How to Value a Solar Development Pipeline (Part 3 of 4)

Originally published by Greentech Media.

When gazing into a solar pipeline, it’s easy to lose oneself. It reminds me of when I was a teenager. A certain type of poster, the Magic Eye, was all the rage. The poster was a dense field of dots of various colors. I was told that if I looked into it — no, through it — I would see an image. I just saw dots. 

In this third installment of How to Value a Solar Pipeline (read Part 1 and Part 2), we will explore the third pillar of project finance success: site control. 

Site control is specific to each project. Like with those dots, a sharp analyst may find patterns emerge across project portfolios or pipelines. Unfortunately, however, there are no shortcuts. Each dot, a unique place on Earth, must be evaluated. These dots have individual geographies, unique title concerns, and bespoke agreements. 

In project finance, “site control” refers to an agreement or set of rights to use land or a building surface for the construction and operation of a generating facility. Most commonly, in the case of offsite projects, site control comes in the form of a lease or an option to purchase land, and, in the case of onsite projects, a lease or a license. Fortunately, determining the pull-through rate, or likelihood of successful execution, for site control is relatively simple. Commercial real estate development is nothing novel, and the essential property interests (fee title, leasehold or license) are governed by the same body of real property laws as any other land transaction.

The traditional stages of solar site control development, in ascending order of execution certainty include:

A) For leased land: 

1. Term sheet
2. Option to lease     
3. Executed lease

B) For purchased land:   

1. Term sheet
2. Option to buy
3. Purchase agreement/deed

Although the agreements have their basis in general real property law, solar particularities abound, categorized here as “The Good News,” “The Bad News,” and “The Tax News.” Ultimately, however, generalities are of little value and risk is tough to anticipate in such a heterogeneous space. Most lessons are learned the hard way. In the hope you may be saved from such project finance cruelty, we have included an assortment of lessons learned.              

The good news: Create value, keep optionality, industry maturity

It is no longer enough for the term of the site control agreement to mirror the term of the offtake agreement. As offtake tenors continue to shrink, investors are relying more heavily on uncontracted merchant revenue following expiration of the offtake agreement (“the tail period”). Site control provides an opportunity here. To assign value to the tail period, the project must have contracted site control. In the case of a lease, adding one or more renewal periods at the option of the tenant is a potential lever to add value to a project. (Note: It is important to carefully draft such options so as to avoid triggering transfer taxes; see “The Tax News” section below.)  

As with all project documents, optionality creates value. Many leases restrict the tenant’s use of the premises for a defined “permitted use.” Generally, reference is made to a solar photovoltaic generating facility.  However, be sure to consider whether the definition includes storage or other ancillary services that may be important to valuation now or in the next few decades.

As the solar industry has matured, national title companies have become increasingly sophisticated in their understanding of the asset class. Some title companies now have project finance divisions. This is helpful, for instance, when reviewing a survey and understanding the necessity of something like an interconnection easement.

Title policies, a necessity for financing, are negotiated instruments, and are often left to the final days before closing a transaction. A developer or investor party with an ongoing relationship with a national title company that has in-house solar expertise provides transactional efficiencies in the final stretch. In some cases where the title situation is particularly hairy, a knowledgeable, collaborative title agent may be critical to execution certainty.

The bad news: Lack of interest, hidden costs  

Anyone who has closed a few solar transactions has a dramatic landowner story — a midnight drive in the rain across three states to meet a farmer in the town pub to collect a final signature on the eve of a closing, for instance.

Landowners are a diverse bunch, from large publicly traded corporations to individual families. Their interest in the project also varies, particularly if rent is near what they would receive for an alternative use. Naturally, landowners are not as close to the project as other counterparties (offtakers, utilities, etc.). Adding to the distance, developers commonly execute site control agreements as the first step in the development process, which can often be years before construction starts.

As the developer proceeds with the project, little thought may be given to updating the landowner. Straining this relationship even further, in many areas there is a built-in trust deficit between landowners and solar developers, where landowners and their neighbors have executed option agreements and reserved land, only to find out years later that the developer has abandoned the project or gone bankrupt. Market participants are still recovering from the bad behavior of their predecessors. These factors make obtaining amendments and/or estoppels from landowners all the more challenging — and all the more necessary for financing. 

A critical diligence inquiry would be all communications with the landlord, including any telephone logs. If the answer reveals that the last conversation occurred in 2015, you have some work to do prior to monetization.  But can a project really break over a lease estoppel, you may ask? Answer: Yes.

