DBRS Report on C-PACE
DBRS Morningstar’s Commercial Property Assessed Clean Energy ABS Sector Outlook: Stable Despite Coronavirus
Despite the ongoing impact of the Coronavirus Disease (COVID-19) on the U.S. economy and on borrowers’ ability and willingness to repay outstanding debts, DBRS Morningstar’s outlook on the commercial property assessed clean energy (C-PACE) asset-backed securities (ABS) sector is stable. The coronavirus pandemic has had a limited effect on the C-PACE sector to date. With the closure of many nonessential businesses across the U.S., jobless claims have exceeded 47 million since mid-March, severely disrupting overall economic activity. We expect portfolios with exposure to hotel and retail properties to be the most negatively affected. Nonetheless, we expect limited credit deterioration in C-PACE securitizations due to the seniority of amortizing PACE assessments and underlying low loan-to-value (LTVs) ratios .
By providing short-term financial assistance, in the form of loans or grants related to the pandemic, the Coronavirus Aid, Relief, and Economic Security Act has alleviated some economic difficulties on borrowers experiencing hardship—including consumers, small businesses, and large corporations.While we expect more pronounced performance deterioration in higher credit risk portfolios, the structural features and protections in typical C-PACE transactions will likely help mitigate the effect of deteriorating borrower credit. However, the uncertain magnitude of the economic impact related to the coronavirus may exert differing degrees of downward pressure on certain subordinate tranches.
In the context of this highly uncertain environment and in the interest of transparency, we revised our set of forward-looking macro-economic scenarios for select economies related to the coronavirus in the commentary Global Macroeconomic Scenarios: June Update, published on June 1, 2020. In our rating analysis, the moderate scenario is serving as the primary anchor for current ratings, while the adverse scenario serves as a benchmark for sensitivity analysis. This moderate scenario primarily considers two economic measures: declining gross domestic product (GDP) growth and increased unemployment levels. For asset classes where commercial-based obligors are the source of cash flows to repay the rated transaction, among other things, GDP provides the basis for measuring performance expectations.
Key highlights for the U.S. C-PACE and Single Asset Single Borrower (SASB) C-PACE asset classes include:
- We believe that increases in C-PACE assessment payment delinquencies will be limited. The combination of priority, low leverage resulting in non-acceleration of senior payment relatively small loan payments, and debt provide the borrower (property owner) with strong incentives to pay the C-PACE assessment rather than risk losing ownership of the asset through a tax foreclosure sale which would jeopardize other typically larger capital components of the project.
- In the unlikely event of a borrower’s failure to pay the C-PACE assessment when due, the same combination of factors provides the first mortgage lender or other junior capital provider with significant capital exposure in the transaction with a strong incentive to make a protective payment to retain its lien on the property.
- We also believe the increased risk of construction delays on properties undergoing new construction or gut rehab should not translate into a significant increase in C-PACE assessment payment delinquencies. Most of these properties have completion guarantees from one or more principals of the developer to help mitigate the construction completion risk.
- A liquidity reserve account is typically established and funded from the proceeds of the C-PACE financing at the time of the loan closing. Proceeds in this account are typically structured to cover C-PACE assessment payments during the property’s construction and stabilization period. Because of the capitalized interest and principal reserves, the first C-PACE assessment due date for payments paid from property operations is typically a year or more out, after the construction is expected to be completed.
In the unlikely event that a payment default forces a foreclosure sale and change of ownership, the new property owner will be required to make delinquent payments, pay any late fees, and take over future payments. Because C-PACE loans do not accelerate, the new owner will not be responsible for an immediate payoff of the current outstanding loan balance. This important characteristic facilitates the transfer of ownership and continuity of payments. However, notwithstanding this benefit, in some cases, the new owner may choose to pay off the outstanding C-PACE loan at time of transfer.
Finally, there are structural features of C-PACE securitizations that are beneficial to investors. For example, a typical structure includes one class of notes, whereby the ultimate payment of principal and interest mitigates liquidity concerns. In addition, as mentioned above, capitalized interest reserves and interest only periods during project stabilization also help to minimize default risk in early loan periods.
For more information, please see our commentary Global Macroeconomic Scenarios: Application to DBRS Morningstar Credit Ratings, published April 22, 2020.