Energizing an old product.
Two painful encounters with international energy crises--first in 1974 and then again in 1978--generated powerful economic and political impetus to reduce energy consumption and dependence on foreign oil in this country.
In response to this wake-up call to American policymakers and consumers, in 1979, President Carter directed all federal agencies providing secondary mortgage market facilities to incorporate energy-efficiency considerations into their underwriting standards.
Specifically, Fannie Mae, Freddie Mac and GNMA were directed to create an Energy Efficient Mortgage (EEM) program designed to finance the construction of energy-efficient new homes, as well as the purchase and retrofitting of existing homes. Borrowers using such a program could finance the high initial expense of residential energy improvements through a first mortgage over 15 or 30 years, thus minimizing one of the major obstacles to undertaking energy conservation measures.
But even with these incentives, the widespread use of this socially conscious mortgage product has remained a policymaker's dream rather than a real accomplishment. However, recently with new leadership in Washington that has elevated energy issues to a higher place on the public agenda, EEMs have been given a new jolt of energy with the announcement of a new pilot program under the FHA banner.
On May 24, acting on a provision in the Housing and Community Development Act of 1992, HUD established an FHA Energy Efficient Mortgage pilot program. The program, outlined in Mortgagee Letter 93-13, will be for existing properties in Alaska, Arkansas, California, Vermont and Virginia. Under the pilot program, a borrower can finance 100 percent of the cost of eligible energy-efficient improvements into the mortgage, subject to either a $4,000 limit or 5 percent of the property's value (not to exceed $8,000), and this can be done without an appraisal of the energy-related improvements.
According to FHA Commissioner Nicholas Retsinas, to be eligible for inclusion, the improvements must be "cost effective" (i.e., the total cost of the improvements, including the maintenance cost, must be less than the total present value of the energy saved over the useful life of the improvements). The job of estimating energy savings must be done by an independent entity, not related directly or indirectly to the seller or the prospective borrower.
According to HUD, the lender under this pilot program will first process the mortgage application and qualify the borrower using the standard underwriting requirements and qualifying ratios under FHA rules. If the borrower elects to have an EEM and add the cost of the energy-efficient improvements to the mortgage, the lender must obtain a report prepared by an independent energy consultant or the Home Energy Rating System verifying the "cost effectiveness" of the installed energy-efficiency measures. Under the pilot, HUD will insure the mortgage before the energy-efficient improvements are installed, provided the lender establishes an escrow account and deposits the funds into it to pay for the improvements.
Higher ratios the key
The EEM mortgage programs established earlier by the secondary market agencies in response to President Carter's directive share certain basic characteristics. The most critical feature is they are mortgages with 2 percent higher debt-to-income qualifying ratios. That one modification can translate into a roughly 7 percent increase in a borrower's purchasing power. This enables a homebuyer to qualify to purchase, finance and/or refinance a home with energy-efficiency improvements that they otherwise might not be able to afford.
For lenders, there is some innate appeal in this product as well. In essence, stretching qualifying ratios by 2 percent for an energy-efficient home might allow lenders to qualify more mortgage applicants for modestly priced housing, who otherwise couldn't afford to buy. It also allows buyers to increase the size of their mortgage and use the proceeds to upgrade the energy efficiency of their homes.
Energy-efficient homes will produce lower monthly utility bills and, therefore, the theory goes, more monthly income will be available to pay higher monthly mortgage payments. As a result of the reduced monthly energy bills, mortgage lenders can justify stretching qualifying ratios without lowering their overall underwriting standards or increasing their default risk. All the secondary mortgage market agencies accept the higher debt-to-income ratios and the subsequent financing of the energy conservation measures. What's more, virtually all lenders can currently participate in the EEM program, which offers both fixed- and adjustable-rate mortgages. Lenders who keep their originated EEMs in portfolio obviously can exceed the secondary market program's qualifying ratios.
Guidelines and mechanism
The Fannie Mae EEM guidelines allow additional financing for energy conservation up to 15 percent of the base loan amount or a maximum of $28,837. The Freddie Mac guidelines allow additional energy conservation financing up to 10 percent of the base loan or a maximum of $18,670.
