Tom Konrad CFA
The last day for a solar developer to submit an application for the Treasury’s 1603 grant program was September 30th, and only for grandfathered solar projects which broke ground before the end of 2011.
Solar panel prices have continued to drop this year, but solar project development remains a capital-intensive business. The 1603 program allowed solar developers to monetize the solar investment tax credit (ITC) much more quickly than they could otherwise, and this essentially reduced their cost of capital. As the rush of projects begun before the end of 2011 are completed, developers are looking for new ways to finance their next projects, especially since traditional forms of financing have been harder to come by since the financial crisis.
Jan Schalkwijk, CFA, a portfolio manager with a focus on sustainable investments at JPS Global Investments based in San Diego, CA says, “Any solution that further improves financing of solar projects should be of interest to investors; especially if returns come in the form of dividends, from financial structures that are collateralized.”
The Solar REIT
Currently, the only way a small investor can invest in solar is by buying stock in solar manufacturers. I have long argued that solar manufacturers are unattractive as an asset class because of the fiercely competitive nature of the solar industry. The massive decline of solar stocks over the last several years has convinced most investors of the danger of investing in solar manufacturers, even when solar installations are skyrocketing. Since inception in April of 2008, the Guggenheim Solar ETF (NYSE:TAN) has fallen 93%, while solar installations have risen six-fold with rapidly falling costs.
While those rapidly falling costs destroy solar manufacturer margins, they improve the opportunities for profitable solar farms. Yet stock market investors find themselves shut out of this opportunity. The two layers of taxation for public companies make common stocks a less than ideal investment medium for solar farms, unlike the private equity investments and LLCs used by large investors.
What sort of structures might be attractive? Master Limited Partnerships, or MLPs come immediately to mind, since they combine the tax structure of a limited partnership with the liquidity of public exchanges. MLPs allow the investor to avoid the two layers of taxation by passing their tax liabilities (and benefits) through to their limited partners (shareholders), which leads to a level of tax complexity most small investors are unaccustomed to.
In addition, MLPs are limited by law to specific businesses, mostly fossil energy extraction and transport. While extending MLPs to solar and other renewable energy has a certain appeal on the basis of fairness, such an extension would require an act of Congress.
Senator Chris Coons (D) of Delaware introduced The Master Limited Partnership Parity Act to allow MLPs to invest in renewable energy on June 7th, and Representative Ted Poe (R) of Texas introduced identical legislation in the House September 19th. Unfortunately, the chances of these bills becoming law seems low. Govtrak.us puts their chances at only 4%.
A second appealing structure is the Real Estate Investment Trust (REIT). Like MLPs, REITs avoid the double taxation of traditional corporate structures, and are limited to investing in certain asset classes, which in the case of REITs means real property. REITs pass through their income, rather than their tax liability to investors: REIT dividends are treated as ordinary income to the investor.
As Jim Hansen, a financial consultant at Ravenna Capital Management in Lake Forest Park, Washington and publisher of the Master Resource Report notes, “for retail investors the REIT would be the simplest and could be used in IRA’s which MLP in many cases cannot” because a certain portion of MLP income may be taxable, even if the MLP is held in an IRA. Indeed, Congress first enacted the REIT model in the 1960s to enable small investors to “secure advantages normally available only to those with large resources.”
Garvin Jabusch, Cofounder and CIO of Green Alpha Advisors in Boulder, CO and manager of the Sierra Club Green Alpha Portfolio also thinks REITs would be a good structure for solar investments.
“Making PV [photovoltaic solar] a REIT eligible asset class will give investors access to what is currently the best value in solar, the annuity of electric power sales agreements. Currently investors can mainly invest in panel manufacturers (and to some degree BOS [balance of system] providers such as converter manufacturers), which is not these days the most profitable way to play solar. Buying a piece or pieces of solar PV projects on the other hand is profitable right now but is currently the province of private equity investors. Utility scale solar on a project basis is very attractive because, unlike a coal or other fossil-fuels based plants, once the solar plant is running it produces electricity which can then be sold essentially indefinitely without risk of the price of its fuel increasing (or indeed ever costing anything at all), with very low risk of plant failure (and if it does fail, it’s likely only offline for a short time, no risk of explosion), and rela
tively low overhead in terms of maintenance.
“The IRS could declare that solar assets were REIT-safe with a stroke of the pen.”
The other potential advantage of REITs as an solar investment structure is that it would not require an act of Congress for PV to become a REIT-qualified investment class. Joshua L. Sturtevant, an Associate with solar aggregator, financier, and developer Distributed Sun of Washington, DC, has done extensive research on the changes which would allow REITs which would generate all or most of their income from solar generation.
He found that “the IRS could declare that solar assets were REIT-safe with a stroke of the pen. Because of the broad authority it has been granted to regulate REITs, it could bring solar assets into the fold simply by issuing a ruling to that effect. … [I]t wouldn’t require legislation or huge changes to the tax code.” Getting a favorable IRS ruling might not be easy, but it would almost certainly be easier than getting legislation through Congress.
