The six transaction costs we’ll cover are the (1) Legal/Diligence Review, (2) Appraisal, (3) Independent Engineering Report, (4) Cost Certification (5) Lockbox Agreement, and (6) Sales-Tax. Each is explained below.
It’s important to understand the context for these costs. The capital provider in the Sale Leaseback, usually a Bank, requires each of these items as part of its diligence process. Typically, the Bank hires an outside party to perform the analysis (such as a law firm or appraiser). The objective is to independently confirm the relevant metrics underlying the solar project pro-forma upon which the Bank is placing capital. Each party then provides the Bank a report, which the Bank uses to re-evaluate the amount of funding the Developer receives. At the end, the Bank asks the Developer to pay for each of these reports. The Legal/Diligence Review costs $20k. It is performed by a law firm hired by the Bank. The lawyers look through all the project documents to assess a number of items (To better understand what the Bank/Investor is looking for check out our Solar Diligence Roadmap). First, they look for contract gaps. In essence, they check to see if the PPA, Site Lease, EPC, and other agreements adequately protect the ProjectCo. For example, if the PPA has a major out-clause at the Off-taker’s discretion, that will be flagged. They also confirm that the contracts all require each party to perform as promised in the project summaries. For example, say that the Developer tells the Bank that a 700kW system will be placed in service by Nov. 2017. The law firm checks that the EPC scope of work is for a 700kW system and that the construction schedule ends by November.
Law firms normally have real estate backgrounds, so they often focus (unduly) heavily on the deal’s real estate issues. Lawyers confirm that the host site owner has clear title and that the Developer has removed all easements under the array. They also look at all the conditions imposed by the Conditional Use Permit to confirm that the site plans satisfy each requirement.
Finally, they also evaluate the PPA for compliance with various IRS guidelines. Their goal is to confirm that the Bank/Lessor will actually receive the Investment Tax Credit. For example, two big issues are whether the IRS will classify the PPA as a “disguised sale” or a “lease to a tax-exempt entity”. If either is true, the Lessor does not get the ITC as planned. The result of the Legal/Diligence review is basically a “go or no-go” opinion from the law firm. The Appraisal costs $4.5k. It is conducted by an independent appraiser. Hopefully, the Bank picks one that understands solar project finance. If you recall from our Solar Sale Leaseback 101, the Sale Price is set at the lesser of the project’s Fair Market Value (“FMV”) or an amount that hits a 1.18x coverage ratio. The Appraisal sets the FMV used for the first half of that Sale Price rule.
The Appraiser builds a financial model to estimate the project’s fair market value (FMV). The FMV is the net present value (NPV) of the project’s cash flows at a given discount rate. In building the model, the Appraiser draws from data supplied by the Developer, some of the other reports discussed here, and their own assumptions. Often it works like this: * System Size/PPA Rate/other technical specs come from the Developer’s model (but confirmed via project docs); * Solar Production comes from the IE Report; * ITC Amount comes from the Cost Certification report;
The Appraiser comes up with their own estimate of the cost of capital in order to set the discount rate used in calculating NPV. If the Appraiser wants to raise the Bank’s profit on the deal, they will assume a high cost of capital. That drives the FMV lower which results in a lower Sale Price paid to the Developer. Similarly, if the IE’s PVSyst or the Cost Cert come in lower than expected, the Appraiser’s model will return a lower FMV than expected. That’s why the Developer has to keep a close eye on the reports from these service providers.
The scary part of a Sale Leaseback is that the “Sale” doesn’t occur until the system has been built and placed in service. At that point, the Lessor/Bank has all of these reports generated. If the final Appraisal comes back with far lower FMV than the Developer expected, the Developer could be underwater. Even worse, the Developer has no leverage at that point. Tax Equity investors that join the ProjectCo after the System is placed-in-service aren’t permitted to claim the ITC. A Sale Leaseback is a little different; the Lessor must execute the lease within 90 days of the System being placed in service. Ninety days is a tight window to start discussions with a new Bank/Lessor, get through diligence, and close a deal. As a result, Developers are often stuck with the Bank/Lessor’s new lower Sale Price because they aren’t able to find a replacement capital provider in time. To mitigate this risk, we recommend Developers push to get a Project Appraisal before construction begins. This forces all the service providers to declare their assumptions and set a pricing framework early enough that the Developer can either negotiate better terms or walk away. Of course, the Bank/Lessor can still change its mind at any point before the day of the actual Sale. But, it sets a precedent and makes it less likely for the Developer to be blind-sided. The Independent Engineering Review costs $5k for systems under 2MW. It’s performed by an “independent” solar engineering firm (the “IE”). The IE takes the Developer’s design plans and runs its own PVSyst. The IE also visits the site, inspects the completed system, and reports on any (a) flaws in the installation, and (b) discrepancies between the physical system and the plan set. The IE Report serves two purposes for the Bank/Lessor. First, it confirms the system they are buying is actually built to the design specs. Second, it provides an “objective” source for the production assumptions used in the models to set the coverage ratio and FMV.