FHA can insure a maximum additional financing of 5 percent of the current maximum FHA loan amount of $151,725 (for high-cost areas) if the energy improvements are appraised by the original FHA fee appraiser. Up to $2,000 in energy-conservation measures can be financed through the FHA-insured loan without an appraisal.
The VA will insure energy improvements up to the maximum of $2,000 without separate determination of the value of improvements. Up to $6,000 of the energy-efficiency measures can be financed if the value of improvements can be supported by a designated appraiser.
In order to determine if an existing home needs energy-saving improvements, the local utility company ordinarily will perform a free energy audit. Most large utilities in the country already have energy-conservation departments staffed with energy auditors who perform free home audits.
Typically an energy auditor will recommend to the homebuyer and borrower one or several of the following cost-efficient energy-conservation measures: putting insulation in the attic, walls and floors; installing water heater insulation blankets and low-flow shower heads; wrapping pipes and ducts; the weather-stripping and caulking of windows and doors; planting shade trees and, finally, installing new energy-efficient equipment such as heating ventilation and air conditioning (HVAC) systems, heat pumps and solar water heaters.
Most utilities currently have a variety of rebates and low-cost financing programs to assist their customers in improving the energy efficiency of their homes.
In addition to utility company energy auditors, energy-efficiency assessments can be made by a VA-designated appraiser or any certified energy manager (CEM) for FHA and conventional loans. In order to ensure uniform standards for the energy audits, auditors and CEM home inspectors must fill out either the Freddie Mac Form 70A, the identical Fannie Mae Form 1004A or the HUD Form 91103 for FHA-insured loans.
After the energy audit is performed, the energy auditor will recommend certain cost-effective energy improvement measures and complete the required form. The homebuyer then selects a contractor specializing in energy-conservation renovations, who then provides a firm bid for the recommended measures. After the contractor's bid is accepted, funds are set aside in an escrow account. Title to the ownership of the property will be transferred from the seller to buyer and the mortgage funds distributed. After the mortgage note is executed and shipped to the secondary mortgage market agency, the energy-efficiency installation measures are completed and the contractor is paid from the escrow account. Only at this point can the escrow account be closed.
With all that going for this product, one might well wonder why EEMs have failed to become more commonplace. The EEM program has achieved, to date, only a very slight share of the new construction and existing home finance market. Neither Fannie Mae nor Freddie Mac keeps separate statistical information on EEMs, so it is impossible to pinpoint with any certainty their market penetration and potential.
Yet, what we know about the volume that's been done so far hardly represents a portrait of an instant success story for a promising and timely mortgage product. The National Association of Energy Efficient Mortgage Companies estimated that only one in every 20,000 mortgages in the United States currently are done through the EEM program.
However, in our view, the market potential is there waiting to be tapped, particularly for the new construction market. Virtually all new construction mortgages in the United States could classify as EEMs, if only lenders and borrowers elected to pursue and apply for them. Fannie Mae adopted the 1989 Model Energy Code established by the Council of American Building Officials as a baseline standard for energy-efficient homes, and most of the new construction homes meet the standard.
Furthermore, 11 states already have state building codes that exceed the minimum guidelines established by the 1989 Model Energy Code. For instance, Title 24 in California mandates certain energy standards; consequently, all new residential construction in the state automatically meet the Fannie Mae definition of an energy-efficient home. Lenders and builders could qualify more buyers of newly constructed homes, and particularly first-time homebuyers, if they simply used the EEM's stretched qualifying income ratios. Yet, very few new homes have been financed through this program.
Why is this the case? Why is this potentially powerful tool for first-time homebuyers not being used to the fullest extent possible, given that the affordability crunch is as bad as it is? The following is a list of some of the primary market barriers holding back the development of the EEM program nationally:
* Diminished financial incentives--The high cost of energy ceased to be the riveting problem that it was in the late 1970s. The real and nominal cost of energy declined in the early 1980s, and consequently, consumers lost the strong financial incentive to conserve energy. Accordingly, home energy efficiency assumed a lower priority for most homebuyers. Secondly, real and nominal mortgage rates declined in the 1980s, allowing lenders to qualify a healthy volume of mortgage applicants without having to resort to the stretched qualifying ratios of EEMs.