Sturtevant says that an IRS ruling might take the form of a “private letter ruling” or through a “revenue ruling.” The IRS grants a private letter ruling in response to a taxpayer asking for clarification on an aspect of the tax code applies to them. A private letter ruling does not have broad applicability, in that it is only binding on the requesting taxpayer and the IRS. However, private letter rulings “often end up having some trickle-down influence on business decisions as they are generally accessible to tax lawyers and accountants.”
A revenue ruling is ”often issued at the prompting of a government official. To the extent that an issue might be a close call, it is better for the request for clarification to come from within the government as there is a better chance of obtaining a favorable (from the perspective of the requestor) outcome.”
The Wheels of Government Turn Behind the Scenes
No one was able to tell me anything definite, but there are rumors that a request for an IRS revenue ruling is imminent. In June, the National Renewable Energy Laboratory (NREL) issued a report, ”The Technical Qualifications for Treating Photovoltaic Assets as Real Property by Real Estate Investment Trusts (REITs).” The report concluded that PV meets many of the important criteria to be considered “real property” and hence a proper asset class for investment by REITs.
The fact that NREL issued this report suggests that someone in the government is working to prepare the way for a favorable revenue ruling. David Feldman, an NREL analyst and co-author of the report, said ”We’re not trying to make the decision the Internal Revenue Service will do that. We’re giving them the technical information they need to make the decisions.” But somebody asked them to write the report.
Sturtevant says, “My pulse of the situation suggests that there are parties who are moving to place a request to the IRS by election time. If such a request were successful, it could be less than two quarters before a company claiming REIT status is developing solar.”
Jabusch has also heard rumors predicting everything “from year end this year to Q2 2013.”
UPDATE: The Renewable Energy Trust Capital, Inc., a San Francisco, CA based mission-driven company founded in 2011 to “facilitate the transition to a clean and sustainable economy” apparently already has ruling request “on file with the IRS.” I’m seeking an interview with RET to determine if this is a request for a private-letter ruling (most likely since this is not a government entity) and when the request was filed. 10/12: I’ve published an article about Renewable Energy Trust’s request based on my interview here.
Will the IRS Rule in Favor of Solar REITs?
If there has already been a request to the IRS for a revenue ruling on PV as real property, the the odds are good that the ruling will be favorable for those of us who would like to see Solar REITs. According to Sturtevant, enough political will would be sufficient to guarantee a favorable ruling. The political will is likely to depend on the outcome of the election on November 6th.
Giving solar a similarly advantageous investment structure to the MLPs enjoyed by investors in fossil fuels should be a “politically neutral concept,” as Sturtevant puts it. Obama has long been in favor of leveling the playing field between alternative energy and fossil fuels, while allowing Solar REITs is seemingly in line with Romney’s expressed belief that alternative energy should sink or swim on its own merits: Investors would evaluate each deal on its investment merits, as both Hansen and Schalkwijk implied above. On the other hand, Romney has repeatedly called green jobs “fake” or “illusory” while championing the fossil industries, and has plans to sharply cut funding for clean energy: He may have already concluded that PV has no “merits,” and hence might see little point in giving it similar privileges to the extractive industries he promises to promote in the name of energy independence.
The First Solar REITs
Even if there is a favorable ruling, it may take a while for the first REITs dedicated to solar to emerge. The first movers are most likely to be traditional REITs that are already thinking about renewable energy investments.
A few REITs have dabbled with solar already as a revenue enhancement. IRS rules allow them to generate up to 25% of their income from sources other than real property, and this allows some scope for solar on REIT-owned buildings, for instance. Some solar developers are even specifically targeting the traditional REIT market. However, few REITs are likely to use this option to obtain more than a few percent of their income from solar because “ the IRS tends to be very wary of anything that doesn’t smell right in the context of REITs” and “ leads to wariness and conservatism by many REIT managers,” according to Sturtevant. REIT managers generally feel that a little extra revenue is not worth risking greater IRS scrutiny.
The conservatism of REIT managers has most likely already proven a barrier to some potential solar installations on REIT property, and a positive revenue ruling would have the added advantage of giving a green light for existing REITs to install solar on their property.
ProLogis, Inc. (NYSE:PLD) is one of the few REITs not waiting for a ruling. ProLogis had installed 75 MW of solar on its buildings by the end of 2011, and claims to be “just getting started.” According to my calculations (using aggressive assumptions of a 20% capacity factor and $0.10 per kWh electricity price), even 75 MW of PV would generate only $13 million in annual revenue, or 0.85% of ProLogis’s 2011 total revenue.
Another REIT which might be expected to take advantage of a positive revenue ruling in a big way is Power REIT (NYSE:PW). Power REIT invests in the embedded real estate of transportation infrastructure and renewable energy installations. PW currently owns only railroad real estate, but its CEO, David Lesser plans to acquire real estate underlying renewable energy generation (most likely a wind or solar farm) in the near future.
Talking ‘Bout a Revolution
ProLogis and Power REIT will undoubtedly continue investing in renewable energy in any case. Lesser says, “We believe that that there is an attractive investment role for Power REIT to play in the renewable energy space with or without a clarification of PV being included as a real estate asset for REIT purposes.”
But for both investors and solar developers, the IRS could completely revolutionize the solar investment landscape by classifying PV as real property. That revolution could be upon us before year-end.
Disclosure: Long PW
This article was first published on the author’s Forbes.com blog, Green Stocks on October 9th.
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