Maryland Commercial Developers ask Solar Energy Questions: Seven Seas Energy responds
Recently I had a great conversation with Brett Weil (LEED AP of Mid Atlantic Air, Inc.). Brett and I met at a Baltimore Green Drinks a few years back and we've always kept in touch. Recently at one of his classes at University of Baltimore, Brett brought out a solar newsletter we had sent out and he and his professor asked the class (as well as other colleagues) to come up with a list of questions.
I would have to say that the questions that were brought up were all PHENOMENAL.
Maryland Solar Energy is a tough field, especially when it comes to commercial installation. Tax code questions, grants, installation issues are all part of the evaluation process each commercial solar customer must consider, and Brett's class was able to compile a list of questions that raise a number of the questions that should be asked.
Below is the original letter and response of the Q/A.
******* SOLAR NEWSLETTER ******
Payback realized within a few years!
Recently the Federal Government altered the tax code in order to allow the full qualified amount of solar energy systems to be depreciated during the first year.
This news is huge for
solar energy because the payback on a solar install is "front end loaded" with nearly a 70% return possible the first year!
This is a short term "boost" for our industry as the tax code will transition at the end of the year to a lessor amount. In order to qualify for this special treatment your system must be completed by the year's end, so please allow ample time for design, installation, and inspection. Have your free site assessment performed today.
Playing the Cap Rate Game?
Solar increases NOI, value of property
We cannot say it more clearly. Solar pays for itself the first day of operation. Is your property valued on a cap rate basis? The savings that a renewable energy system provides decreases your operating expenses. This decrease justifies an increase in general property values outweighing the cost for the system. Solar Systems provide this benefit even before any tax incentives are handed out!
Example: A medium commercial solar system costs approx. $90,000 to install (before fed/ state grants and tax credits). That same system will provide nearly $8,000 a year in savings. An $8,000 increase in your NOI will result in a $100,000 increase in value at an 8% cap rate!
REMEMBER- This is before any grants or tax credits. In reality, that $90,000 system costs approximately $30,000 after credits, which could be argued that the system doubles in value within the 5 year mark.
**** QUESTIONS ****
WEIL, Brett
FIN 750 (Real Estate Investments and Finance), Spring 2011
Prof. Daniel Thomas (St. John Properties)
University of Baltimore, Merrick School of Business
Re: Contribution to online discussion board
Regarding the solar salesman’s assertion that 1) solar will yield lower operating costs and 2) these lower operating costs actually impact cap rate which measures market value, I collected a variety of responses from some real estate industry veterans.
Impact on NOI
• At first glance, if the operating expenses actually decrease (and NOI increases) it has a direct impact on value.
• However, this model also assumes that the owner is paying for energy/utilities when most tenants pay for energy, so it would never even be considered into the NOI equation. The reality in the market is that many more TENANTS with high energy consumption are exploring these options rather than Landlords and property owners.
• Nevertheless, this either has a direct impact on the NOI in the case where the landlord is responsible to pay for utilities or an indirect impact if the tenant is responsible.
• If landlord pays utilities, a higher NOI will lead to a higher market value—which is a textbook case.
• If it is a net leased property where tenant pays utilities, then NOI won't be affected directly. There is a benefit in that lower utilities will positively influence tenant retention since the existing tenants who now pay lower expenses. Additionally, as the leasing term expires and renegotiation or advertising to new tenants occurs, the tenant pays lower utilities under a net lease. This means more rent can be charged by the owner. For instance if the annual market rental rate for a property is $22/SF + $3.50/SF in utilities, the tenant is essentially paying $25.50/SF. If expenses are reduced to $2/SF then the tenant could now afford to pay $23.50/SF to the owner.
• Mitigating factors: solar panels need maintaining and replacing too often to justify the installation expense. Energy savings are insignificant as an owner increases NOI more on the top line (i.e., incased rents) than on making nominal changes on power usage. The $8k annual savings used in this example is also not a static number. That savings can only be achieved based on a building of a certain size, and power usage of a certain amount.
Payback v cap-rate (sales speak)
• The reality is energy savings are not achieved simultaneously with the installation of the solar panel
• Solar should be valued solely on the basis of payback and the NOI increase/Cap rate impact is more sales speak than anything else. If you're achieving $8k of annual savings in this scenario, it would still be nearly 4 years before you received a full payback after the tax credits.
• Do the energy savings over time outweigh the increased basis in the investment? Often times, it will simply depend on the specific goals of each particular investor. Some could justify these increased costs because they plan on retaining the asset for another 10, 20 or 30 years. Others may never be able to recover those costs if they plan on disposing of the asset in a much shorter cycle. Some large industrial Landlords ( in California, Arizona, etc) have started to install these solar panels on roof tops to provide energy for their own buildings as well as other buildings around them, creating new income streams for a particular property. This scenario has a greater effect on a project's NOI than any reduction in energy.