* Market acceptance--Many lenders and appraisers openly question whether investment in home energy improvements translates automatically and equally (dollar-for-dollar) into higher property values. Very few, if any, home improvements translate automatically and proportionately into higher property values. Appraisers are reluctant to automatically assign higher property values to these energy-efficient homes without market confirmation from current sales prices that higher values are warranted. In the event of default and repossession, lenders are concerned that the appraised value of energy-efficient homes will not reflect the higher loan amounts extended under the EEM program.
Property value is a function of many local real estate market variables. One such local market variable is the consumer preference and attitude regarding energy efficiency in that area. Homeowners in real estate markets in colder climates place much higher value on energy efficiency than borrowers in the Sun Belt, where energy cost is mitigated greatly by the mild climate. For instance, real estate markets in the Northeast can easily translate energy-efficiency improvements into proportionately equal increases in property value.
Another local market factor is that it takes time to translate consumer awareness and attitude regarding energy efficiency into higher market values. It took many years for fuel efficiency ratings for new cars to become a standard factor influencing car buyers and affecting new and used car values. Energy ratings for homes eventually could influence property values as much as the miles-per-gallon sticker influences car values now.
* Increased risk--Lenders are concerned that an EEM's higher loan amount translates into a higher loan-to-value ratio and thus represents greater risk of default. In order to address this issue, in 1992, Fannie Mae examined a list of 10,000 energy-rated homes that were rated by an Arkansas-based nonprofit organization Energy Rated Homes of America. According to Chip Coffay, the manager of mortgage standards at Fannie Mae, 1,031 homes on that list were in Fannie Mae's portfolio, and the delinquency rate for those loans was 0.6 percent. That rate is almost identical to Fannie Mae's overall portfolio delinquency rate of 0.55 percent. In addition, 63 percent of the 1,031 homes that were part of Fannie Mae's portfolio had a loan-to-value ratio below 75 percent, and only 6 percent of those homes had a loan-to-value ratio exceeding 90 percent.
* Limited consumer awareness--In our view, the main reason that the EEM program has experienced limited market penetration is due to scant consumer awareness about the program. When consumers understand the value of EEMs and demand the product, then lenders will offer the mortgage and promote it as one of their product offerings. "In the 1980s, lenders, secondary market agencies, energy-rating groups and utilities spent a lot of time educating and informing each other about the EEM," said John Hemschoot, the Freddie Mac director of mortgage policy. "Now is the time to educate and inform the consumer/homebuyer, which will take a visible and high profile effort."
* Lack of guideline uniformity--Currently, there is no uniform standards among the secondary market agencies with respect to procedures, loan amount limits, completion deadlines and types of allowable improvements. Current EEM standards are complex and vary significantly among different lenders.
* Institutional reluctance--Lenders and real estate agents fear that including energy-efficiency improvements into the conventional mortgage financing process when buying an existing home would only delay the closing and eventual sale of the loan into the secondary market. The perception of many mortgage industry participants is that EEMs only complicate and delay an already complex mortgage approval process. Both real estate agents and mortgage originators are paid commissions only when escrow is closed, so there is a built-in institutional reluctance to postpone the closing of the escrow.
* Seller's and buyer's reluctance--Purchasing a home is an emotional experience for both parties. Both buyer and seller are eager to complete the transaction and close the escrow as soon as possible. Installing energy-efficiency modifications in older homes only adds factors that can potentially complicate or even derail the transaction.
The seller is understandably reluctant to disclose the extent of energy inefficiency or the true energy cost of the existing home if it's under par, because doing so might jeopardize the sale or the price paid. The buyer is often reluctant to hike the cost of purchasing that particular home by adding energy-efficiency improvement costs to the basic purchase price. Furthermore, most private mortgage insurance companies will not waive their policy requirements and allow an EEM to exceed established loan-to-value ratios. Consequently, homebuyers might end up paying mortgage insurance premiums if the added mortgage amount to pay for energy improvements increases the loan-to-value ratio. Finally, the buyer always has an option to postpone home energy-efficiency improvements and to pay out of pocket for the improvements at a later date.
* Value of the energy efficiency to the buyer--The EEM program is designed specifically to finance energy-efficiency improvements in older homes and not to qualify applicants for a home that otherwise they could not afford. Stretching the qualifying ratios does not mean that a buyer can buy a bigger house, or a house in a better neighborhood, but only an energy-efficient home and thus an improved home. The basic purpose of an EEM is to allow the borrower to merely purchase a house that can be upgraded into an energy-efficient home and make available the necessary funds to accomplish this at the time of purchase.
