Q&A: Residential Solar Finance with KeyBanc Capital Markets
Residential solar finance has come a long way in recent years, employing structures ranging from aggregation facilities to back-levered term loans, private placements and asset-backed securitization. PFR editor Richard Metcalf recently discussed these products as well as the latest trends in M&A and the future of the sector with Andy Redinger and Daniel Brown, managing directors at KeyBanc Capital Markets.
To download a PDF version of the Q&A, click here.
PFR: To begin with, are you able to estimate the size and rate of growth of the market for residential solar, tax equity and debt in the U.S.?
Dan Brown, KeyBanc Capital Markets: We’re projecting about 2.5 GW of installations in residential solar in 2019. We think there’ll be a 15% growth trend over the next five years. As we think about financing volume, it’s highly correlated to those installations. We think the markets are wide open for all sources of capital in residential solar, perhaps more so than ever before, and we expect that will continue.
Andy Redinger, KeyBanc Capital Markets: And clearly, costs continue to decline for residential solar systems, driven mainly by higher module efficiencies and lower inverter prices—if cost reductions continue to accelerate further, there's an upside to those numbers. Another changing aspect to the business I’d mention is the mix of ownership. Residential solar systems can be financed through a solar loan, lease or power purchase agreement. We see the loan market continue to take share away from the PPA/lease market. It’ll be interesting to see how that develops over time.
PFR: What do you think is driving that shift toward loan products?
Redinger: Well, more of the installers are offering a loan option through both traditional and non-traditional lending institutions than ever before. Also, the number of solar companies offering third-party ownership—PPAs and leases—as a financing option has shrunk.
PFR: And in terms of the breakdown between tax equity and debt, is that staying the same?
Redinger: Yes, the percentage breakdown between tax equity and debt has mostly been consistent up until now. Moreover, both debt and tax equity can enjoy attractive returns as there are just fewer project finance banks chasing residential solar, unlike the large number of institutions active in the utility-scale space.
Brown: But I think you’re also starting to see advance rates creep up in the bank market and the ABS market, as debt markets get more familiar with this product. It’s not, like a 15% increase, but we’re starting to see more aggressive advance rates.
PFR: Other than that, how has the availability and pricing of capital, including both debt and tax equity, developed over time?
Redinger: I can’t speak to the pricing of tax equity, Richard, but the cost of debt continues to improve in the developer's favor, although still well above utility-scale. The margin for traditional residential solar debt typically has a two handle on it. However, it's decreased quite a bit in the last 18 months. I wouldn’t be surprised if it broke through the two handle, on a margin basis, sometime soon.
Brown: Certainly, I agree, the margins are compressing. But you might have developers tell you that the cost of debt is about the same, due to Libor creeping up. My belief is that whether you talk about equity, tax equity, or debt, there’s more options and capital providers available for the residential sector than there have been in the past.
There used to be a view that a lot of institutions didn’t know how to translate their utility-scale platforms to these residential deals and didn’t know how to underwrite this or process it or think about consumer compliance. We hear those concerns less and less throughout the capital structure. As a result, the amount of capital available for the sector is robust.
PFR: And Andy, when you talk about that two handle, is that for specifically term debt?
Redinger: Yes, I should be more specific. That is for term debt and aggregation facilities.
PFR: Okay. We’ve seen residential solar companies also placing debt with institutional investors in the form of privately placed notes, as well as, of course, in the bank market. Are you able to comment on how the universe of lenders has grown?
Redinger: Absolutely. We see more and more infrastructure funds, pension funds, and energy-focused capital that is realizing that there's real bang for the buck in residential solar. It continues to be one of the places that we think, in the marketplace, that you're getting paid adequately for the risk. Across the capital stack, returns are just higher than other similar opportunities in the market.
Brown: Just to expand on that, I would say commercial banks are actively providing capital to this sector. You’ve seen life insurance companies active in the space as well. The ABS market, which we can talk about later, has embraced this product. You have folks like Hannon Armstrong and other sources of structured equity that look like them pursuing this as well. We are also getting more and more inquiries from energy-focused private equity funds that historically might not have looked at this, that are sniffing around portfolios of these assets.
PFR: And the relative returns being more attractive in this area versus large-scale contracted renewables—to what can that be attributed? Do you think it’s primarily because there aren’t as many lenders in this area?
Redinger: That scarcity of capital providers is primarily the reason. You know, you have to commit yourself to spend the time to understand the space, right? So that's happening. It's just been slow to happen up to this point.
We’re getting more and more requests from clients to help with their understanding of residential solar, we're reaching out to more and more investors proactively about residential solar, and we're seeing more and more of those investors being able to invest in the space, every single day. So it’s coming.
PFR: Key has been lending in this area for quite a while now. Was there anything in particular that you had to do in order to really start being one of the first movers in this area?
