By Scott Bank and Kelly Kogan

Renewable energy companies are looking at renewable energy investment trusts or REITs, among other vehicles, as ways to raise capital at lower cost.  REITs must own largely real property.  It is not clear how much beyond the land underneath wind farms and large solar projects or buildings underneath rooftop solar panels qualifies as real property for this purpose.  Nevertheless, some REITs are already engaged in the renewable energy market.  Several such REITs spoke at a meeting organized by Chadbourne in Washington in mid-May.  

The panelists are Jeff Eckel, president and CEO of Hannon Armstrong Sustainable Infrastructure Capital, Bill Hilliard, CEO and co-founder of CleanREIT Partners, Arun Mittal, vice president of business development for Power REIT, Pavel Molchanov, senior vice president of investment bank Raymond James, Will Teichman, director of sustainability for Kimco Realty Corp., and Drew Torbin, vice president for renewable energy at Prologis.  The panel was moderated by Scott Bank, Chadbourne real estate partner in New York, and Kelly Kogan, a Chadbourne tax lawyer in Washington.

MR. BANK:  Where will dividend yields need to be for renewable REITS to be attractive to investors?

MR. HILLIARD:  The percentages are hard to determine because when people talk about a percentage, they are often talking about an after-tax return or an internal rate of return on a specific project, and not the actual cash returned each year from that project or from the investment.  The same project portfolio generating a 10% cash return for a 20-year period, for instance, will have a 12% internal rate of return if the cash flows are augmented by a 30% investment tax credit or an 8% internal rate of return if not.  All three numbers -- 8%, 10% and 12% -- are accurate investor return descriptions.  But they are not comparable.

We are going public in Canada because we believe there are good comparables in the Canadian market even where the listed entity is not a trust.  For example, Brookfield is at the low end with a yield of about 4 1/2% to 5%.  Others are at the higher end with a yield of about 6 1/2% to 7 1/2%.

Based on the information we have seen, we think that to go public in Canada, you need to be paying a 6.5% to 7% annual cash dividend to investors.  That kind of arrangement begins to look like an interest-only 7% loan with no principal repayment.

MR. MITTAL:  Power REIT is publicly traded and has been for a while.  Power REIT is unique because it owns a railroad, but it is also transitioning into owning renewable energy properties.  Its current dividend yield is just under 4%. 

Renewable energy is a new market that is dependent on both the underlying assets and other attributes of the project.  For example, to the extent you have better assets, you obviously are going to trade at a lower dividend yield, and vice versa.  The type of leverage makes a difference, but so does the business plan.   The size and structure of the project are also relevant.  In short, the renewable energy market is highly differentiated.    

MR. ECKEL:  I can’t talk about our yields because we are still in a quiet period, but I am not sure that being a renewable energy-focused company brings added market benefit.  During our road show, we looked for investors interested in sustainability and renewable energy.  We found that those kinds of investors are not big participants in IPOs.  We might see them in the after market.

Ultimately, whether such specialized investors exist does not really matter.  Investors in the capital markets have plenty of ways to generate yield.  We met with 60 investors.  Two of them scoffed at the sustainability theme.  The others were quiet or politely dismissive of the idea.  So while the people in this room may care a lot about sustainability and renewable energy like Hannon Armstrong does, I am not sure investors do.

Kimco and Prologis  

MS. KOGAN:  Some people will be surprised to learn that a few of the more traditional REITs are already involved in renewables.  Will Teichman and Drew Torbin, could you tell us how Kimco and Prologis are participating in that sector and the reasons –- financial or otherwise -- for their participation?

MR. TEICHMAN:  Kimco Realty is a REIT that owns approximately 900 shopping centers in 46 states and Puerto Rico.  Kimco is also involved in the Canadian and Mexican markets through joint venture structures.  Kimco's properties total 130 million square feet of single story buildings, which equates to 130 million square feet of roof space. 

