On Tuesday, August 18, 2022, President Joe Biden signed into law the Inflation Reduction Act (IRA); a 700+ page document that reads like legalese referencing every government code imaginable, but a few of those pages included changes to Section 48 of the Internal Revenue Code. Section 48 of the code sets out the Investment Tax Credit (ITC) available for installing solar energy, which has been amended by the IRA and will give a much needed boost to the solar world at least for the next two years.
The IRA changed the base ITC from 26%/20% to a base ITC of 30% with several 10% “adders”. These 10% adders include: (a) use of at least 50% US materials for solar; (b) installation of solar power in a designated low-income census tract (link to map here); and (c) including an additional 20% if solar energy is installed for the benefit of a low income housing project. The US material adder seems reasonably doable and the low income location adder will be site specific, so it’s safe to say it’s possible to achieve a minimum of 40% ITC. A caveat to all of this is that a “going wage” must be used for solar development, which will likely increase overall project costs.
The ITC is a dollar-for-dollar direct tax credit that can be used by individuals to offset “passive income” and by corporations/banks to reduce corporation tax. Disclaimer: Consult your accountant on these matters; I do not provide accounting advice or guidance. Solar also provides payback, which can be accelerated to take 80% payback in the first year of commissioning.
There are many ways to structure financing on solar projects to effectively monetize this ITC; however, I will discuss one option that I believe is most effective for developing RV storage facilities and solar awning boats and the option that I use on many of my own projects.
My preferred method is to have my bank finance 100% of eligible solar costs (carports, solar panels, covers, etc.). We then enter into a sale-leaseback agreement where the bank owns the solar assets and takes the ITC and depreciation. In turn, I pay monthly rent to the bank for the use of its assets. The bank’s securitization for assets is a UCC-1 deposit to secure personal property – it does not have a lien on real estate.
After seven to 10 years, it’s negotiable of course, I buy the system from the bank for 10% to 30% of the original cost, ie the “residual”. If you’ve ever rented a car, it’s a similar structure, the only difference being ITC and depreciation. The advantage of this sale-leaseback structure is that the principal of the solar capital is significantly reduced by the ITC and the depreciation taken by the bank. For example, on a typical project, I might have a $12 million solar sale-leaseback with an ITC of 40%. The bank assumes that it will receive $4.8 million in tax refunds from the Treasury Department within one to two months of project completion, which reduces the bank’s exposure by $12 million to around $7 million. In addition, the bank can take accelerated depreciation on the $12 million (less ITC of $4.8 million) and apply that depreciation of approximately $7 million to obtain tax refunds of approximately $2.1 million ($7 million x 30% corporate tax rate). This has now essentially reduced the principal from the original $12 million to $5 million.
On a project of this size, annual lease payments would be in the range of $150,000 to $250,000, which is within the effective rate range of 1% to 2% on the $12 million of origin and significantly cheaper than current interest rates. As an example of the profitability of this method, with the increase in ITC, the debt payment on one of my projects was reduced from $800,000 to $400,000 overnight, all the other factors remaining the same.
However, this solar financing does not finance costs not related to solar (ie purchase of land, paving, office, site work, etc.) and therefore, I must also have a traditional mortgage, guaranteed by a first deed of trust on the property for these costs.
I find it best to think of financing these as having two debt obligations. For my 500-unit, 12-acre prototype site, I would have: (1) an initial conventional trust deed of $6 million property-secured home loan to fund non-solar costs; and (2) a $12 million solar tax lease secured by personal property and all solar assets (carports, panels, etc.). The bank takes all the solar ITC and solar amortization under this tax lease and in turn the effective interest rate of the payment is around 1%!
Another option and it depends on how your partnerships are formed and other factors, if you or your partners can use that full amount of ITC and have significant passive income to offset, is to retain ownership of the solar energy and transmit this ITC to the LP, GP, partners, etc., via a K-1. On one of my projects, that would represent an ITC of nearly $6.5 million! This would make the solar payment much higher and change the economy. The transfer from ITC to the bank provides a nice low debt service and we benefit from this $12 million project cost which is being reimbursed $7 million by the federal government through ITC and the amortization.
When we think of it as two different financing instruments, we can also think of this as essentially two projects: one, a covered RV boat storage business; and, second, a solar system.
- The RV boat storage business will have a $6 million loan secured by the property and will generate approximately $1.5 million in NOI for the rental of the covered RV boat stalls, this which will give it a value of around $23 million or an LTV of 26% ($6 million / $23 million). Once leased, you can refinance this home loan at a conservative 50% LTV and withdraw $6 million or refinance to retain a lower loan and higher cash flow. This factor, to me, is one of the greatest value propositions I have ever seen in a profitable real estate investment! Also, my lender will grant favorable terms with such a low LTV/LTC and my loan guarantors like to have their risk mitigated as much as possible.
- The solar system will generate revenue of $340,000 by selling electricity to the local utility company with minimal operating and maintenance costs and debt service of $200,000. This system will have about $140,000 of positive cash for seven to 10 years, and then much more revenue once the solar lease is paid off or refinanced with a new, longer-term loan.
The uniqueness of the solar awning that takes all the tax credits is the real success of these solar awning boat and RV storage projects. Essentially, it’s about 100% financing the building we use to get premium rents from RV and boat customers, plus having about 65% of that cost reimbursed by the federal government through the ITC and depreciation. I don’t know of any other asset class or development opportunity where this structure works so effectively. For example, I am currently developing two self-storage projects with solar energy but I am not getting the ITC on the actual storage structures, only the solar costs; as I get the ITC on the sun shelter structure, canopies.
This article is part of a three-part series. In the next article, I will discuss ways to sell the power generated by these large solar canopies and receive double revenue per square foot of covered space: revenue from rooftop solar and premium rent for the RV covered and boat storage below.