Redinger: It’s a lot of the typical diligence you would do on any solar project loan, with some extra bells and whistles. It’s very similar to that diligence. But in addition to that, there is a consumer credit and consumer compliance aspect to this. So there is additional consumer diligence and compliance review that has to take place. So understanding those risks
—for anybody that’s going to invest in the space—is extremely important.
PFR: Dan, you mentioned the ABS market and how those investors have become more comfortable with residential solar over the years. Could you talk a bit about how the term debt options for residential solar companies compare? I guess the dynamics of that changes over time.
Brown: Yes. I would say they have and they continue to. There’s been a lot of activity in the ABS market and the bank market. I think they will both remain viable options going forward. The ABS market can be subject to a little bit of volatility and sometimes that market is more open than other times. It’s kind of difficult to give an absolute comparison, you know, one market is X number of basis points above the other one.
We’ve seen some aggressive views in terms of advance rates from the ABS market recently, probably more so than in the bank market. Some companies are trying to figure out how to warehouse or aggregate enough assets to maintain optionality of terms of an ABS takeout going forward. Both markets are open.
PFR: Solar ABS transactions are usually categorized by ABS bankers as an esoteric product. Is that perhaps a limiting factor?
Brown: I think there was a time when that argument might have been valid as people weren’t really sure how large this industry would become. I think we’re at a point where there’s enough critical mass to make it a viable market. It’s not like credit cards or auto loans; I don’t think it’s ever going to be anything like that in terms of volume, but, you know, esoteric is a word that sometimes gets used to describe this industry by folks who only read negative headlines in the Wall Street Journal, in my opinion. I don’t think it’s representative of the actual fundamentals. There are sophisticated people who are issuing and investing in these markets in the face of other alternatives, and I don’t think they’d do it unless it made economic sense.
Redinger: I think the residential solar market has matured past that label. That was true several years ago when the industry was in its infancy, but we’re in the middle innings here and well on the way of becoming a well-understood asset class. Just like in the bank market, there are more and more institutional investors getting comfortable with and learning about this asset class. Most are coming to the same conclusion as the banks active in the market. They’re saying, wow, given the understood risk there’s a premium return that I can get by investing in this asset class right now.
PFR: When they’re deciding which debt market to approach to lever up portfolios of residential solar assets, do the issuers or the borrowers consider criteria other than cost of capital?
Redinger: Ultimately it’s a balancing act between the cheapest cost of capital and total proceeds.
PFR: So they have to strike a balance.
Redinger: That's right. So remember, there are all kinds of different capital sources and capital providers that will all offer you different terms on the same cash flows.
Brown: And it’s all the same cash flows we’re carving up between different parts of the capital stack, so you want to make sure you don’t cannibalize one in favor of another.
PFR: We’re hearing more people on the more utility-scale and C&I segment of the solar industry talking about risk mitigation strategies, whether those are insurance products that promise to insure against weather or counterparties defaulting, or financial hedges. Is anything like that going on in residential solar, or could it?
Redinger: We know those firms are out there. We are seeing more of those firms. kWh Analytics, clearly, is one. We've seen a couple of others. Just recently, we were talking to a firm that was willing to insure non-credit rated offtakes. So that product, you're right, continues to develop. However, I'd say that's in its infancy. I've not seen it yet in the residential solar space, but I suspect it's coming. It's coming.
PFR: Another thing that has been present throughout the history of the residential solar industry has been its susceptibility to policy changes. Net metering was a huge topic, a year or two ago. How have recent policy developments affected the market?
Brown: I think that there are more headwinds than tailwinds than in the past, when you had the noise around net metering in certain states. There was also uncertainty in terms of what tax reform might mean for tax equity, whether it was BEAT or the ITC step downs. I'm not sure any of those are viewed as existential threats anymore. If anything, there are some positive things happening, such as the state of California mandating residential solar on new homes.
We can talk about the ITC going away, but as a counterpoint to that, I think a lot of providers are going to protect themselves by finding ways to safe harbor equipment. The noise about net metering I do not hear as much as I did in the past, so I think that there’s policy stability on that front at the moment. Historically, the first question that you’d get asked in any interview was about policy, and it’s telling that it’s now something that we get asked as a second- or third-tier question.
PFR: In terms of the phase out of the investment tax credit, we have heard about developers looking to qualify equipment, solar panels, inverters, and so on, for those tax credits ahead of the step-down. I’ve been told that that is also applicable in the residential solar industry. Are you seeing much activity of that kind?
Brown: Yes, I would say there are active discussions going on with several residential solar providers about how to make that happen.
PFR: Do you think that the ITC phase-out will cause spikes in activity ahead of deadlines? Perhaps just making things a little bit lumpy, in terms of deal flow?
Redinger: No. Over the next three years we think it’s going to continue to grow each year at a consistent rate.
Brown: I think certainly you see that on a lot of utility-scale projects but I think there are some different dynamics in play in that sector. I'm not sure you’re going to see that here.
