In May of this year, the U.S. Treasury Department filed proposed federal income tax regulations that would, to a limited extent, open up real estate investment trusts (REITs) to solar energy investments. Solar and wind developers in particular have recently been looking to REITs as a potential new financing source for their renewable energy projects. Yet despite years of anticipation, the proposed regulations have mostly been met with a collective yawn from the renewable industry.

On one hand, a REIT’s ability to own or operate a renewable energy project should increase the debt financing opportunities for solar projects. Currently, there is a very robust debt market for REITs, and the potential influx of new participants to the market could improve competition amongst the existing participants and decrease overall costs.

More importantly, it is believed that the push of renewables towards REITs will allow more renewable projects and portfolios of such projects to be rated. If this were to happen, it could serve as a boon for the solar industry in particular by helping to thrust solar energy into the mainstream finance world.

Good intentions

If REITs were to go for solar investments, it could also open up the market for commercial-scale projects. Currently, it is very difficult to get financing for portfolios of commercial-scale projects that are not investment grade; however, in the REIT market, it is very common for many of the tenants in the buildings to not have investment-grade credit. If the same applied to large rooftop solar projects, then one could envision a scenario whereby the commercial-scale solar market could open up significantly.

If the use of REITs for solar investment could actually open up new sources of capital for renewables, allow more debt financing and potentially solve the debt-rating challenges for the commercial-scale renewable market - then what’s the problem?

The problem is the federal tax code. If REITs can readily invest in solar projects, those projects will still need to find tax equity to utilize the federal tax benefits from those projects, i.e., federal tax credits and accelerated tax depreciation. Because given that most REITs are typically passive entities and, thus, are passive investments for tax purposes with respect to the REIT owners, a taxable REIT subsidiary (to allow for “tax equity investors” to participate in a partnership) would potentially be required.

This type of financing structure could also provide the required active management of the renewable assets and provide the typical indemnities and other guarantees for the tax equity providers. Those providers also typically require substantial net worth and liquidity from the sponsor, another facet of the partnership that would need to be addressed.

Another aspect to consider is that REITs are not necessarily able to participate in development and, therefore, could only invest when the project is completed. While there are some REITs that have taxable REIT subsidiaries, these subsidiaries are usually not large enough - i.e., they don’t have enough taxable income to efficiently monetize on the tax benefits that come with the larger portfolios of projects - and therefore can’t bid like a tax efficient buyer.

But why aren’t REITs doing it now on their own buildings?

A very small handful are doing so, primarily because most REITs don’t owe taxes at the company level and cannot utilize the tax advantages listed above due to existing federal tax rules. Also, REITs typically require their tenants to pay the utility expense for their share of the building’s energy costs, i.e., the REIT passes on the costs through to the tenant.

If the REIT installs solar on its buildings, the REIT is effectively just decreasing the amount that the tenant would pay to the utility, but the REIT is not able to monetize the difference. While the potential exists to structure a vehicle around this, to date most REITs have not found it profitable to do so. Therefore, renewable project developers probably shouldn’t get overexcited about REITs or the recently proposed REIT regulations at this point.

However, there is good news. The renewable market has already seen a major improvement in the cost of capital, and it is more competitive than ever. Part of this is due to the advent of yieldcos as another provider of low cost of capital. Yieldcos could actually be a better form of capital as compared to REITs for renewable energy projects because of the taxation structure. Distributions in yieldcos may be a more tax-efficient vehicle for shareholders, as REITs are taxed at regular income tax rates for distributions while the yieldcos’ cash distributions are taxed at the capital gains rates.

So while interest in REITs may herald a new wave of capital looking to enter the market, it doesn’t necessarily mean that it will be the lowest cost option. R

Conor McKenna is managing director of Reznick Capital Markets Securities and head of the firm’s West Coast operations. McKenna’s primary responsibilities include mergers and acquisitions, debt and equity financing, tax equity advisory, buy-and-sell-side advisory, and due diligence services.