A simple new rule of the Federal Housing Administration should be counted as a recent innovation in energy efficiency finance: For a homebuyer to qualify for an FHA-insured mortgage to purchase a newly built house, the house must meet the standards of a modern energy code.
You might be surprised this merits an award for innovation because to most people this rule sounds like fine-tuning, not grand invention.
But FHA's rule is important on two levels. Directly, it means every FHA borrower will be sure to get a code-compliant house. FHA insured about 700,000 purchase mortgages in 2013. About 10 percent were for new home purchases. FHA's policy will save money for these approximately 70,000 homeowners — every year, for the life of the house — and cut pollution from power plants that don't have to make power that would otherwise be wasted.
But FHA’s innovative policy will have a broader effect on the market: It demonstrates that lenders and investors should be interested in the efficiency of the property that secures their mortgage loans.
Why? Because energy efficient houses are better, more valuable houses. Homeowners in these houses realize savings every month in the form of lower utility bills. These factors make for better loans.
Any house that fails to comply with the energy code should have a label that says: “This house probably has hidden defects your inspector and appraiser won’t notice…Caveat Emptor!” Alas, non-compliant homes don’t carry such a label. People buy non-compliant houses unaware of what’s in store. They are soon stuck with high utility bills and will likely face pricey repairs to insulate the house, improve air sealing, and install a modern air conditioner.
It makes much more sense to build houses properly in the first place.
FHA’s policy is simple to implement – the home builder merely signs a builder certification form attesting the house meets or exceeds the applicable code. Now, it's the 2006 International Energy Conservation Code, but it's on the way to being upgraded to 2009, then 2012.
Yes, it’s true that most cities and states already have building codes, including energy codes. Some will ask why lenders should be involved. The answer is that some cities and states still have sub-par energy codes, and many cities and states have insufficient funds to monitor and inspect all newly built houses.
It is also true that a code-compliant house is more expensive — in other words, it’s cheaper to build a defective house. But the requirements of the energy code are grounded in cost-effectiveness. This means the savings from lower utility bills, on average, will more than pay for the added cost of building a house without hidden defects. (Click here for the Pacific Northwest National Lab’s report on the cost-effectiveness of 2012 IECC codes).
FHA relies on appraisers to validate the value of a house – this is the cornerstone of prudent risk management. But appraisers do not — and are not expected to — account for the many aspects of the house covered by energy codes, such as the amount of insulation in walls, or the integrity of the air sealing in the attic or around windows. These defects are hard to detect in the typical home purchase/sale process, so it is unlikely they are "priced into” the value of the house today. When a builder cuts corners on these factors, the homeowner discovers it, especially on days like we had in D.C. last week – 20 degrees F and windy!
FHA’s policy is market-leading. In contrast, Fannie Mae, Freddie Mac, and major mortgage lenders (e.g., Wells Fargo, Citi Mortgage, Bank of America, Chase, etc.) currently do not have similar requirements – their loan process ignores whether a house complies with minimum energy codes when deciding whether to loan money to the homebuyer.
FHA’s new policy points the way forward for 2014 — here's why:
For many years, the spotlight in energy efficiency was on new kinds of loans intended to help a homeowner or commercial building owner fund efficiency repairs. PACE loans, On Bill Loans, and energy service agreements are a few examples of new ways to finance improvements. Many of these are in place and can be useful.
A priority for 2014 is to improve how conventional loans enable and encourage investment in more efficient houses and buildings. FHA's smart new policy is instructive about the role of minimum property standards and should be followed by other lenders, but code compliance is not the only tactic. Fannie Mae’s excellent “Green Refi Plus” loan program is very instructive — it enables multi-family owners to invest in needed efficiency repairs to bring the property up to a minimum standard at the time of refinance.
We urged FHA to make a priority of implementing this rule (click here to see the group letter we authored to HUD Secretary Donovan). The policy was actually required under the 2005 EISA Act, but FHA had never implemented it!
There are compelling reasons why other lenders and investors should adopt similar requirements. I would argue that mortgage enterprises Fannie Mae and Freddie should implement a similar energy code requirement on new single-family home purchase mortgages. Not only because it helps Fannie Mae and Freddie Mac fulfill their important affordable housing mission by reducing the cost of housing, and not only because the policy helps to fulfill the important national goal of cutting pollution from dirty fuels to produce power that is wasted in defective houses, but becasue it is prudent and sensible risk management to raise the quality of the housing stock that secures mortgage loans they purchase.
This blog post originally appeared on Switchboard. It was cross-posted with permission. Philip Henderson is a Senior Financial Policy Specialist for the Natural Resources Defense Council (NRDC) in Washington, DC. He's worked for years to bring innovation to the mortgage finance industry, including at two dynamic technology companies. At NRDC's Center for Market Innovation, he and other colleagues are working at the intersection of finance and efficiency to promote innovation and to make the better future that is possible a reality today.