In 2009, we began to consider how to use that roof space.  We also realized that many of Kimco's larger tenants were interested in solar electricity as a hedge against increasing energy costs and as a way to lock in lower electricity rates through a long-term power purchase agreement.  We felt that the combination of these factors presented a business opportunity.

In deciding how to incorporate solar electricity into Kimco's portfolio, an important consideration was the ability to use the section 1603 Treasury cash grant.  We learned that the grant was available to a taxable REIT subsidiary but not to the REIT directly.  For this reason, we decided to use a wholly-owned taxable REIT subsidiary or TRS as the vehicle that would own, finance and develop Kimco's rooftop solar systems.  The TRS partnered with a third-party developer on construction of the projects. 

To date, Kimco's TRS has developed and owns about 3 megawatts of installed solar capacity on several shopping centers in New Jersey.  Its TRS sells the power generated to several of its major tenants at those sites under long-term PPAs.  The TRS manages all aspects of these facilities, including system operation, customer billing and contracts for sale of the solar renewable energy credits or SRECs.

MR. TORBIN:  Prologis' reason for moving into renewables is similar to Kimco's.  Prologis is an industrial REIT that owns warehouses and distribution centers with over 550 million square feet of rooftop space around the world.  Its objective in participating in renewable energy is to create additional value for its existing assets. 

Initially, Prologis started simply by limiting its involvement to leasing rooftop space on its distribution warehouses to third-party developers and project owners.  Later, it moved into developing and constructing these projects through a taxable REIT subsidiary. 

The two big differences between the way Prologis and Kimco operate are who owns the project and who buys the electricity.  Prologis' TRS is involved in the development and construction of a project, but then the TRS sells its interest in the project to an investor or utility.  Electricity generated by the project is retained by a utility owner or sold to a utility offtaker.  After the sale of its interest in the project, Prologis' role is limited to acting as a construction contractor and leasing rooftop space to the project owner. 

Currently, Prologis is host to about 100 megawatts of solar projects that its TRS developed and sold or developed with a partner.  The majority of these projects are in southern California with others located across Europe and Japan. 

MS. KOGAN:  How do Kimco and Prologis meet the REIT income and asset tests taking into account the assets and income from these solar projects? At least 75% of the assets held by a REIT must be real property, and at least 75% of the income must be rent from real property or interest on mortgages secured by real property.

MR. TORBIN:  Prologis' development activities are performed by its TRS.  Prologis' long-term participation is limited to leasing rooftop space.  The rental income from these leases is good REIT income.  Prologis does not own the solar projects.

MR. TEICHMAN:  Kimco's taxable REIT subsidiary leases rooftop space from individual property-owner landlord entities, it develops and owns the system, and eventually it earns taxable income from the sale of electricity and SRECs.  Any impact that this structure would have on Kimco's income and assets tests is nominal due to the small scale of these projects relative to Kimco's total income and asset base.

MS. KOGAN:  Has Kimco's taxable REIT subsidiary distributed any of its after-tax income to Kimco?

MR. TEICHMAN:  Yes, I believe it has.

Power REIT

MR. BANK:  I would like to turn to Power REIT, which has an unusual history.  I also understand that Power REIT made a decision to pursue properties that do not require a private letter ruling from the Internal Revenue Service.  Arun Mittal, can you tell us about Power REIT's history and its no-PLR strategy?

 MR. MITTAL:  Power REIT's sole asset for most of its history has been the Pittsburgh and West Virginia railroad.  How it came to own that asset is very interesting. 

The railroad was assembled around 1900, but with the advent of the interstate highway system in the 1950's, it started to have problems.  When the REIT rules were enacted in 1960, its owners saw an opportunity to reorganize its structure.  The only thing they needed was confirmation from the IRS that railroad properties qualified as good REIT properties.

