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Energy and Real Estate are Colliding

Elias Hinckley's picture

Elias Hinckley is a strategic advisor on energy finance and energy policy to investors, energy companies and governments. He is an energy and tax partner with the law firm Sullivan and Worcester...

  • Member since 2018
  • 79 items added with 25,179 views
  • Jun 9, 2015

real estate and energy greening

A wave of technology and innovation is fundamentally changing the way that building owners and other real estate investors are thinking about the role of electricity in real estate investments.

Since the very earliest days of electricity generation the world’s electric systems have been based on a model centered on large generating stations, with complex transmission and distribution systems to transport and deliver electricity to users.  Now we are in the early stages of a fundamental shift, driven by trillions of dollars of investment, from the traditional centralized energy model to a system that is significantly distributed. This investment will manifest in several distinct forms, including onsite power generation like solar or combined heat and power systems, enhanced energy efficiency and energy management tools, on-site electricity storage, as well as systems built around supporting electrification of vehicles. 

In the old model electricity came in from the wires and was a cost over which a building owner had either no control (in settings like self-used and gross leased property, where electricity might be paid by a building owner and recovered through higher rents) or no real interest (as with net leases, where a tenant is responsible for energy costs).  As that old energy model is being replaced, the increasingly distributed energy system is creating tremendous opportunities for real estate investors to profit from this multi-trillion-dollar energy market transformation.

Who will own these assets is far from settled in this changing market. 

Traditional energy companies are only just beginning to embrace the economic potential of this shift – and will continue to struggle to adapt, for a few reasons. Utilities are subject to regulatory limits on owning generation or energy management tools inside a building and beyond the meter where the sale of electricity occurs.  Traditional energy companies have also not been quick to embrace a market that represents demand destruction for their core product and does not build off of core skills within these companies.  Finally, the culture of the traditional power business is one built on glacial-like response to change, in which advancements (if they occur) take decades to unfold, making it very difficult to react to what is now a technology driven market,  producing new technologies and new ideas around process on a time scale measured in months.

New energy companies are emerging. The current environment, with persistently low interest rates, has made the use of money extraordinarily inexpensive, and investors have been willing to enter parts of these new energy markets at a scale and pace that has surprised many as they search for new sources of yield.  The result has been several early success stories among these new energy companies.  Residential rooftop solar has been the most notable early success.  Deals are easily replicated with take-it-or-leave-it approaches to documents.  Credit risk is pooled based on FICO scores just like mortgages and the result is a market that can not only attract capital, but one where investments have successfully driven public stock offerings or have been re-sold into the secondary, market further reducing the cost of money supporting these projects. 

One area where these new energy-focused investors have struggled to find success so far is in the market for energy projects associated with commercial and industrial buildings.  Finding consistently credit worthy owners and tenants, along with the complexity and expense of the transactions, have presented the biggest challenges.  There are layers of decision makers within the process, with owners, tenants and management companies rarely aligned on the energy value proposition, and navigating these relationship from the outside can be very difficult.  There have been some limited success stories working with very large companies (where multiple sites can be managed under a single transaction process and credit ratings make evaluating credit risk easy), but across much of the commercial real estate market we have seen limited activity, despite the potential for very significant investment returns. 

New groups of investors have begun exploring this untapped part of the market.  Some real estate investors have recognized that these new energy investments are remarkably similar to the underlying real estate investments that they serve.  There are certain identifiable operational risks, but once these are controlled, the payment risk is a combination of occupancy and tenant credit risk – exactly what a building owner already models to determine the value of the underlying real estate investment.  The energy investment can actually enhance the value of the underlying real estate by reducing occupant operating costs, augmenting cash flows, and improving a tenant’s ability to pay for property use.

These investments require a better understanding of the relationship between building use and energy than has been necessary for most real estate investors to date.  Otherwise, the most significant difference is that these energy investments can generate substantially higher rates of return than the underlying real estate investment.  For a real estate investor who has already evaluated a property, layering on an energy investment to increase returns has obvious appeal.  An investor that is already comfortable making the real estate investment understands the loss, default, and occupancy risks of a property, so adding a further layer of additional investment is a relatively easy decision. 

The emergence of this new type of real estate-energy investor has broader significance.  The need for investment to support the energy transition that has just begun is immense – this transition will require the largest deployment of capital in human history, so there is plenty of room for new participants, especially investors that are filling in underserved portions of the market.  By applying a more sophisticated understanding of real estate-related risk and process to the distributed energy market, these new investors will rapidly and dramatically expand the available capital for distributed energy investments.  With this expansion expect a new class of energy companies and investors to become a vital part of our energy mix.