Generally, site control is modeled as an operating expense, in the case of a lease, or a fixed cost, in the case of a purchase. Costs reflect rent or the purchase price. However, when valuing site control, it is important to think not only of cost to use the land. One must also consider the cost to prepare the land. Geographic and physical attributes matter. 

This may hardly be a revelation, but it is an often forgotten element in early-stage pipelines. Later-stage assets have generally already gone through a geotechnical analysis, a topographic survey and other review. Earlier-stage assets, on the other hand, may not yet have been evaluated in the normal course of development. Certain site preparation costs can destroy the economics of a project, such as grading or tree removal.  Such costs (not squarely in the site control cost bucket and not squarely in the engineering, procurement and construction cost bucket) do not always find a home in the model.

Therefore, look for site preparation costs. If the answer is, “there are none,” it is appropriate to ask, “Why not?”

The tax news: Solar property and real property assessments

In a solar lease, the landowner often continues to pay all taxes assessed on the underlying real property, and the project owner pays all personal taxes assessed on the solar system, as well as any incremental increase to the real property tax assessment due to the solar installation. It is less common, but not wholly unusual, to encounter a “triple net” lease, where the tenant pays all taxes, including real property taxes. Complicating matters, certain jurisdictions such as New York have solar property tax regimes that implicate real property taxes, so that the project company most likely pays real property taxes, if they are assessed.  

This post will not explore all the various tax treatments of solar property, which vary by state and municipality and, in some cases, are quite byzantine. We’ll trust that you will call your lawyer on this one. Nevertheless, it is worth noting certain commonly recurring tax matters.

First, if the land is rezoned or the use of the land changes such that it no longer qualifies for an exemption or lower rate (as is often the case with agricultural land), there may be rollback taxes assessed. It is important to clearly delineate who is responsible for these rollback taxes and the process for payment.

Second, if the lease term extends beyond a certain length, the lease may be subject to transfer taxes. The length of term beyond which transfer taxes apply depends on the jurisdiction, though some can be surprisingly short.  

Third, certain jurisdictions tax leases regardless of length. In such jurisdictions, the filing of a memorandum of lease may trigger an assessment. Thus, you may find portfolios or pipelines with unrecorded leasehold interests where developers have decided to wait to file the memorandum of lease. 

Fourth, if property is being purchased for the solar project, it is important to structure and stage the land transaction and the project transaction to avoid less than advantageous tax treatment.

10 lessons learned the hard way

1. Solar site leases and option agreements typically include cliff dates by which the project must commence construction and/or begin to pay rent. If projects in the pipeline are nearing cliffs, assume extensions will require more development capital. 
2. Until a title report and an American Land Title Association (ALTA) survey have been completed, there still may be binary risk associated with the land. 
3. For rooftop systems, the offtaker may operate in the building, but not own the building. Ideally, the project has a lease with the owner of the building. For certain offtakers, however, their relationships with their commercial real estate counterparties are sensitive enough that they do not allow direct conversations with the building owner. In this instance, site control may flow through the offtake agreement and building owner consents become critical.
4. If the landowner has design review rights, a clear understanding of and adherence to timelines for review is a must, particularly if the project’s revenue is volatile over time (as in the case of solar renewable energy certificates revenue).
5. Often, developers will leave certain economic terms to be negotiated at a later date. This may include the exact layout of the leased area or performance assurances with respect to decommissioning. If this is the case, finalize these terms well in advance of any cliff dates for financing. Otherwise, the landowner may sense the urgency and your negotiating position is weakened.
6. A positive landowner relationship can be helpful during permitting, particularly if the projects encounter NIMBY concerns. Certain pipelines are particularly susceptible to NIMBY concerns.
7. Always consider the operations at the site, which may have implications on project schedule and cost. As to cost, for instance, if the site is agricultural and the developer intends to break ground during the grow season, the developer may need to compensate the landowner for planted crops. As to schedule, for instance, assume certain delays due to testing schedules at school sites and holiday shopping at retail and warehouse facilities.  
8. Long-stop dates need to be just that — long. 
9. Don’t forget your relationship with adjacent landowners. If a project cannot reach the point of interconnection without crossing one or more other parcels, begin conversations with the neighbors early on in the process.
10. Engage real estate and title experts. Both of these matters are incredibly nuanced. A specialist is required.

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