In 1967, the railroad received a private letter ruling from the IRS concluding that its property, including the trackage, roadbed, superstructure, buildings, bridges and tunnels, qualified as real property for REIT purposes.  (Ed.:  The IRS later converted that private ruling into a broader revenue ruling that applies to all taxpayers and has been cited extensively in later private letter rulings and revenue rulings.)  Shortly after receiving the PLR, the railroad was transferred to Power REIT, a REIT traded on the then American Stock Exchange.

For more than 40 years, Power REIT did not do anything other than own the railroad and receive rent from a single lessee, the railroad operating company to whom the REIT leased its assets.  Shares in Power REIT were similar to a bond that paid out a fixed rate of return to its shareholders.  Power REIT was not interested in doing anything else.    

When we stepped in a few years ago, we saw a real opportunity to capitalize on what we believed to be an innovative public platform that could provide capital to and monetize real estate-related assets owned by energy and infrastructure projects. 

Initially, we considered applying for a private letter ruling.  However, after talking to large asset owners and describing what we were doing, we decided that it did not make economic sense for us to incur the cost of obtaining a private letter ruling.  Coupled with the fact that there are a number of other people hiring law firms to do exactly that, we decided to focus on acquiring properties that are clearly good REIT property under the existing rules. 

That said, we are certainly willing to consider properties in the grey area.  We also have no aversion to jumping on the bandwagon if and when the IRS rules that a particular type of renewable energy property is good REIT property.

CleanREIT

MR. BANK:  Bill Hilliard, your firm has a slightly different PLR-related history.  CleanREIT actually started down the road to obtain a private letter ruling but then aborted the process.  Can you take us through how far down the road you went toward getting a PLR, the decision to pull the plug, and what CleanREIT decided to do afterwards? 

MR. HILLIARD:  My partners and I have backgrounds in both tax credit investing and mortgage REITs.  In 2009, the idea of starting a mortgage REIT did not seem very attractive, so we started thinking of other ways to combine our expertise in REITs and renewable energy.  We came up with the idea of a renewable energy equity REIT. 

After doing our homework and even hiring tax counsel, we put out feelers to the IRS about its views on the status of renewable energy property in general as good REIT property.  We quickly learned that the IRS had significant reservations about whether many of the components of wind farms could qualify.

At this point we decided to focus exclusively on solar.  We even got to the point of asking the IRS for a pre-submission conference, a meeting with the IRS to discuss our possible ruling request.  We thought that if we could help the IRS get comfortable with the idea that solar is both inherently permanent and passive and that our proposed investment structure is also passive, then the IRS might be willing to issue a PLR confirming that solar assets are good REIT property.  (Ed.:  Equipment and machinery do not qualify as good REIT property.  Only real estate does.  What looks at first glance like equipment can qualify as real property for REIT purposes if it is considered permanently affixed -- "inherently permanent" -- but not if it is machinery.)    

It quickly became clear that the IRS didn't really understand solar technology.  For example, it did not understand that although solar PV assets perform the activity of generating electricity, they are not like more traditional electric generating assets.  For example, they do not have moving parts and do not require fuel and on-site personnel to operate.  They just sit passively. 

About this time, we also started talking to bankers who specialized in REITs and other specialty finance companies.  To our surprise, we learned that they viewed solar energy REITs as a niche REIT similar to REITs that owned things like vineyards, and that they had little interest in bringing such a vehicle to market.

At this point, two things happened.  First, we began to reexamine our strategy of pursuing an IRS private letter ruling.  We decided to put that strategy on hold at least until the markets caught up with us.

Second, we were introduced to the concept of a Canadian income trust.  This is a type of pass-through entity formed in Canada that generates high yields.  Its units are traded on Canadian stock exchanges.  It is used to raise money in the capital markets, which it pools for investments outside of Canada. 

Because Canada does not impose any limits on the type of property an income trust can own other than that the property not be used in carrying on a business in Canada, Canadian income trusts are a good option for owning renewable energy assets in the United States.  A second benefit is that there is plenty of information in the Canadian markets about how to price these investments.  For these reasons, we were able to engage bankers for an IPO.  We were also able to raise some initial capital to begin acquiring assets.

