PACE (“property - assessed clean energy”) voluntary assessment programs have emerged recently as an intriguing method for property owners to finance energy retro-fit projects on their properties, whether residential or commercial. According to PACENow, a non-profit policy group supporting the build-out of PACE, 31 states (representing nearly 80% of the population) have already adopted legislation enabling PACE voluntary assessment programs.

As described below, the secured payment streams that arise from PACE programs are an attractive asset, and although there are challenges involved in developing the market for PACE programs and in understanding their unique legal and commercial features, the potential for rapid growth of PACE voluntary assessments as an asset class for securitization is strong. For any fixed-income investor in rated asset-backed securities or in residual cash flow from securitization trusts, or for equity investors interested in companies that originate financial obligations, PACE programs deserve special attention.

PACE programs are a specialized form of traditional “land-secured finance,” a type of infrastructure financing in which land-secured revenues are raised to pay for public improvements, which has been in common use for many years throughout the U.S. “Land-secured revenues” are special assessments imposed on the real estate that benefits from the public improvements. Property owners on whose property the special assessments are imposed are generally required to pay their special assessments at the same time as their ordinary real estate taxes. The special assessments have a lien priority equal to real estate taxes and ahead of previously recorded mortgages. The obligation to pay any remaining assessment installments at the time of sale of the property is assumed by the subsequent owner. Landsecured financing has been applied to pay for a wide range of public projects, including bridges, roads, flood control, water supply, and many others.

One required element of land-secured financing is that there be a public benefit to the project being funded. Traditionally this requirement has meant that the improvements funded with land-secured financing are built on public land, or directly affect all property owners in a particular district. As a result, all properties within the related district are assessed a fixed amount, payable by the property owners with their other real estate taxes, for a limited period, to pay for the improvements.

PACE programs began to develop in California in 2008 with one significant change to the traditional land-secured financing approach. Once a municipal entity adopts a PACE program in its district, PACE improvements are only installed on a property in cases where the property’s owner voluntarily agrees to participate. There are still public benefits associated with the PACE program, namely energy and water conservation, reduced reliance on carbon-based fuels, and job creation. However, a PACE assessment is levied only on a participating property and only in the amount needed to pay for the installation of the qualifying improvements on that property plus certain related administrative costs. The actual improvements that can qualify under a PACE program are fixed by the municipality that adopted the particular PACE program and include, among others, items that are energy efficient, use renewable energy sources, or reduce water usage. This element of consumer choice is one reason for the growing popularity of PACE voluntary assessment programs. The property owner selects the type of improvement and the contractor (subject to eligibility guidelines) and the length of the period in which the assessment installments will be payable, provided that the selected period does not exceed the useful life of the related improvement.

Once a PACE voluntary assessment has been levied on a property, the property owner begins paying fixed assessment installments for a specific period of time, secured by a lien on the property. The payment stream is similar to that of a mortgage, except for two key characteristics of assessments and taxes that are found in other land-secured financing arrangements: the PACE assessment has lien priority over a previously recorded mortgage, and non-payment of the PACE assessment does not result in acceleration of the remaining amounts due. As with other real property taxes and assessments, although non-payment does not result in acceleration of amounts due in the future, penalties and default interest rates do apply to late payments, and the public entity to whom the assessment is owed can ultimately foreclose on its lien and sell the property to pay delinquent amounts.

In order to pay for the costs of the improvements funded under its PACE program, the sponsoring public entity issues limited obligation improvement bonds. These bonds, which are coming to be known as “PACE bonds,” are not general obligations of the municipality; payments on the PACE bonds are limited to the payments received by the municipality on the pool of PACE assessments securing the bonds. The limited obligation improvements bonds are a kind of municipal pay-through obligation and have many of the same characteristics as the underlying PACE assessments.