A low production estimate in the IER lowers the FMV which lowers the Developer’s fee. This means that even if the Appraiser uses reasonable assumptions, the IE’s assumptions could still drop the sale price. The solution is the same as it is for the Project Appraisal. Get a pre-construction IER. That way, the Developer can contest the IE’s assumptions to negotiate for a better sale price or walk away from the deal. The pre-construction IER is $2.5k. The Cost Certification (“Cost Cert”) is $5.5k. It is conducted by accountants. The point of the Cost Cert is to independently assess the Investment Tax Credit dollar amount available to the Bank/Lessor. In performing the Cost Cert, accountants review all project invoices and contracts to determine which are eligible for inclusion in the ITC basis.
A lower ITC results in a lower FMV, which lowers the Sale Price. If the Cost Cert comes back significantly lower than expected, the Bank may reprice its lease. In addition, the lower ITC estimate will bring the FMV down in the Appraisal. Unfortunately, Cost Certs are normally only done post-construction. However, Developers can still account for a low ITC estimate. How? By conservatively modeling the eligible basis in their own internal models. The Bank/Lessor will also require the ProjectCo set up a Lockbox. All project revenue and expenses flow through the Lockbox account. The account is hosted by the Lessor’s bank and is not free. The Trustee Bank charges set up costs around $10k. It also charges ongoing account management fees around $12.5k annually. Sales Tax is the last fee worth mentioning. It’s not a “transaction cost” but it is a charge that often surprises solar Developers. Sales tax is charged differently for leased equipment than equipment sold outright. When buying equipment outright, sales tax is paid normally. In leasing equipment, sales tax isn’t paid on the upfront price but rather on each lease payment. Notably, many states have a solar sales-tax exemption. No sales-tax payment should be made in this case. If the project is in a state that charges sales tax on solar equipment, the Lessor will add a sales tax charge to each lease payment. If that happens, Developers should make sure that the EPC isn’t also charging sales tax, otherwise they’re getting double-taxed.
This sales tax charge can raise each lease payment by 5%-9%. Oddly, the Appraiser and the Lessor’s team often don’t catch this until after the lease closes. On one hand, that’s good because it gives Developer’s a higher Sale Price. On the other hand, Developers can suddenly find themselves violating coverage ratio covenants after lease payments begin. At that point, they’re required to add cash to the lease reserve to stay in compliance. As a result, the best practice is to figure out if sales tax applies and include it in the pro-forma early on. Initial transaction costs are $47k plus the rent reserve which varies based on the lease payment amount and operating expenses. The $12.5k lockbox management fee and sales tax expense recur annually across the entire lease. Again, we recommend for Developers to try and push for a pre-construction Project Appraisal and IER. Although this costs $7k, it frequently ends up in a higher sale price and fewer headaches for Developers.
The Six Transaction Costs
A Little Context
1. Legal/Diligence Review
2. Appraisal
PRO-TIP
3. Independent Engineering Review
4. Cost Certification
5. Lockbox Agreement
6. Sales-Tax
Wrapping Up
About The Author
Solar Sale Leasebacks: 6 Hidden Transaction Costs
Rather than raising Tax Equity, some solar Developers are turning to Sale Leasebacks. It’s an easier transaction, but don’t let that fool you. There are still a few significant transaction costs. These costs are paid out of the Developer Fee. Worse, Developers can feel a little blindsided when the bill comes because these costs aren’t often disclosed during negotiation. To help our clients evaluate a Sale Leaseback, this article discusses six common transaction costs and includes ballpark numbers to add to your model.