There are two additional comments I would like to make.  The first is that the capital markets want to see a stream of cash flows.  While the markets are interested in the presence of a development pipeline as a way to ensure future growth, the only assets they will value are an entity's operating assets that generate cash flow.  For this reason, we are looking for post-COD solar assets that are either more than five years old or that are 1603 cash grant-financed (since we can acquire both kinds of assets without triggering recapture under our acquisition structure).

Second, because a solar project is a wasting asset more akin to an amortizing mortgage than a parcel of real estate that grows in value, we plan to adopt a strategy of limiting our payouts to about 80% of our cash flows.  The remaining 20% will be used to reinvest in new properties.   This is one way we hope to grow our asset base.

Hannon Armstrong

MS. KOGAN:  Turning to Jeff Eckel, your company, Hannon Armstrong, received a private letter ruling from the IRS last fall.  Because the PLR has not been made public yet, there has been tremendous speculation about what is in it.  Many seem to think that it will open the floodgates to investments by REITs in renewable energy projects.  Can you tell us about the PLR and whether that speculation is warranted?

MR. ECKEL:  Sure, but first let me take a step back for a moment.  Hannon Armstrong is a 32-year-old specialty finance company that provides debt and equity financing for sustainable infrastructure projects.  We do equity transactions and we do mezzanine debt transactions, but we are best known as a senior lender. 

We securitize many of our assets.  Since 2000, we have arranged close to $3 billion of securitizations.  Most of them are energy.  Some are telecommunications.  Some are water assets. 

Because a lot of what we do is related to buildings and their structural components, we have always had the sense that our assets would be good REIT assets. 

We have also wanted to broaden our investor base.  Our historic investors have all been institutions.  We have had private equity and personal equity, but it was not a broad investor base.  With a REIT structure, we were able to generate significantly more capital that is economically priced. 

In addition, under a REIT structure, our capital is permanent.  We do not have to go back and ask a private equity firm for a little more capital.  It also allows us to act with discretion, something we think we deserve given our history.

What we did not seek to do is to convert to REIT status in order to avoid taxes, and I have been rather alarmed by New York Times articles suggesting that is the case.  It never occurred to us that there was a tax angle.  We converted from an LLC, which is a pass-through entity, to a REIT, which is also a type of pass-through entity.  There was zero tax-related motivation for our decision.

As for our decision to request a private letter ruling, that was really belt and suspenders.  After we hired our very expensive IPO counsel but before we incurred significant legal fees, we wanted to make sure that the IRS would be comfortable with our REIT status. 

The PLR was a way to do that.  It is very narrowly focused on our balance sheet that we have built up over three decades.  It is specific to our situation. 

That said, we never felt that we needed the PLR to qualify as a REIT.  We were confident that we could have closed the IPO without it.   However, being a pretty conservative company, we like having the insurance policy that the PLR represents.

As for the future, we are very active in the renewable energy business.  Our platform reflects our intention to invest in a lot more renewables: solar, wind, geothermal.  We also have a bias toward assets that contribute to the reduction of carbon.   

We also hope to migrate to additional investors who care about sustainability, but frankly we will always have to compete for capital like every other REIT.  I do think we are in a good position to do that.

Buying Assets

MS. KOGAN:  Arun Mittal, I understand you closed on one property acquisition earlier this year, and this month you announced that a term sheet had been signed for a second one.  Please describe the types of property that Power REIT seeks to own and how you look for those properties.  What attributes make them appealing to you?

 MR. MITTAL:  Power REIT's goal is to purchase good REIT properties without going to the IRS.  This means that we are focused on acquiring land and certain other items that can be bundled with the land.  The first transaction we did was the acquisition of the land under the largest solar farm in Massachusetts.  We just announced a similar type of transaction in California.    

