Summary:
“There’s a Stranger in My House”-lyrics from a classic song by country western star Ronnie Milsap, who received a Grammy Award for Best Male Country Vocal Performance.
“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’ve got to be someone else...”
The (stranger) of loans is referred to as PACE or “Property Assessed Clean Energy” and HERO or “Home Energy Renovation Opportunity” loans, which were created to facilitate the installation of energy- and water-efficient improvements for real property owners.
While the loans are advertised as serving worthy goals, knowing the potential risks is crucial. The danger of Pace/Hero loan programs is that they circumvent conventional loan and underwriting standards, as well as the recording of any security instrument at the recorder’s office. This should raise a red flag for all lending professionals and real estate investors, prompting a cautious approach.
Article:
The legislature implemented regulatory guidelines under which PACE/HERO loans appear as a super “priority lien” with a 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, encumbrances, and memoranda relating to the security interest in the property.
As of 2025, PACE legislation is active in 40 states, plus Washington, D.C. The programs are currently active and operating in 32 states, plus the District of Columbia.
The program administrator in California is the Department of Financial Protection and Innovation.
https://dfpi.ca.gov/pace-program-administrators/pace/
https://cscda.org/property-assessed-clean-energy-programs/
https://en.wikipedia.org/wiki/PACE_financing
https://en.wikipedia.org/wiki/HERO_Program
This is often a massive problem for the secured real property lending industry. Many lending practitioners do not understand how "Pace/Hero” loans work. Bridging this knowledge gap and comprehensively understanding these loans is crucial for making informed decisions.
These securitized loan programs aim to finance energy efficiency upgrades or renewable energy installations for residential, commercial, and industrial property. Someone can use Pace/Hero to finance building envelope energy efficiency improvements, such as 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 energy savings.
The definitions of covered allowable purposes for this type of loan are broad. Both programs are sold to real property owners as "voluntary assessment contracts” and amortized over 5 to 25 years, with payments made through increased property tax assessments. The lender will create an impound escrow account to manage the Borrower's fees for both the property tax and loan payments, referred to as “assessments.” The lender will adjust the account every month.
A typical mortgage loan is secured by a trust deed, which is recorded at the recorder’s office, thereby creating a lien on the property. A lien is a legal right, 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 defaults. A lien is a monetary claim that 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,” meaning the first lien recorded on a property has the highest priority. California law also provides exceptions for some types of liens, such as property taxes, to provide for "super priority” or “skipping power” to the front of the line. Government regulations permit certain liens to advance to the front of the line, so they become senior to, or super-priority to, other liens.
Disclosing a voluntary lien: The C.A.R. residential purchase agreement(RPA-CA) now requires a seller, in paragraph 8.B.(4), to disclose to the buyer whether any items in paragraph 8.B. of the contract are subject to a lien or encumbrance 8.B. includes all fixtures and other features of the property, including solar power systems, plumbing and heating fixtures, and any other item included in the sale: When we review a preliminary title report (PTR), the public is notified oanyhe additionaassessmentsnt under the exceptions portion of the report. With the notice, a lender can request subordination of the Pace/Hero lien or the requirement to pay off the Pace/Hero loan with the proceeds of the new loan. Subordination means that the Pace/Hero lien is placed in a lower priority than the new loan. Still, it does not eliminate the financial obligation. However, even with the subordination in place from the Pace lender recording their security instrument, the encumbrance remains a part of the property tax payment, making the subordination potentially moot.
Pace/Hero loans are designed to enhance property savings on energy bills and property value, all while being paid for with an increased property tax bill, referred to as a voluntary assessment. This innovative approach holds the potential for significant benefits, so what’s the problem?
Let’s list a few considerations:
Both current and future recorded liens are subordinated to Pace/Hero loans by operation of law.
Pace/Hero loan interest rates are 3-4% higher than traditional mortgages, and up to 5% of these are administrative costs, including brokerage and securitization fees. The subordinated lender could have to pay for this in the event of Borrower default.
Secured real property lenders are not notified of current or future Pace/Hero loans because there is no requirement to inform the secured lender(s).
Understanding Pace/Hero loans requires a different level of due diligence than regular trust deed-secured loans. It’s not just about the electronic valuation of the estimated property value and verification of current trust deed-secured loans. The Borrower's signing of a ‘voluntary assessment contract’ that never appears on public records adds another layer of complexity. Thorough due diligence is crucial in these cases to ensure the security of the investment and to keep you informed and prepared.
The loans are funded with government resources, bundled, packaged, and resold as a security investment on Wall Street. The government has entered the property lending business, competing with private enterprises, but with priority to perfect its security interest.
Since Pace/Hero loans are repaid through voluntary assessments and property tax payments, a current or future secured lender of actual property would only become aware of a Pace/Hero loan by scrutinizing the property tax bills regularly.
