Choose Credit Enhancement for Property-Assessed Clean Energy Financing and Apply Recovery Act Funds
During the fourth step in the process to launch a commercial property-assessed clean energy (PACE) financing program, the local government (grantee) decides how to achieve the best interest rates for the program and how best to apply and leverage American Recovery and Reinvestment Act (ARRA) funds to fit the program’s design.
Key activities include:
- Credit enhancement
- Debt service reserve fund
- Interest rate buy-down
- Subsidize transaction costs
- Offer additional rebates beyond utility rebates.
Credit enhancement refers to techniques used by debt issuers (in this case the local government) to raise the credit rating of their offering and thereby lower their interest costs. Stated another way, credit enhancement simply refers to the steps taken to artificially improve the likelihood that lenders or bond investors will be paid on time and in full. Reducing risk increases the comfort of those key stakeholders and increases the odds that they will participate in a PACE program.
Commercial PACE already provides a relatively secure means of repayment by including the payment obligation in the owner’s property tax bill. In the context of PACE, credit enhancement is generally used to provide even greater assurance that full payments to lenders would be made even if the property owners fail to pay their taxes on time. There are two primary methods used to “credit enhance” PACE.
First, and most commonly, the program planner creates a reserve fund to make up for any shortfalls in PACE assessment receipts. This reserve, described in more detail below, is almost always essential for an assessment bond to achieve an investment grade rating (a highly desirable goal because it broadens the number of potential bond purchasers and typically results in significantly lower interest rates). A rating is a key feature for any bank or lender looking to participate. To achieve similar investment grade rating and attractiveness to banks or lenders, program planners can set up a slightly more sophisticated “senior-subordinate” payment structure (also described more fully below).
Second, local or state governments can fully or partially guarantee repayment by placing a general or moral obligation on the bonds. Under a general obligation, local or state governments pledge their full faith and credit to the bonds—effectively guaranteeing that if tax receipts fall short, they will make up the difference out of their own treasury. A moral obligation is a similar, but somewhat weaker, enhancement that is being used by Boulder County, Colorado, for its PACE program. Moral obligation bonds do not require a local government to cover bond defaults, but do indicate it is very likely they will do so. Such guarantees improve the credit quality of the bonds or loan, but also affect the credit quality of the local government and count against the government’s indebtedness limits.
Grantees have a number of options for using ARRA funds to support their commercial PACE programs, some of which address the credit enhancement options above. Details on several of the major options are presented in the next sections.
Debt Service Reserve Fund
Bond investors typically expect there to be a debt service reserve fund (DSRF) to cover bond debt service (i.e., payments made to bond investors) in the event of late payments or defaults by participants. This is commonly an amount set aside with a trustee. Note that other sections in this Finance Guide refer to this reserve as a loan loss reserve fund (LRF), but in this chapter it is called a DSRF. For assessment bonds, the typical DSRF is in the range of 5% to 10%. The reserve can be funded in several ways, but is usually added to the financed amount for each participant, so participants pay for it. For example, a $10,000 project would be financed at an $11,000 level in the case of a 10% DSRF. If a bond experiences low or no defaults, then the money in the reserve fund is generally used by the PACE program toward making the final payment on behalf of the property owner (assuming the owner funded the reserve). A DSRF may or may not be required for owner-arranged financing, but such a reserve will be expected in all other forms of property assessment bonds.
Adding an additional 5% to 10% on top of the total project financing amount increases the annual percentage rate (APR) and can give applicants significant reason to pause and think hard about the costs of the PACE financing option. Therefore, anything that can be done to lower or alleviate that cost can bolster program participation. One appealing option is for grantees to use their ARRA funds to provide the debt service reserve fund so that program applicants do not have to cover its cost.
If ARRA funds are used for a 10% DSRF, the APR to the property owner will be reduced by approximately 1.6% (in contrast to the property owner funding the DSRF and having it added to the financed amount). The difference can be seen by contrasting columns 1 and 2 in the table below (note the applicant APR of 9.6% versus 8.0%).
A common capital markets approach to establishing a DSRF to enhance the credit of the financing would be to set up a “senior-subordinate” structure. In such an approach, the ARRA funds would be combined with private capital and provided for project financing rather than held in reserve. In the event of a default, the losses are taken first by the ARRA funds, leaving the private investor unharmed unless all ARRA funds are exhausted. Using ARRA funds in this “first loss” position has two advantages. First, it allows for more total project funding. Second, it is set up in a manner more appropriate for a securitized capital markets takeout (i.e., combining all the project financings into a bond or security and selling it to investors).
Interest Rate Buy-Down
A third option is for grantees to use ARRA funds to buy down the interest rate that will be paid by property owners to such a point that PACE financing becomes an attractive option. That can be a way to gain more attention for the PACE program, reward early participants in a newly launched program, and build market demand.
On a dollar-for-dollar basis, an interest rate buy down will result in the same APR as the funding of a 10% DSRF. That result can be seen by comparing columns 2 and 3 in the table below (note that the resulting APR in both cases is 8%). However, it is better to use ARRA funds to fund the DSRF because defaults on property taxes are historically very low and any defaults will be satisfied at the time of property sale. This means the money in the DSRF will be preserved and available for continued use as a DSRF, or eventually repurposed. Contrast that with using ARRA funds to buy down the interest rate, in which case the funds are exhausted.
|1. Applicant Funds DSRF||2. ARRA Funds DSRF||3. ARRA Subsidizes Rate|
|Term in Years*||15||15||15|
|Debt Service Reserve Fund (DSRF)||10.00%||10.00%||10.00%|
|ARRA Funds Applied||$0||$1,000||$1,000|
|Applicant Interest Rate||8.00%||8.00%||6.48%|
|DSRF Amount Financed by Applicant||$1,000||$0||$1,000|
|Bond Price (Par 100)||100||100||90.91|
*Assumes 15-year semi-annual assessment and 8% par (100) priced coupon
Subsidize Transaction Costs
As described in previous sections, applicants can face additional costs associated with participating in a commercial PACE program. ARRA funds can be used to partially or fully cover one or more of those costs. A good candidate that could be subsidized or paid in full is the energy audit conducted on the property. That is an early and key step in the application process, so offsetting part or all of the audit cost might encourage more applicants to get involved. Funding for the audit can be made contingent on the property owner ultimately completing an energy retrofit or improvement.
Offer Additional Rebates beyond Utility Rebates
Finally, ARRA funds can be used to augment the rebate/incentive amounts offered by utility programs to property owners undertaking clean energy improvements. That would, in turn, reduce the total amount of financing needed by the applicants for their projects. This is another way of encouraging participation in utility programs and possibly reducing the costs borne by the program associated with processing and approving an application or a project payment (in other words, use ARRA funds to subsidize transaction costs).