Photo Credit: Greening Real Estate?/shutterstock

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Josh Nilsen's picture
Josh Nilsen on Jun 9, 2015

I’ve been thinking about the centralized model.  Maybe we’re just upgrading it. 

Instead of having grids at the regional level, we’re going to have grids at the continent scale soon.

When you look at renewable energy across the US, it’s largely centralized already.  Most of the wind and solar are in 3-4 different macroscopic regions.

Fossil fuel energy just doesn’t work very well when you’re operating a grid across an entire continent.  Renewable energy could give a crap how long it gets transmitted, free fuel input.

Texas and ERCOT are a prime example of this.  Texas knows that if they opened their grid, they would be getting so much renewable energy coming in their fossil plants would largely sit idle.  Got to keep those investors making profit at the expense of the tax payer amirite, freemarket yeahhhhhhhhhhhh.

Bob Meinetz's picture
Bob Meinetz on Jun 9, 2015

Elias, how does a market which represents less than one-half of one percent of American electricity threaten “destruction for [utility’s] core product”?

You must be joking.

As evidence that “now we are in the early stages of a fundamental shift…to a system that is significantly distributed”, you link to 100% pure, unadulterated, investor-hyped Kool-Aid from a law firm which boasts of:

  • Representing a hedge fund in the development and deployment of a solar REIT
  • Representing an investment fund on the purchase of a 40 MW solar portfolio in the United States
  • Representing an investment fund on the sale of a 20 MW solar portfolio in the United States
  • Represented a private equity fund in creation of a $50 million dedicated solar investment fund
  • Represented an investment fund in the acquisition of a solar portfolio and design of novel financing structure
  • Represented an investment fund development of distributed solar business in the Caribbean
  • Represented hedge fund in acquisition of utility scale solar project in the Caribbean
  • Represented an Italian investment firm in its expansion into the North American solar market
  • Represented a Canadian private equity fund in its expansion into the U.S. solar market
  • Represented a leading solar developer and finance company in receiving capital investment from two private equity investors
  • Represented a leading solar developer and finance company in a debt conversion as part of new capital investment
  • Represented a captive solar developer of a large commercial real estate developer

Your blind enthusiasm is less representative of status quo than renewables advocacy’s tenuous grip on reality.

Elias Hinckley's picture
Elias Hinckley on Jun 9, 2015

Bob – thank you for the thoughtful summary of some of my firm’s energy finance experience!  

Bob Meinetz's picture
Bob Meinetz on Jun 10, 2015

Elias, you’re welcome, and it was a good idea to change your link to a location other than your own law firm.

But you jumped out of the pan, into the fire. Because the Bloomberg Business article you now link to is based on the opinion of David Crane, CEO of NRG Energy, who owns a Tesla, gave his son a Nissan Leaf, and “worries about the impact of warming on the earth his grandchildren will inherit”.

That’s touching, except the hypocritical Mr. Crane paid for those clean automobiles with the proceeds from $4 billion in annual sales of dirty energy – 96% from fossil fuels, and over half from coal. A full six-tenths of one percent came from sales of “distributed energy”.

Apparently he’s not that worried, after all.

Did you do any investigation into how Mr. Crane was qualified to “doom [the utility industry] to obsolescence”, or was the fact he bought a Tesla enough to sell you on his credibility?

Nathan Wilson's picture
Nathan Wilson on Jun 11, 2015

Real estate issues are another reason that society probably should not go too far in the direction of distributed energy (in addition to the higher cost reletive to utility-scale generation).  Bundling energy production capital assets with homes and businesses raises the up-front cost of ownership for them.  That means that it will be harder for first-time home-buyers to make a downpayment, and harder for would-be-small-business-owners to get started.

The emergence of third-party ownership arrangements for residential solar also creates disadvantages for home sales, since in these cases the solar electricity contract (which may or maynot be appealing to subsequent prospective buyers) becomes an inseparable part of the home purchase contract.

Fortunately, investors who want a piece of the sustainable energy industry can always invest in utility-scale merchant electricity producers, or start their own solar power company.  The grid allows us to separate the electricity generation from the point of consumption, and the cost saved by economies of scale (around 50%)  greatly out-weigh the value of the transmission losses (only about 10%). 

For commercial real estate on the other hand, roof-top solar generation is not a big problem, as systems can be larger (therefore more cost effective), and  ownership could be unbundled from building ownership without affecting other tenents (assuming appropriate feed-in tariffs are in place).  Business owners could get extra revenue by renting-out the roof, or choose to own the solar system themselves.

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