The buyer can prequalify for the same house without the EEM program, but the house would lack the energy-efficiency measures or the necessary funds to make the energy-efficient upgrades. Stretching the qualifying income ratios by 2 percent and thus increasing borrowers' purchasing power by 7 percent means that the buyer can afford to invest today in energy-efficiency improvements. But the homebuyer must be energy conscientious to want and insist on such a mortgage program in the face of possible seller and real estate agent resistance to the extra steps involved.
* Competition from the local utilities--Finally, the EEM program has one major competitor. Many local utilities have aggressive energy-conservation programs that offer customers attractive rebates and low interest rate financing for home energy-conservation improvements. Often, homeowners actually are better off participating in the utility's energy-conservation programs than undertaking and financing their own energy-efficiency improvements through the EEM program. However, utility-sponsored energy programs are often seasonal in nature and subject to availability of funds; thus these programs are not continuously available.
The initial intent of President Carter's 1979 directive to the secondary market agencies to incorporate energy-efficiency factors into their underwriting standards was to foster energy-efficiency and not to promote mortgages.
Mortgages, under this program, are really only a vehicle for achieving energy conservation. Consequently, the local utility with an active energy-conservation program is a prime candidate to assume the role of EEM program coordinator. A local utility company can easily and inexpensively promote and advertise the EEM by providing and mailing the necessary program information along with the utility bill. A local utility company, which in major markets probably spends millions of dollars on energy-conservation programs, can assign one person, on a full- or part-time basis, to coordinate and manage the EEM program locally. For instance, that person could be responsible for introducing the program to the local real estate community by sponsoring workshops and operating a telephone hot line.
Make it simpler
But there is another factor that must be addressed to put EEMs on the map in a significant way. The EEM program for resale properties has to be simplified. The EEM program for new construction is simple and straightforward because building codes in many states mandate construction of energy-efficient homes. The stretched 2 percent qualifying income ratios provide clear and substantial incentive for lenders and borrowers to originate EEMs for newly constructed energy-efficient properties. However, the program is complex for financing the resale of older homes built prior to the enactment of strict, energy-efficiency building codes.
For the program to have real value for homebuyers, participation in the EEM program should be made easy for all interested parties, including sellers, buyers, lenders, real estate agents, energy auditors, energy-retrofit contractors, appraisers, mortgage insurance firms and escrow agencies. Fannie Mae, Freddie Mac, the VA and FHA should develop a single, uniform EEM program standard with a maximum additional loan amount (for example, $5,000) that can be invested in energy-efficiency improvements without any additional appraisal documentation.
In addition, the EEM program delivery mechanism can be simplified. Once an energy audit is scheduled, either by the buyer or real estate agent, a cooperating utility company can assign a priority to the EEM audit request, so that turnaround time can be shortened. After the energy audit has been completed and the required secondary market form filled out, the buyer can then apply for the EEM and solicit firm bids from established energy contractors, referred by the local utility. After the firm bid is accepted, then the additional loan amount for the energy improvements is determined and added to the total mortgage amount. At this time, additional escrow instructions can be executed so that predetermined funds are allocated and specified for the energy improvements.
All of the energy-efficiency improvements are done at a later date, within a certain specified time, after the mortgage funds are distributed. The entire process can take only several additional days in escrow, so there is no substantial delay in the closing of escrow. After the energy-efficiency improvements are completed and accepted by the homebuyer, the contractor will receive the funds from the specified escrow account.
The EEM program provides local utilities with an opportunity to add many more participants to their energy-conservation programs by going beyond their limited energy-conservation financial resources. This can be done by tapping into the capital of the federally sponsored secondary mortgage market to further a cause that benefits many. In many ways, putting a little energy into making this program work would pay big dividends.
Misha Sarkovich, Ph.D., is an economist for the Sacramento Municipal Utility District. Nancy Sequest is president of the Energy Efficient Mortgage Service Company in Sacramento.
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|Title Annotation:||energy-efficient homes|
|Author:||Sarkovich, Misha; Sequest, Nancy|
|Date:||Aug 1, 1993|
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