Rethinking the Cap rate
• Ultimately, buyers are buying income. The lower the cap rate of a property the better the solar investment would be. However, in the example below, if the cap rate was 10%, it would not make economic sense.
• I wouldn't be motivated to buy the system for $90,000 if I'm only netting a $10,000 increase in property value. The reward isn't worth the risk. Especially considering the $10,000 is assuming the cap rate is 8.0%. Suppose the property could only trade at 9.0% (cap) - the increase in value is less than $90,000 yielding a net loss on my investment. Solar may not stand on its own as an investment.
• Cap rates are a multiple, and will vary based on the micro and macro characteristics of the economy and the property. It does not exactly follow that an 8% cap rate can be used as a standard valuation metric across the board.
Price of Electricity
• Uncertain whether solar panels actually create a hedge in price of utilities due to upfront costs and maintainence.
• Keep in mind that there is risk to the utility savings projections depending on the price of electricity.
• Solar is better than buying power off the grid
Special thanks in compiling this analysis to:
Stewart Bernstein - Commercial Real Estate Broker (Planters Realty)
Dave Dannenfelser – Commercial Real Estate Broker (Hearn Burkley)
Dani Greenwald- Commercial Real Estate Appraiser (Integra Realty Resources)
Gil Neuman – Commercial Real Estate Broker (KLNB)
Isaac Pretter – Commercial Real Estate Underwriter (White Hat Capital)
Mark Renbaum – Retail Real Estate Developer
*** RESPONSE ***
February 2, 2011
Brett,
I appreciate the comments and many of them are common concerns I hear from building owners as they begin the education process prior to investing in a
solar energy system. I broke down my response below by topic. Your author made a number and valuable points and there are risks associated with solar.
First, I have 15 years of commercial real estate experience and my Master’s Degree from the Ed St.
John School of Real Estate (Johns Hopkins University). In fact the financial models that
Seven Seas uses are ones which I initially developed during my tenure at Hopkins and fine tuned as my final thesis required for graduation.
Impact on NOI
It would be hard to make the argument that solar will impact cap rates and I apologize if my letter made that assumption. Cap Rates are a percentage return which is based on the (1) market conditions directly surrounding the property, (2) the overall strength of the economy, and (3) the property type/ condition. I could make the argument (specifically to point 3) that solar panels help the building become greener and add to LEED points which all combined can raise the class type of the building thus justifying a lower cap rate, but the overall statement that solar panels could lower the cap rate were not my intentions.
However, solar energy will lower the operating costs of a property, which benefits landlords mostly in a (1) full service lease, or (2) where the landlord has the ability to recuperate CAM fees. Most landlords, even in a NNN leased property do charge tenants a basic CAM fee for some services which are provided (ie snow removal, parking lots maintenance and lighting.). This however is not the case on most singe tenant NNN deal such as small grocery or pharmacies, but is present in most flex buildings and even shopping malls where utilities are usually 100% separately metered. These are where my position on solar would apply.
Although we are mostly looking at owner occupied or full service scenarios, we are preparing to install our first energy system on a flex building where the landlord has the ability to either (1) power common area fixtures and (2) sell excess energy to tenants making a profit from the spread that would normally BGE would charge. In the 2nd scenario the landlord will of course have to sign an agreement with the tenant to purchase the energy, thus we will install a system that is sized accordingly. Further in this case the landlord will take on additional risk of the tenant paying their electric bill and this should be an internal risk assessment the landlord consider.
Finally on the impact of solar on the NOI, solar panels do not require much maintenance if any at all. There are no moving parts and beyond an occasional cleaning (twice a year) and annual inspection, the actual work is minimal. In fact, Seven Seas Energy offers 5 years of free maintenance of every system we install, this is generally done to repair any defects from manufacturing and/ or workmanship and insure a solid 30 years of energy production. All panels also come with a minimum 25 year warranty on production output and are replaced for free if problems arise.
Payback vs Cap Rate:
Again, these are two separate issues which may be viewed as one, as my case stated. My argument is that both are profitable on their own and the impact is twice as strong when combined.
Solar Panels begin saving the building owner money from the first day they are turned on. From the moment we “flip the switch” energy is being produced which no longer must be purchased from the utility grid. This happens the instant the system is installed contrary to the first point of this section in the response.
