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Jun 5, 2013

How Real Estate Investment Trusts Can Change the Clean Energy Industry


At the risk of imitating New York Times columnist Thomas Friedman, I was recently reminded just how amazing cellular infrastructure is when I used my cell phone in the Colorado Rockies to call my dad’s cell as he was traveling in southeast Asia. The technology that’s enabled this kind of instant connectivity is truly impressive. Equally impressive (at least to a finance geek like me) are the financial structures behind much of our cellular infrastructure today. Namely, I’m talking about an internationally used company entity-type called a Real Estate Investment Trust (REIT).

Here in the U.S., REITs are companies electing such a designation under Form 1120-REIT and abiding by Internal Revenue Service (IRS) real property asset and income tests necessary to maintain that designation. REITs can often allow anyone—from real estate tycoons to retail investors like me—to invest in real estate and related assets like the Colorado cellular towers that played a major role in carrying my phone’s signal from the Rockies to Bangladesh.

While REITs don’t finance all cell towers, a leading wireless infrastructure provider in the U.S., American Tower (NYSE: AMT), recently converted to a REIT, while several other companies in the space have signaled their intent to convert to a REIT structure over the next few years. Now, this REIT financial instrument is coming to the world of clean energy.

In one of the larger recent clean energy-related public offerings, the same financial instrument that’s capturing an increasing share of the cell tower market was recently applied to renewable energy and energy efficiency projects. On April 18, Hannon Armstrong Sustainable Infrastructure Capital Inc. went public as a renewable energy and energy efficiency REIT (NASDAQ: HASI), raising $167 million in the process. That’s more than the well-publicized initial offerings of SolarCity ($92 million) and micro-inverter manufacturer Enphase ($51 million) combined. The company has said it will focus, in order, on energy efficiency, renewable energy, and other sustainable infrastructure projects (think transmission and distribution projects and smart grids).

This offering comes at a crucial moment. Despite global investment in renewable energy to the tune of $260–$290 billion in 2011, right now in the U.S. there’s simply not enough low-cost capital to enable the kind of explosive growth in renewables and efficiency needed to realize our 2050 Reinventing Fire vision. However, the path to 2050 is certainly helped by the introduction of REITs to renewables and efficiency, providing a new, public source of capital.

What are REITs and why should we care?

REITs help renewable energy developers since their structure avoids taxation at the company-level. All things being equal, a project-financing developer can offer more affordable renewable power from a project if they don’t have to pay taxes. That means more competitive renewable power!

Hannon Armstrong’s successful IPO as a REIT may be a signal for other companies considering the same tax-exempt structure. For some time, it’s been unclear if the Internal Revenue Service considers solar assets “real” as opposed to “personal” property (75 percent of a REITs annual gross income must come from “real” property) and we still don’t know with any certainty whether REITs like Hannon Armstrong officially meet this standard. But even though the IRS private letter ruling to Hannon Armstrong technically only applies to them, it could be used as guidance for other industry participants, according to some legal experts.

These are all salient observations, but they don’t quite hit on the central point: REITs—like other low-cost financing mechanisms for renewable energy projects such as asset-backed securitization, master limited partnerships, and crowdfunding—can help lower the cost of renewable energy and energy efficiency.

How does a REIT lower the cost of capital?

A high cost of capital is a major barrier to deploying affordable energy efficiency and renewable energy projects on buildings of all shapes and sizes. This high cost of capital can translate into high-cost electricity, even if the cost of the actual equipment (solar panels, high-efficiency HVAC systems) is low. And while some mechanisms, such as debt-based crowdfunding, are helping to lower the cost of capital, REITs have a valuable role to play here as well.

I’ll use a solar example to illustrate how financial instruments like REITs can change this. Right now, a typical solar developer financing a pool of residential or commercial building projects uses capital with a combined hurdle rate in the 10–15 percent range. This high, credit-card-interest-like rate is largely due to financing via tax equity and developer equity partnerships. There is a limited pool of tax equity providers, leaving a supply/demand imbalance and high cost of capital, and the venture equity currently supporting many distributed solar development firms also expects high returns.

Like solar developers, REITs take investor money and use it to construct projects, generating an average total yield of about 10 percent annually over the past 30 years. So while the cost of capital should be toward the lower end of capital currently coming from solar developers, the pool of capital to pull from is much deeper. Hedge funds, pension funds, endowments, mutual funds, and retail investors can all invest in REITs. If solar proves to be the reliable asset class we believe it will be, costs of capital for REITs exclusively or heavily invested in solar should be able to come down further over time.

However, it’s a bit tricky to know how REITs will be able to participate alongside tax equity. While there’s a lot of entrepreneurial minds trying to crack that nut, it seems likely that today REITs can provide debt or “take-out” financing, buying out the cash flows from the developer once the tax equity has exited the deal structure (after about year six; early lease/PPA deals from 2006 and 2007 are the first candidates). So this could be a way for developers to put more cash on their balance sheet to fund more new projects now, instead of waiting for the cash flows to come in slowly over another dozen years or so.

Will retail investors and their lower cost of capital have continued appetite for renewable REIT stocks? Several financial analysis outlets have made some positive points surrounding Hannon Armstrong’s IPO and its attractiveness to the retail investor. Statements have included predictions of consistent, risk-insulated returns for investors in part due to asset and geographic diversity. Similar features should lend themselves to additional renewable REITs.

How important will REITs be in the future?

Because of their low-cost capital advantage, REITs could be an interesting tool for renewable energy and energy efficiency developers for years to come—especially if IRS treatment of renewable energy and energy efficiency technology is favorable as initially indicated by Hannon Armstrong’s IPO. Also, likely higher impact would occur if REITs can invest equity cleanly alongside tax equity, a challenge still being worked out.

Moving forward, I think REITs have huge potential in the renewable energy and energy efficiency space for another reason entirely. The REIT structure, signed into law in the U.S. in 1960 and amended in subsequent years, was initially created to draw retail investors into the real estate market, a market initially only accessible by high-net-worth individuals and corporations.

When you look at the history of investment in renewables and efficiency in the U.S., it’s really the same story: low-liquidity, private investors have been the dominant financial participants. But REITs investing in energy efficiency and renewable energy could help change this and enable ordinary Joes like me yet another way to reap the financial and social benefits of investing in our clean energy future.

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