By acquiring a portfolio of PACE bonds, an investor acquires exposure to a diverse pool of priority-lien, real estate-backed obligations with a low assessment-to-value ratio. The maximum assessment-to-value ratio is specified by the operating guidelines of the PACE programs, which are intended to encourage prudent property owner behavior and also to make sure that the overall priority-lien obligations on the property remain at a reasonable level. PACE assessments are collected together with the property owner’s real estate taxes by the local taxing authority and remitted to the trustee for the related PACE bonds. Given these characteristics, PACE bonds provide the kind of cash flow that typically would support securitization in considerable volume.

Creating a securitization of PACE bonds involves aspects of municipal finance, traditional ABS, and CDOs. One issue not found in other ABS transactions is the need to understand how the timing and operation of the relevant tax collection process actually works, including the potential effect of a bankruptcy proceeding by the tax collecting authority. Although the collection of the assessments is akin to the role of a servicer in a typical ABS structure, the fact that the “servicer” here is a municipal entity makes a significant difference. Replacing the tax collecting authority may not be feasible in practice, unlike in ABS where replacement service providers are usually readily available to perform all aspects of the servicing function. Similarly, the issuer of the PACE bonds itself will be another public body, making it important to understand how the issuer would be treated in a Chapter IX bankruptcy case, or whether the issuer is subject to the U.S. Bankruptcy Code at all.

Owners of PACE bonds have limited remedies against the issuer, as it may not (depending on the specifics of the program and state law) be possible to foreclose on the PACE assessments or sell them, hence the PACE bonds themselves (like the PACE assessments) may not be susceptible of acceleration. The underlying PACE assessments, if unpaid for a sufficient length of time, would, however, trigger a foreclosure remedy, which should ensure strong recoveries on delinquent assessments that are ultimately passed through to the owners of the PACE bonds, and then to an investor in ABS backed by the PACE bonds.

Investors also need to understand how the PACE assessents in each particular PACE program are originated and on what basis property owners’ applications are approved. The scope of underwriting and eligibility guidelines may vary among PACE programs. Given the public purposes of the PACE programs, the programs are usually designed to encourage rather than limit participation. The small dollar amount of the assessments (in the case of residential assessments) relative to the overall property value is intended to keep the property owners’ overall land-secured obligations at a manageable level.

PACE assessments are available for residential and commercial properties in a similar manner in terms of how the programs are designed, although the scale and credit issues associated with residential and commercial PACE assessments are significantly different. In terms of their market perception, PACE assessments on residential property also enjoy for the time being a certain controversial reputation, due to the warnings sounded by FHFA over the introduction of residential PACE programs. FHFA has on numerous occasions voiced its objection to residential PACE programs on the grounds that, if not responsibly designed and underwritten, residential PACE assessments could burden property owners with excess fixed costs secured by their property. In addition, in FHFA’s view, the additional priority-lien obligations represented by PACE assessments could impair the value of mortgage obligations held in the portfolios of Fannie Mae and Freddie Mac.

FHFA’s position has slowed the introduction of residential PACE programs, although certain local public bodies have pushed ahead regardless. For local governments, there are strong incentives to move forward given the growing demand for residential PACE programs from homeowners in places where the programs have found traction. In addition, residential PACE programs are already having a measurable impact on energy savings, carbon fuel reduction, and job creation in certain communities. It may also be possible by adopting a “loss reserve program” of the type currently being proposed in California to create an insurance scheme that would cover losses (if any) attributable to a PACE assessment and thus address the concerns raised by FHFA.

PACE programs have already attracted broad support from state and local governments across the U.S. and several active programs (commercial and residential) are under way with committed financial backing. A combination of three factors is likely to propel the origination of PACE assessments to new levels in 2014: local government commitment to promoting the benefits of PACE programs, greater awareness of the opportunity among investors, and addressing FHFA objections (to residential PACE programs only) through a “loss reserve” program or another negotiated commercial or political compromise. The momentum behind PACE programs at the local level, given its demonstrated popularity with consumers and its twin effects of energy savings and job creation, is already strong. The volume of PACE assessments is poised to grow, creating interesting investment opportunities.