The Top 10 Rules of Green Project Finance
[Editor's Note: This is the first of Shari Shapiro's multipart series on green financing. Part 2 on alternative financing and Part 3 on government incentives are available on GreenBiz.com and GreenerBuildings.com.]
The first step to any green building or renewable energy project of any size is finding the financing to make it possible.
Since the bottom fell out of the economy, finding investors and financial institutions willing to finance building projects of any sort has been close to impossible.
Real estate finance prognosticators, however, indicate that 2011 will be a year to buy back into the real estate market. According to a Wells Fargo report:
In 2011, we expect trends in commercial and residential real estate, two areas of the economy that have been significant drags on headline growth, to turn positive for the first time since the beginning of the recession. Despite being near record lows, housing starts will begin to gain momentum breaking 700,000 in 2011. The turnaround in housing is largely attributable to gains in employment, consumer income, as well as favorable demographic trends. Meanwhile, from the financing perspective, mortgage rates remain low and housing affordability remains high. Though broadly positive, these trends do not reflect a return to the boom years, which were characterized by excessive liquidity and perverse incentives.
Commercial real estate should begin to contribute to growth by the second half of 2011. Operating fundamentals for all major property types are either improving or showing signs of stabilizing. Leasing has picked up, rents are rising or stabilizing and sales have increased. Demand for high quality properties in choice locations remains exceptionally strong, which has helped pull prices higher for non-distressed deals. There are still plenty of troubled projects that need to be disposed of, however, and prices for distressed projects are likely to fall further once lenders become committed to cleansing their portfolios.
Green projects are an increasing percentage of new and rehab projects, and renewable energy projects have very attractive balance sheets in certain areas. However, structuring financing for green building and renewable energy projects requires more legal creativity and effort than financing other types of more traditional projects.
Let me give you an example. Banks have been loaning money to companies to buy equipment for hundreds of years. Every bank has a set of documents designed for this purpose, and a specific set of rules and requirements for deciding when to take on the financing risk, and how repossession would work in the event of default.
Let's say Company A wants to borrow money from Bank B to buy a truck.
Company A gives Bank B information on the value of the truck, the value of Company A's other assets, and so forth. Bank B goes to its set of standard form documents for equipment loans, confirms Company A's credit worthiness, and knows that it can repossess the truck and sell it for some known value in the event of default.
Now let's say Company A wants to borrow money from Bank B to finance a solar array. First, Bank B has to figure out what, exactly, it is financing. Is a solar array equipment, like the truck, or construction? Then, what value can Bank A put on the solar array? The value of the solar panels on the resale market? The value of the electricity the solar array produces? How about the renewable energy credits (Banker A says to Banker B, "What's a Renewable Energy Credit?").
Then comes the issue about how to handle default. The solar array is worth a lot more in situ than it is as scrap, but Bank B has to figure out how to structure the relationship with its now-defunct borrower which would allow Bank B&to get the benefits of the electricity and the RECs.
The same concept is true for green building projects. When examining a green building deal, what value, if any, should Bank B put on the potential energy savings from a high performance building? Will the high performance building command higher rents? LEED Certified or not certified? What happens in the event of decertification?
A few rules for green project finance:
1. Find a bank or financial institution committed to green projects. Some banks now have financial arms that are dedicated to financing renewable projects.
2. Pick a model. It's easier to tweak an existing project finance model than to create a new one from scratch. Construction? Equipment?
3. Recognize the need for tweaks. Whatever the model (see No. 2), it will need to be tweaked for the unique features of green building and renewable projects.
4. Set out the deal terms in advance, particularly the obligations of the parties in the event of default.
5. Identify and address the roles of the lender and borrower with respect to any incentives or other government financing that is part of the project. Each incentive has its own requirments regarding transferability and assignment, and ownership status is often an important factor.
6. Make sure your green project pencils out. Seems simple and obvious, but when seeking financing, it is important that the project actually be a wise investment.
7. Provide as much data about the beneficial financial features of the green project as possible. The growing body of data about the financial benefits of green buildings and the balance sheets of renewable energy projects should enable borrowers and lenders to better evaluate the risks and benefits of green projects.
8. Where available, use green specific financing tools, like energy efficient mortgages. A good primer is available here.
9. Be prepared to cross-collateralize. There is so much risk aversion that many financial institutions seek cross-collateralization of non-green projects to alleviate the fear, real or imagined, associated with financing green projects.
10. Acknowledge a longer financing timeline. Getting all parties on the same page regarding the financing deal and the documentation may take longer than traditional projects. But, as lenders and borrowers get more projects under their belts, this timeline will shorten.