PFR: And even with smaller amounts of ITC, these deals will still make sense and people are going to be signing up for rooftop solar?
Brown: Here’s what I would say. You look at this versus utility-scale solar. You’re competing at the retail price of electricity, not at the wholesale price of electricity. Wholesale prices are pretty flat, maybe there’ll be a little bit of escalation, people have different views on that. Retail prices of electricity have a pretty strong track record of going upwards, that’s just the way a lot of investor-run utilities make their money. I don’t think that changes going forward. For that reason alone, given that we’re always going to be competing against the retail price of electricity, that makes me confident. I do think that there’s tremendous room in residential solar for cost to come out of the system, which may not be true of utility-scale or C&I. So I do get that that’s a piece of the capital structure that’s going to be decreasing but I think there’s a lot of room in the sector to find other ways to continue to be competitive.
PFR: Andy, is there a secondary market for equity in portfolios of residential solar assets, and would you describe it as an actual M&A market at the asset level, or do you think that’s likely to develop?
Redinger: We think it's likely to develop. Compared to utility-scale solar, the equity returns available in the residential solar space represent a unique opportunity for first movers. Utility-scale solar projects typically trade at 7% to 8% 35-year IRR. A portfolio of residential solar assets will trade well inside 35 years at and at a significant premium to utility-scale or commercial and industrial solar. Investors have a way of finding opportunities in the market. We are seeing more and more investors realizing the benefits and opportunity that residential solar offers each day. It's just a matter of time before this opportunity becomes mainstream.
PFR: And with assets changing hands, I guess that also provides opportunities for banks like Key to get involved again. You were involved in the financing for the 8point3 Energy Partners acquisition on the residential side, for instance.
Redinger: From a risk-adjusted basis, I think this is the best place in the marketplace, and I think it's better than any other solar asset class on a risk-adjusted basis. You're getting compensated here.
PFR: The equity side will be relevant where there are PPAs and leases, and the ownership of the system is still with the company. But for the loan product, we’re also seeing whole books of residential solar loans changing hands. Banks like Goldman Sachs have been playing in that area. Is that something that’s going to develop as well?
Redinger: Yes. As banks strive to find loan growth, more and more banks are turning on to residential solar as a place to grow their book. So you're right, there are quite a few U.S.-based banks already purchasing—you mentioned one, and there are others—purchasing these solar loans from firms like Mosaic, Loanpal, and Dividend Solar. So that’s already happening, absolutely, and that will continue to grow.
PFR: And then they can either hold those on their balance sheets or securitize them.
Redinger: Yes. That’s right.
PFR: And what about M&A at the corporate level? The most prominent residential solar companies are publicly listed—Vivint Solar, Sunrun, and SolarCity until it was acquired by Tesla, which is also a public company. But there are others, and residential solar finance companies, you mentioned a few just now. Do you expect to see consolidation in this space, or at least corporate M&A?
Redinger: We hope.
PFR: Do you think it needs to happen?
Redinger: No, I don't think it needs to happen. However, I think there's an opportunity for it to happen. I believe the more investors realize the benefits of residential solar and direct access to the customer to provide other products and services, I think it will drive more M&A, yes. I also feel as the utility space continues to turn on, regarding acquiring renewables, I think that will help drive M&A in the space, including residential solar.
Do I think it's here today? No. However, I think it’s developing, and something to keep an eye on. Regarding the solar loan providers, I do think there’s going to be some consolidation in that space, sooner than later. I believe that those players are more than likely to be acquired by banks. They act as the front end while they’re the ones that go out and manage the channel partners, help originate the loans, and then sell the loans to the banks on the back end. It seems it would be a natural fit for banks to acquire these providers.
PFR: So do you expect to be pitching for financial advisory mandates on some of those M&A transactions?
Redinger: It is one of the capabilities that we offer. So we're always pitching that.
PFR: What else do you think is going to shape residential solar financing in the next 12 months?
Redinger: It’ll be interesting to see how PACE and home improvement loans affect the speed at which people acquire solar panels for their homes. We have been seeing a lot of traditional and non-traditional banks offering home improvement loans for energy efficiency windows and high efficiency furnaces with the capability of rolling the cost of a solar system into that loan. With these new capital sources as well as other government programs targeting the residential consumer it’ll be interesting to see how quickly solar makes inroads.
Brown: I think we’re at 1% of the addressable market so far.
I think near term, some of the things we talked about before, equipment loans to safe harbor equipment are going to be a big trend. I think we’ll see some cost curve improvements in near term as well.
I think longer term, at some point there’s going to be a viable solar-plus-storage residential option available, and that will unlock a lot of that remaining 99%. I'm not sure that’s something we’ll see in the next 12 months, but as storage just continues to improve from a reliability, costs, etc., perspective, I think pairing that with residential solar will be very compelling.