3) the 

PACE lien may not restrict transferability of the property (any consent rights of other parties are prohibited, unless the property owner has the ability to terminate such rights), (4) the terms and existence of the PACE assessment must be fully disclosed and transparent in applicable public records and (5) following foreclosure, the outstanding amount of any PACE assessment must be the responsibility of the new property owner. The Guidance also notes that, in relation to the sale of properties subject to a PACE assessment, the sales contract must specify whether the seller will pay-off the outstanding amount at closing and, if the PACE assessment will continue in place, the new buyer must receive disclosure of all terms and conditions of the PACE assessment. In addition, any appraisal must take into account the existence of the PACE assessment. As a general proposition, the conditions imposed in the Guidance overlap consistently with the terms of the typical residential PACE program.

The Guidance was released in conjunction with the Obama administration's broader Clean Energy Savings for All Americans Initiative, which also saw the U.S. Department of Veterans Affairs ("VA") issue similar guidance in relation to VA-insured mortgage loans2 and the U.S. Department of Energy release draft Best Practice Guidelines for Residential PACE Financing Programs, which are meant to serve as a model for jurisdictions to create new PACE programs.

IMPLICATIONS

The response to the new Guidance has largely been positive, with the consensus that a large obstacle to the expansion of PACE financing has been removed. Certainly, PACE financing is expected to grow significantly as a consequence of the Guidance. The expansion of PACE financing should prove beneficial for the further installation of residential solar panels, in particular. In addition, the Guidance could prove to be an impetus to states to implement PACE programs and revitalize existing dormant programs. As PACE loan origination grows, we would expect the number of securitizations backed by PACE bonds to accelerate. Lastly, given the increasing focus of financial institutions on socially responsible investing and promotion of environmental sustainability, greater involvement with PACE programs may prove appealing for such firms.

Parties looking to make investments in PACE bonds or provide financing secured by PACE bonds should carefully consider the terms of the relevant PACE program to ensure compliance with the criteria established by the FHA. While the Guidance generally adheres closely to the terms of the typical PACE program, diligence will be needed to confirm that conclusion. As new programs are evaluated, investors should also consider the bankruptcy risk of the related county or municipal authority, particularly if assessments are commingled with other tax receipts for some period of time, and the eligibility of such program for any state or county reserve fund or other credit support.

REMAINING ISSUES

The takeaways aren't all sunny. Upon release of the Guidance, certain organizations, including the National Association of Realtors and Mortgage Bankers Association, expressed dissatisfaction with the ramifications of a first-lien for PACE loans. In the past, realtors have pointed to the higher property assessments on homes with PACE improvements as an impediment to resales and many mortgage lenders have expressed concerns with the priming status of PACE assessments, which typically arise after a mortgage loan has been made and which serve to subordinate the mortgage lender's lien to the extent of unpaid prior assessments.

In addition, the FHFA, which oversees Fannie Mae, Freddie Mac (collectively with Fannie Mae, the "Enterprises") and the Federal Home Loan Banks, remains publicly staunchly opposed to most PACE programs on the basis that the "super-lien" status of a PACE lien unacceptably shifts the risk of loss to a first lien mortgagee and hence, taxpayers, in the case of the Enterprises. The FHFA instead suggests a second-lien approach for PACE programs. Indeed, as recently as June, FHFA general counsel Alfred Pollard testified before certain committees of the California state legislature that "FHFA cannot sanction first-lien status PACE programs for Enterprise participation"3. It is worth noting that FHA-insured mortgage loans, however, are not subject to the purview of the FHFA, because they are not sold to the Enterprises.

CONCLUSION

Despite these concerns, most industry participants expect an acceleration of PACE projects as a result of the Guidance. While there remains some political risk with a new administration after the presidential election, the promotion of clean energy and energy-efficiency remains a broadly popular policy aim. We will continue to monitor developments with respect to this potentially growing asset class.