Tapping the Capital Markets: Are REITs Another Tool in Our Toolbox?

Posted with permission from the National Renewable Energy Laboratory (NREL). This NREL article/blog is not to be used to promote any commercial product or service or to imply an endorsement regarding the same by NREL or the U.S. Department of Energy.

There’s been a lot of talk lately about non-traditional strategies to finance renewable energy projects. Securitization and master limited partnerships represent new mechanisms to potentially tap vast sources of capital by pooling projects and creating small, tradable stakes (securities) that can be easily priced, purchased, and sold. However, certain market and regulatory hurdles need to be overcome before these mechanisms can be applied to renewable energy projects. In the meantime, another potential tool in the financial capital toolbox is the Real Estate Investment Trust (REIT).

REITs are designed to enable investment in income-producing property. They were created in 1960 under the Eisenhower administration, and can invest in all types of "real property" including office buildings, apartment complexes, malls, and self storage facilities [2]. At year-end 2011, there were 160 publicly traded REITs with a market capitalization of $450 billion [1].

So, what advantages do REITs provide as an investment class? Because REITs pool different assets, they reduce the risk of any single asset not performing. And as REIT shares are tradable with a market-set price, they are attractive to a wide-range of investor classes, including pension funds and private wealth. Yet unique to a purely securitized product (think sub-prime mortgage-backed securities, and the mess that resulted from shortcuts in proper oversight), publicly traded REITs are actively-managed corporations subject to ongoing governance standards [3].

According to Deutsche Bank, pension funds and private wealth alone held roughly $70 trillion in assets as of 2009 [4]. That’s trillion with a T. Compare that number to a projection of $30 billion in total project finance capital to be awarded to U.S. renewable energy projects in 2012 [5]. Even if 1% of pension funds and private wealth invested in these projects, that would increase the amount of capital available by 233,000%.

Pension funds and private wealth have largely been left out of the renewable energy investment picture primarily due to the complexity of using the tax benefits available to renewable energy projects. These sources of capital, on the other hand, commonly invest in REITs. Because REITs are so liquid (i.e., easily traded), they can access capital at very low cost. Since 2009, publicly traded REITs have paid out a dividend yield of roughly 4.6% [6]. That’s well below the expected returns associated with tax or sponsor equity invested in renewable energy projects [5].

At present, tax benefits comprising tax credits and accelerated depreciation require specialized tax equity investment, and complicate the application of REITs to renewable energy. However, these benefits decline over the next several years and may become irrelevant to project success, opening up the opportunity to securitize project capital costs through REITs or some other vehicle.

At first glance, REITs can be applied to fund RE projects through two generic business models. First, existing REITs can use the rooftops from their portfolio of properties as an asset to deploy solar resources. This model is in use today, it’s best known example being Prologis, the world’s largest owner, manager, and developer of distribution facilities (i.e., warehouses) [7]. Prologis is building photovoltaic installations on a number of its properties in a wholesale distributed model (i.e., interconnecting directly to the electricity grid and selling to a utility). Another example is KIMCO Realty Corp., a commercial-property REIT. KIMCO is using its rooftop space to develop solar facilities which an affiliate will operate and sell the power to KIMCO tenants [8]. In both cases, the REIT will increase its revenue through incremental use of the existing asset portfolio.

Second, new REITs may be created to specifically pool renewable energy assets without ownership of the buildings where those assets are located. For example, a REIT may hold photovoltaic installations that produce an income stream from the sale of power and renewable energy credits. To date, this model has not been implemented because of uncertainty over whether the IRS considers the solar facilities "real property" (as opposed to personal property). However, the IRS is likely to rule on the issue in the near future. Time will tell if this business model is viable, but it could allow access to very broad markets.

To finance the anticipated build-out of renewable energy projects, innovative funding opportunities are necessary to raise more capital at lower cost. Are REITs the perfect tool for fixing the RE finance conundrum? Perhaps. But more importantly, they fit in a toolbox of strategies that can make renewable energy more affordable.

References

[1] "Historical REIT Industry Market Capitalization: 1972-2011", REIT.com, accessed February 21, 2012

[2] "All about REITs", REIT.com, accessed February 21, 2012

[3] "The Investor’s Guide to REITs", National Association of Real Estate Investment Trusts, 2011

[4]"Investing in Climate Change 2011, The Mega-Trend Continues: Exploring Risk and Return", Source: Deutsche Bank Climate Change Advisors, February 2011

[5] "Renewable Energy Project Finance in the U.S.: An Overview, 2010 Year in Review, and Future Outlook", Mintz Levin, December 2011

[6] "U.S. Real Estate Index Returns", February 21, 2012, National Association of Real Estate Investment Trusts

[7] "Prologis Trust", Incomeinvestmenthome.com, accessed February 22, 2012

[8] "Kimco Realty and American Capital Energy Launch Rooftop Solar Array at New Jersey Shopping Center", PR Newswire, accessed February 22, 2012

Michael Mendelsohn is a Senior Analyst with the National Renewable Energy Laboratory’s project finance team and oversees the portfolio of solar photovoltaic and concentrated solar power analysis. His expertise spans 20 years and encompasses various aspects of renewable energy technologies, markets, policies, and finance.