In the example I made the argument that there are two ways that a solar energy array can have a payback. The first was in energy savings which directly reduces the operating expenses thus increases the NOI. The increase in NOI directly impacts the property value. Although that is sales speak, I am certain that most building owners value their properties on cash flow and the current market conditions (I know I do however because of my professional background and business credit I am required to submit annual personal net worth statements which require this valuation method). It is my opinion that solar energy speaks directly to both of those areas and it is the foundation of real estate valuation.
As the author pointed out, the system saves owners $8,000 per year and after tax credits, has a cost recuperation of just under 4 years. I would argue that in fact, this is a valid reason to increase the cost basis of the building because as in real estate, that would equate to a 25% cap rate. I personally would love to find a building valued with those returns and would jump at the opportunity to expand my personal portfolio.
Secondly, with the reduction in operating expenses, when the owner chooses to sell (and if he sells the building), the savings are still a valid reduction separate from the previous payback which we have already counted. At the 4 year mark, when the solar panels have already “repaid” themselves, the owner can sell the building and based off of the annual savings alone he would be able to increase his sales price an amount roughly equal to or greater than the original cost. In this case, we have proof of my argument in “Double Payback”.
Finally, I would make the argument that Solar energy still pays for itself if the owner sells the building on day 1. He does not have to wait 10, 20, 30 years as stated although if he does, his return will only compound the longer the time. Of course if a cap rate is higher the margins are smaller. It should be noted that a $90,000 system actually costs $30,000 after incentives therefore the additional $100,000 (or $80,000 if the cap rate is 10%) of value added on a cap rate basis would still justify a 300% increase in value. With that in mind I would actually make the argument that every building owner who has a building on the market should consider a solar energy system.
Rethinking the Cap Rate:
I agree that cap rates vary. As someone who is familiar with the real estate market, my assumption of an 8% cap rate was based on the many buildings I found currently on the market in the Annapolis Area. In fact, most building were at a lower cap rate therefore before I used the 8% rate, I verified the appropriateness with a leading real estate broker at Marcus and Millichap.
The author is partially correct when drawing the conclusion that at a 10% cap rate, my theory on “Cap Rate Return” is much different. However even at a 10% cap rate, we still have a reduction in operating expenses, and at that rate we still have annual savings which add up to the cost of the system at just under 4 years. But note, even in this scenario, we must consider the Federal and State grants as they are legislatively mandated. This case will lower the system cost to $30,000. At that cost, the selling cap rate would have to exceed 25% in order to net out our value added . These grants and credits are all mandated by legislature and each system is pre approved of these prior to construction start.
So at the 10% cap rate, that $8,000 in savings is $80,000 in increased value. With a $30,000 investment the owner could obtain nearly a 300% return.
Price of Electricity
On average, electricity has increased 5% to 8% annually in the State of Maryland based on the past 15 years. Although electricity has remained flat for the last year, there is risk of increase in energy prices especially as Maryland continues to import more electricity than we produce. I would also point out that any plans of a new powerplant would not be realized for at least 10 years from issuance of permits. That being said, if electric rates were to remain flat, or drop, returns would decrease and the risk associated with this should be taken into consideration. The overwhelming expectations of energy prices in our state point to higher rates in the future. In fact I cannot think of a single prediction which shows lower pricing.
Overall
- Solar panels do not require much maintenance. All panels come with a minimum 25 year warranty on production output and are replaced for free when problems arise.
- The incentives behind solar energy amplify the savings and increase payback. The truth is none of the United States Energy sources do. From Solar Panels down to the equipment for mining coal- all require tax credits and incentives to make energy affordable. In fact, Coal and Oil receive just as much as solar however the incentives provided for solar are strictly designed to benefit the small building and business owners, not a large mining corporation. Solar is simply a way for our local real estate owners to lower their carbon footprint, hedge against volatile energy rates, and take advantage of the energy incentives on a small scale. It may not stand on it’s own without these incentives however they are our there and being offered to us, why not take them?
My newsletter was a quick advertisement and left out a lot of details, as it should to keep the readers attention. I appreciate the opportunity to explain my thoughts further as solar energy is a complicated field. That is of course, why one needs to consult a professional solar energy expert before considering this valuable asset.
Please let me know if you have any further questions. I absolutely appreciate the feedback and enjoy the conversation,
Best,
Sotereas Pantazes
Co Founder,
Seven Seas Energy 410-562-9103
Seven Seas Energy
I would also like to thank Daniel Thomas, UB Professor and Developer with St. John Properties.
Brett Weil, LEED AP of Mid-Atlantic Air, Inc. and a student in UB's Master of Finance program, presented the following objections/comments which he gleaned from leading colleagues in the real esate field.