The maximum annual property taxes and voluntary assessment payments allowed by a Pace/Hero loan program can go up to 5% of the subject property’s market value. This means you add up the annual property tax and the Pace/Hero loan payment so that the total amount cannot exceed 5% of the value. Upon review, this is a considerable sum or a high loan-to-value ratio, which could encumber the property in a superior or super-priority position.
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 that holds the secured first lien believes it has a 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, for a total of $4,322.67 monthly payments for PIT, principal, interest, and taxes.
Could you assume, for example, that the subject property is a 10-unit apartment complex built between 1955 and 1960? Here is an illustrative but inconclusive list of needed upgrades that could be financed through a Pace/Hero loan.
These improvements can be made possible through energy efficiency, water efficiency, and the use of renewable energy.
Replace the aluminum frame single-pane windows with double-pane low-E pane windows.
Abatement and replacement of 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 finished plumbing and fixtures with low-flow.
Install solar panels on the rooftop.
Replace your water heaters and furnaces with energy-efficient models.
Repair stucco or lath and plaster, and repair/replace deteriorated/dry-rotted wood as required.
Replace Sheetrock with non-asbestos material.
Could you repaint the entire building with non-lead-based paints?
Replace kitchen and laundry appliances with energy-efficient models.
Replace exterior doors.
As mentioned above, a Borrower wants to rehabilitate a 10-unit property and elects to get a Pace/Hero loan. The new loan is $400,000 at 6.5%, with an amortization period of 200 years. The amortized payment would be $2982.29 monthly or $35,787.48 annually. Assume the current property tax is nearly 1% of the market value. Assume that the market value is $1,000,000. The property taxes may be approximately $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, which include Pace/Hero loan payments. This reflects a monthly obligation of $3,815.62 or a total yearly obligation of $45,78. According to the regulation, the maximum allowable amount is 50% or 11% off the market value of Pacr, which is $ 1,000,000. In this example, a $400,000 loan is close to the maximum allowable loan under Pace/Hero regulations.
The actual property owner now has two monthly payments: the First lien of $3,489.34 plus the Pace/Hero assessment payment of $2,982.29, totaling $6,471.63, which includes the monthly property taxes of $833.33. Can rents be increased? However, the property owner still has other operating expenses and vacancies. Operating expenses may be 35% to 40% of the income.
The Borrower did not understand the financial ramifications of this and defaulted on his Pace/Hero loan. The statutory default interest rate for Pace/Hero loans is 18% annually. Assume that the Borrower files a Chapter 13. After two years, the bankruptcy settlement occurs, and the property is foreclosed by the secured lender, who then sells it on the open market for $950,000. During that time, the Pace/Hero loan accrued two years of default payments of $144,000. The Pace/Hero lender placed 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, the charges reflect sales and broker costs of 8%, or $ 76,000, the Pace/Hero loan payment of $564,000, leaving net proceeds to the secured lender of $310,000 for an original loan amount of $650,000. Also, please note that the secured lender most likely incurred $ 0,000 in administrative costs to hire a lawyer to file for a stay of relief in bankruptcy. The secured lender could sustain a loss of $290,000 on what appeared to be a cookie-cutter first loan.
Using the above example, assume that the property owner had encumbered the property with a 50% institutional long-term loan and requested a private money second mortgage of 15% of the value, or $150,000. For the second trust deed lender to protect their interest in a foreclosure, they would need to keep all other payments current, including property taxes, voluntary assessments, and first trust deed loan payments. The innocent second trust deed holder may be unaware of their priority position and that it was wiped out on day one when the Borrower obtained the Pace/Hero loan.
No matter how you look at it, this paradigm, scheme, or “fraud” is now law. As lenders, we must change our front-end due diligence, loan processing, and underwriting guidelines. Lenders should include a notice in their loan documents stating that if the Borrower contemplates a Pace/Hero loan, the lender reserves the right to approve the loan terms and documents and that the Pace/Hero lender will subordinate its position. As part of best practices in loan processing, it is necessary to check property tax records to determine if the taxes look unusually high. The base should be 1% or less. If the taxes are high, contact the Borrower and inquire whether a Pace/Hero loan is on the property.
The bottom line is that Lenders need a new disclosure, which all prospective borrowers must sign, stating that there is no Pace/Hero loan in place and that it does not contemplate one. This disclosure should be a separate document so the Borrower cannot argue to a judge that it was buried in boilerplate language. It should also state that if the Borrower contemplates a Pace/Hero loan, the Borrower will notify the lender. The lender may review the documents, approve the loan, and request that the Pace/Hero lender subordinate its position. If the Borrower does not comply, the lender may call the secured loan due. The loan would default, with foreclosure proceedings to begin if the Borrower refuses to comply.