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Summary

  • Pershing Square's thesis makes sense, except, there's no there there.
  • Property appreciation will increasingly be linked to on site clean energy generating capacity.
  • Predatory "green finance" practices fleece property appreciation from mortgage holders.

Fannie MAE (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) (I call them F&F) make a fascinating story and studying the recent Pershing Square presentation is well worth the effort. A few years ago, when F&F were at the height of their sub-prime malfeasance, an opportunity came along that they promptly dismissed at their own peril, and it is now coming back to haunt them. One of the consequences is that they cannot simply go back to their knitting as Bill Ackman would like to suggest.

The incident I am referring to was the confrontation with the initiators of the PACE (Property Assessed Clean Energy) finance concept. What upset the GSEs at the time, was that PACE would have seniority over first mortgages because the payments are collected with property taxes. Of course it was all a thinly veiled way of deflecting attention from the deterioration of underwriting at the GSEs themselves, under the guise of safeguarding the repayment ability of mortgage holders, but the GSEs achieved the exact opposite of what they claimed to want by foregoing this opportunity to control the process--by means of an adequate underwriting standard.

The missed opportunity of PACE

At the time these events took place, I contributed some advice to the point that the right Clean Energy projects would be constructive to property values, and lead to appreciation, and therefore improve asset values and the ability to repay, and reducing mortgage risk.

However, the PACE advocates themselves at that time were their own worst enemies, for like so many greenies, they ruined their own cause by co-opting "energy efficiency" as a substitute for clean energy, and thereby scuttled the value of their proposition.

The best the PACE folks could do was to come up with a study documenting a number of "energy efficient" homes with a number of comparables without efficiency upgrades, and they were narrowly able to demonstrate a slightly better appreciation. The outcome was a compromise which included among other things that energy retrofits could not be more than 10% of the assessed value of the property, thereby largely locking PACE-financed energy retrofits into the value destroying "energy efficiency" racket.

What was missed was the opportunity to introduce an FHA underwriting standard that could have guaranteed that ONLY energy projects that were additive to property values should be undertaken. The percentage of the assessed value is irrelevant if a permanent energy price hedge can be created by means of clean energy generation on site. On the contrary, this limitation leads to a focus on projects (predominantly of the "energy efficiency" variety) that make only incremental improvements, instead of doing the things that PACE was meant to do, which is on-site clean energy retrofits, where the real capital need and value enhancement is.

Diminishing returns versus compounding returns

Financially, "energy efficiency" destroys value, for it is a proposition with diminishing returns, therefore undermines long term capital appreciation and by implication the ability to repay mortgages. From an engineering standpoint also, it should be understood that if you compare a fossil fuel based system to a renewable energy system the spending on energy efficiency will be partially the same, but very definitely different in important ways.

Notably, energy efficiency in a clean energy system pays off in reductions of installed capacity (i.e. reduces capital investment), while energy efficiency applied to a fossil fuel system pays off in reductions of future fuel bills. Moreover, to name just one example, in a clean energy system you are reducing indoor air pollution, so it lends itself to a tighter building envelope, and possibly heat-recovery ventilation. In short, you cannot assume that you can just blindly start with energy efficiency (of a fossil fuel based system) and switch to clean energy later - you need to have a comprehensive energy plan to make sure you do not lock yourself out of opportunities. Without such a plan, switching tracks from efficiency to renewables will produce write-offs.

Seen as the intra-marginal investment that it is, clean energy moves energy production on-site, and financially moves energy from liabilities to assets, and therein lies the magic of property appreciation, assuming we select the projects that are financially most rewarding based on a long term (thirty year) capital budget (CAPM). I.e. maximizing Site Derived Renewable Energy (SDRE) generation paid for by energy savings, enabled by appropriate (PACE?) finance.

Sub-prime in green: PACE, Solar PPAs, and "energy efficiency"

With the GSEs passing on the opportunity to set underwriting standards for energy retrofits, they turned loose the wolves of Wall Street in yet another raid on other people's property appreciation, under the guise of "green finance," which is merely a variant of Asset Backed Lending (NYSEMKT:ABL), based on "energy savings," and therefore deemed "self liquidating" and a low credit risk for lenders.

Nobody is paying attention that the resulting finance business is driven by the interests of the vendors of screwy light bulbs, window caulking and even solar panels, and their financiers, not to mention the customer retention interests of energy companies. And these "self liquidating" propositions, helped along by tax incentives, are presented to property owners in a manner that leads to the serial adoption of small (least cost), energy efficiency enhancements, usually prioritized based on payback periods from energy savings.

