March 15, 2010

The Right Time to Go Green?

The current economic environment poses significant challenges for shopping center owners as well as big-box retailers. But, although counter-intuitive, it may be the right time for owners to invest for the future to differentiate their developments from the competition. "Going green" by investing in renewable energy facilities (such as wind turbine or solar panels) provides a competitive advantage by reducing operating expenses and enabling owners to market to consumers who desire to shop at environmentally-conscious establishments. Having lower operating expenses and being perceived as "green" also provides advantages when competing for tenants who may also want to be perceived as environmentally conscious (while also having lower expense ratios). Federal subsidies and potential new Minnesota legislation make investing in renewable energy more attractive now.

 

This article will describe: (1) how the federal renewable energy subsidy works, (2) how existing leases might help pay for renewable energy improvements without increasing costs to tenants, and (3) potential new Minnesota legislation that will provide an alternative way to finance these improvements.

 

Federal Subsidy for Renewable Energy Facilities

 

There are actually two federal renewable energy tax credits—one is generally referred to as the "production tax credit" (PTC) and the other as the "investment tax credit" (ITC). In addition, for 2010 renewable energy projects, owners may elect to apply for a cash grant instead of the tax credits. Because the amount of the PTC varies over the life of the project and requires the sale of electricity to third parties, it is not as relevant to those not in the energy-production industry. Accordingly, the investment tax credit is generally more attractive to shopping center owners and other retailers. (The ITC cannot be combined with the PTC).

 

The investment tax credit is a one-time, dollar-for-dollar federal tax credit that is based on a percentage of the cost of the owner's new renewable energy system. Unlike the PTC, the ITC does not require a sale of electricity to others—the energy system can simply be used to reduce the operating expenses of the owner's building. The amount of the subsidy is generally equal to 30% of the qualifying cost of the energy system, including installation costs.

 

The ITC is available for systems that produce electricity from wind, geothermal, solar (including photovoltaics or solar thermal systems, but not passive solar systems), and other less relevant sources. Generally, the ITC is claimed for the year in which the energy system is placed in service. The tax credit offsets the owner's income tax liability, and may be carried back 1 year and forward 20 years, if the owner is not able to use it for the current taxable year.

 

There are other tax benefits as well. Even though the effective cost of the energy system is only 70% of the actual cost (after considering the 30% subsidy), tax law allows the owner to depreciate 85% of the actual cost of the new system. In addition, owners may depreciate the renewable energy systems using an accelerated 5-year schedule. The net present value of this accelerated depreciation schedule, relative to a 20-year straight-line schedule, has been estimated to equal 12% of the system's costs.

 

Example calculation of ITC and depreciable basis:

 

Total solar panel cost with installation

$400,000

ITC percentage

        30%

Investment tax credits

$120,000

Effective net cost of solar panels

$280,000

Depreciable basis (for 5 year depreciation)

$340,000

 

Owners of energy systems may claim ITCs directly. But for those that anticipate not being able to use the credits themselves could consider "selling" the credits. Because the tax credits must run to the owner, "selling" the credits is done by creating a separate ownership entity in which a 99.99% ownership interest is sold to a tax credit investor. Although commonly done, this structure involves high transaction costs and some exit strategy risk so is generally not done except for larger, more expensive, energy systems.

 

If the owner sells the energy system within its first five years (e.g. as part of the sale of the shopping center), then all or some of the credits are recaptured. If the sale took place during the first year, 100% of the credits will be recaptured, with the recapture percentage decreasing by 20% for each year thereafter (e.g. if the sale takes place more than two full years after the system was placed in service, only 60% of the credits would be recaptured). Interestingly, the recapture rules are actually more lenient for the grant program.

 

Paying for the Renewable Energy System

Shopping center owners may be able to pay for a renewable energy system through their existing tenant leases. Generally tenant leases do not allow landlords to pass through capital expenditure costs to the tenants. But many leases allow pass-through of capital expenditures that are made for the purpose of reducing, or limiting increases to, operating costs such as utility expenses. The amount of the capital expenditure cost that can be passed through in each year depends on the specific language in the lease, which may require that the cost be amortized over the estimated useful life of the improvement, and may or may not include an assumed interest component on the unamortized portion. In addition, when negotiating leases, tenants will typically request that the amount of such capital costs for which they must pay be limited in each year to the amount of savings (whether direct cost savings or avoidance of cost increases) achieved by the capital improvement during that year. Accordingly, the language of the shopping center owner's tenant leases—and the estimated annual utility expense savings—will determine the amount of additional revenue the owner will have to pay for the energy system.

 

Financing the Renewable Energy System

 

One of the bigger challenges of installing a renewable energy system now is obtaining financing. Generally, commercial lenders are wary in this market of increasing their exposure to commercial real estate. But, as of the date this went to publication, the Minnesota Senate and House stimulus bills include an innovative provision that would allow energy conservation improvements on private property to be financed with a city's special assessment bonds. If this bill becomes law, a shopping center owner (or any real property owner) could petition a city to specially assess its property for the cost of the "energy conservation improvement" (e.g. solar panels). In such case, the city would pay for the energy conservation improvement (even though it was owned by a private owner) and then levy a special assessment for the cost of the improvement. In effect, the city would be financing the cost of the renewable energy system. The city's financing cost should be less than what the private owner could otherwise obtain (assuming the owner could actually obtain any other financing) because special assessments have priority over any mortgage liens. The financing cost could be even lower if the city pledged its full faith and credit to back the special assessment bonds that otherwise would be backed solely by the special assessments paid by the private owner.

 

Conclusion

 

The investment tax credit is set to expire after 2013 or 2014 (depending on the energy source), and the federal grant program is currently only for 2010 renewable energy projects. Although financial resources are scarce now, investment in shopping centers and other retail facilities is more important than ever because of the increased competition for retail tenants. If feasible, shopping center owners should consider using these financial incentives to make their centers more "green", both environmentally and financially.

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