Solar Projects for Commercial & Industrial Properties: How to Enjoy the Bright Spot
Date: November 24, 2020
Solar Project Financing and Construction Basics
Solar projects are essentially commercial lease transactions and should be evaluated in those terms including the practical considerations, financial incentives and risks, and potential liabilities. The typical solar project is financed by the project developer through a mixture of tax incentives, sales of solar renewable energy credits (“SRECs”) on an open trading market, and electricity sales contracts. As discussed below, this financing structure limits the flexibility of the developer to negotiate deal terms with respect to leases and electricity sales contracts, the latter referred to as a “Power Purchase Agreement.” (Power Purchase Agreements will be the topic of a subsequent issue of The Real Deal.) In most instances, the developer funds the cost of the project by transferring state and federal tax incentives to an investor who contributes capital to the construction costs. Qualifying for these incentives requires the financing party to stay with the project as a tax equity investor or as the “owner” of the project, through a sale-leaseback arrangement with the project developer, for up to five years. These financing agreements are negotiated in advance of the solar developer proposing its project to the C&I property owner, often locking in certain terms such as minimum lease term, assignment provisions, and liquidated damages in the event of a landlord breach.
Rooftop Solar Projects
Rooftop solar projects are, as the name suggests, constructed on existing building roofs by the solar developer and tied into the building’s electrical system. The typical project can advance from initial lease negotiations to producing electricity in six to eight months. Most often, the value for the C&I property owner is in low cost or no cost power from the system provided by the solar developer in lieu of cash rent. If the C&I property owner is not the power purchaser, cash rent may be paid and tied to the production capacity of the system measured in kilowatt hours (“kWh”). These projects are typically initiated by the project developer either through a direct unsolicited offer or through a sales and marketing partner. Alternatively, C&I property owners may seek out solar developers through their advisors, e.g. lawyers, accountants, and property managers, or through energy advisory companies specializing in solar projects. For the project developer, rooftop projects are attractive due to their built in customer base (the C&I property owner) and the ability to leverage existing building infrastructure. For the C&I property owner, the benefits are the ability to monetize an unused asset, through rent or reduced utility bills, and the opportunity to market environmental attributes of their building to prospective tenants. Additionally, in certain instances, the project developer may contribute to the cost of a roof replacement if it coincides with the solar project development.
These scenarios assume that the solar project will be installed on an existing building. However, it is not uncommon now for developers to integrate rooftop solar projects in ground up developments. In particular, rooftop solar projects integrated with green roofs are an economical way to meet storm water planning requirements in urban core developments, particularly in Washington D.C. There also are circumstances where the C&I property owner may self-execute a rooftop solar project in which case there may be federal and state grants available to reduce project costs.
For these rooftop projects, many of the lease terms will be similar to standard commercial leases such as the representations and warranties, indemnities, and insurance provisions. However, certain terms are unique to solar projects and as the landlord under the lease, the C&I property owner should take special care when negotiating with solar developers, particularly with respect to the following, which often may be included in a binding letter of intent:
- Defaults and Liquidated Damages: To cover potential losses in the event of a landlord breach, solar developers will push for default provisions that require the landlord to cover any lost revenue associated with the project including tax incentives and SREC sales. Alternatively, solar developers may propose a “buy out” schedule for the landlord to purchase the array, which often doubles as a liquidated damages schedule. These losses could surpass the project’s financial benefit to the landlord by a substantial factor.
- Term of Lease: The solar lease term often will be presented as a base term of twenty (20) to twenty-five (25) years with a unilateral renewal right in favor of the solar developer of at least one five (5) year term. The renewal right is frequently required by the developer’s investors leaving the developer little flexibility to negotiate a mutual renewal. Solar developers also may request a brief (three to six months) rent free “decommissioning term” to remove the system.
- Lease Assignment: The solar developer’s investment strategy often includes selling the project within the first five years, normally to an institutional investor or utility company. Landlords should review the lease assignment provisions carefully and require that any assignment be to an entity of at least equal or better financial strength and operational experience.
- Roof Replacement and Offline Penalties: In most instances, the building’s roof will require replacement during the lease term. Solar developers will frequently agree to include in the lease a onetime landlord right to request that the solar developer temporarily remove the entire solar array for thirty (30) days to allow landlord to replace the roof.
- Operations and Maintenance Requirements. Solar projects require regular inspections and maintenance through Operations & Maintenance (“O&M”) contractors. The lease should include a covenant for the solar developer to maintain an O&M contract for the life of the system.
In most instances, the landlord and solar developer find ways to reach a compromise on these terms. In the long run, rooftop solar projects incur minimal ongoing costs or administrative burdens once operating.
Ground Mounted Solar Projects
Ground mounted solar projects tend to be larger and more complicated than a rooftop solar project in terms of financing, permitting, and construction. Additionally, ground mounted solar projects most often cannot leverage existing infrastructure and therefore construction costs will be relatively higher for solar panel foundations, gathering lines, and utility connection. For these reasons, ground mounted solar projects span several acres to achieve the economies of scale necessary to make the project financially viable. The typical ground mounted solar project may take up to three to five years to progress from the initial offer to electricity production, and returning revenue to the C&I property owner. However, the financial upside for the C&I property owner is likely to be higher and in the form of cash rent, as opposed to rooftop systems in which the rent is in the form of low or no cost electricity.
Ground mounted solar project leases share many similarities with rooftop solar leases. However, there are additional concerns, given the added complexity of ground leases. Special care should be taken when defining the various boundaries of land affected by the lease agreement and that they work together within the lease and also in connection with other similar agreements that the tenant may have with adjacent landowners. Ground mounted solar developments generally affect a large parcel or multiple parcels of land and within this area other rights and areas may be defined. For example:
- Due Diligence: During the due diligence phase, the solar tenant may determine by survey, solar studies or otherwise that only a portion of the Property is a suitable lease area for the solar facilities (the Premises) and may wish to limit the leased Premises.
- Exclusion Areas: The landlord may require that certain areas be excluded from development altogether (areas slated for future development, conservation areas, buffers, etc.) or subjected to only limited rights such as access or utility easements.
- Substation Purchase Option: The solar developer may need to construct a substation and may desire to purchase land for this purpose rather than lease it. The landlord may seek to limit the size or location of such an area.
- Easements and Right to Sunlight: The solar developer may need certain easement rights for access, solar radiation (light) or utilities serving the leased Premises, or easements for connectivity between the leased Premises and offsite facilities which may or may not be adjacent to the Property.
- Future Development Constraints: It is important to consider how the boundaries of such areas affect the landlord’s ability to develop the balance of its property, particularly with respect to an easement to be granted to the developer and associated rights to access and sunlight.
The extent of, or even need for, each of these areas will not usually be known until some due diligence is completed, it is important that the initial agreement is structured in such a way that the each of the various grants of lease options, easements, purchase rights and any rights of first refusal, which could be nested within one another in the contract, meet the applicable state law requirements for a valid lease, including consideration, mutuality and certainty as to their essential elements. Since ground mounted solar facilities are usually developed in phases which could extend for decades, the parties should address what other uses by the owner or existing or future third-party tenants may be appropriate at various stages (such as the option period or the due diligence phase), in certain areas or with particular conditions, such as farming, timbering, mining, etc.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.