The serial undertaking of these "energy efficiency" enhancements faces diminishing returns, enough so that after exhausting the screwy light bulbs and the window caulking, not to mention fuel switching, and upgrading boilers, property owners eventually get desperate enough to take ridiculous technology risks and bolt a solar PV panel to the roof of their leaky properties, because it will save some percentage of their energy bills. At that point, property owners have been completely backed into a corner. The incremental decision making has locked them in for 20 years into the proposition of saving 20 or 25% on their energy, when current technology might have allowed 80% reduction, if you understand the engineering and the finance.

Example: Hybrid Solar Thermal HVAC system. Solar thermal is harder to implement but delivers 5-8 times more energy per square area than current PV, so who, at NY real estate prices, can afford to put PV on their roof, instead of Solar thermal? Answer: the victim of the latest "green scam," the "free" solar PV panel, courtesy of the Solar PPA.

Constructive underwriting standards to support PACE

Given this bit of ancient history, a reformed F&F could and should retake control of the PACE mechanism, to LOWER underwriting costs for PACE loans, eliminating the need for Rube Goldberg solutions such as the EDF's "Investor Confidence Project." For new construction net-zero and near-zero are becoming the norm, and what happens on the margin will drive property evaluations in the long run.

The bargaining chip F&F have in this matter is the peace offering of undoing the silly 10%-of-assessed-value PACE restriction, which is actually counter-productive and has doomed PACE finance to the irrelevant if not regressive activity of "energy efficiency" finance. On that basis they should be able to enforce proper underwriting standards for PACE finance as described here, i.e. based on the business of moving energy from liabilities to assets courtesy of SDRE, and increasing property values. In the process with such an FHFA underwriting standard for PACE finance, the transaction costs for PACE financing should come down, and communities should make rapid progress in Clean Air compliance and economic competitiveness.

The EDF "Investor Confidence" project ain't it

The investor confidence project is an overly complicated solution for a self-created problem that does not exist, except as an outcome of faulty analysis and faulty policy. This approach to creating investor confidence in energy efficiency projects, is "necessary" only because energy efficiency is NOT an investable asset. This mistake was further compounded historically by the inappropriate rationalizations of "the fifth fuel" (Amory Lovins), and "negawatts," which resulted in a financial mythology that energy efficiency is an investable asset, when it is only an operational savings, and a secondary objective, because it applies equally to fossil fuel or renewable energy systems. Once it is seen that value creation lies in SDRE, in moving energy from liabilities to assets, F&F could instead have a simple requirement that hinges on two things, a proper thirty year energy plan for the property, based on the EPA's Energy Star Portfolio Manager, combined with a 30-year CAPM analysis showing a positive NPV for the energy retrofit.

Climate Change, and Net-zero construction

Besides the fact that net-zero construction has been the most consistently healthy part of the construction industry for the last 40 years, the states are also moving ahead. California just adopted a rule that all new buildings have to be net zero by 2020. New York in its 2014 draft energy plan speaks of achieving 50% GHG-reductions by 2030, and 80% by 2030. In other words, any new projects that are to be undertaken must produce a minimum of 50% GHG reduction, and we can't afford any longer to waste precious resources on the typical 15-25% improvements of "energy efficiency" projects.

Off a cliff, or off into the sunset?

F&F must address the issue of energy upgrades constructively, lest they abandon the one opportunity for a sure path to structural capital appreciation in real estate that is in front of us today. If this is done, they can do more for the country's energy future than the piecemeal approach that has prevailed so far. It would get even better if the Baucus energy-tax revisions were seriously pursued and extended to include the demand side, replacing widget-level incentives with simple overall goals of GHG-reductions which can be easily verified, with tools like the Energy Star Portfolio Manager.

Property valuation and underwriting standards

With the drive to net-zero new construction and higher value SDRE upgrades to existing properties, it is inevitable that eventually finance for new construction will demand net-zero, to qualify for the lowest cost finance. For existing properties, PACE upgrades will become the norm, and with new purchases of existing properties perhaps we will see combination deals of mortgages with PACE financing, for after all, typically a PACE upgrade can be repaid quicker than a thirty year mortgage.

The downside is that existing properties, if they do not have at least the potential for 50% SDRE, have energy efficiency as their only option, with all the limitations that come with that. It seems almost inevitable that 50% SDRE will become a standard for mortgage lending for resale of properties, because of what it implies for long term stability of the property. Below that, properties are likely to be scrapped before their designed economic life. In short, there will be a fallout of value decreases in properties that are not capable of being upgraded. The impact of these changes on the F&F holdings should be studied and understood in order to design a meaningful future underwriting policy.

Source: FNMA, FMCC - You Can't Go Home Again