We are looking at operating assets, like the one in Massachusetts.  We are also looking at partnering with developers and asset owners in the late development or preconstruction stage.  We believe this will provide several benefits.   

First, it provides developer liquidity in cases where developers have contracted to buy land.  Second, we think it provides a part of the capital stack that is not well suited for a tax-oriented investor. 

As to how we find assets we are interested in purchasing, I would say we talk to a lot of people and come to programs like this.  So if any of you has assets, come talk to me.

MS. KOGAN:  Given that REITs are required to distribute 90% of their taxable income each year, how do you come up with the cash you need to buy these other assets?

MR. MITTAL:  Most REITs are very aggressive capital raisers.  Power REIT has a $100 million shelf offering in effect with the US Securities and Exchange Commission.  We also have access to the capital of institutional and private investors who are interested in renewables energy and with whom we have been speaking for a number of years.  We also use debt. 

With access to these three sources of capital, we will be looking to capitalize transactions as they show up.  We do not like to raise money and then have it sit on the balance sheet waiting to invest.  Our goal is to capitalize as assets show up.

Foreign Assets

MS. KOGAN:  Drew Torbin, you mentioned that Prologis has a lot of warehouses and other buildings outside the United States, and Will Teichman, you told me before the panel session that Kimco has some involvement in the Canadian and Mexican markets.  One of the things this reflects is that good REIT property does not have to be located in the US.  It can be outside the US.  Can each of you comment on your experiences with developing and owning renewable-type assets outside the US?  Are there opportunities for US developers, US equipment suppliers, etc. to help in those efforts outside the US?

MR. TORBIN:  Solar is certainly a global industry.  One of the bigger aha moments for us was when we were given vastly different prices on an installation in France, which at the time had a very attractive feed-in tariff, and an installation in the US.  This happened even though the technologies were the same.     

Obviously, people were pricing to the market.  We have had face-to-face discussions with our suppliers letting them know that this is a global industry and that the real estate owner is the one that should be controlling the upside, whereas the supplier should be pricing on a cost-plus basis.   

The other big lesson we learned with international development is that you have to have a local partner.  An example of learning that lesson is an 8-megawatt project in Spain we completed with a US-based development partner.  We tried twice to fit within the feed-in-tariff window.  We sent in people from both our firm and our partner.  We did not actually succeed, however, until we sent in local colleagues.

I think that is true in the US as well.  I have had meetings in some parts of the US in which having a local person attend with you has been very helpful.

The biggest opportunity I see is in operations and maintenance.  There is a huge O&M procurement gap in this industry.  It is hard to find a large bankable, geographically-diverse O&M provider.  For better or worse, investors have gotten used to accepting smaller O&M providers that are geographically oriented in one spot.  It would be very nice to have somebody that is much larger, and with a much larger balance sheet, to perform that side of the business.

MR. TEICHMAN:  Kimco does not have any solar projects yet outside the US, although we are in the process of exploring some opportunities through portfolio reviews.  One possibility is the Mexican market.  There are a lot of things going on in Mexico that potentially may open that market up for solar. 

The other thing I can talk about is the portfolio review process itself.  One thing we look for during that process is a good local partner.  Having local boots on the ground is an important factor, which we learned through our experience in doing energy efficiency projects.

In terms of assessing locations, a very important consideration obviously is the prevailing rates and market for local power from the grid. 

Another factor is the potential offtaker.  In the US, Kimco sells power to its tenants.  In Mexico, the situation is a little different.  All of Kimco's Mexican shopping centers have enclosed common areas, which means that Kimco itself can consume a portion of any solar electricity it generates to electrify, heat and cool those common areas.  The third factor, perhaps surprisingly, is the roof itself.  One of the things that has continually surprised me is the number of potential projects that fall off the list as a result of the condition of the roof.  This may be due to the fact that in the shopping center industry, buildings and their roofs tend to be a little bit older. 

Also, the roofs of larger properties tend to vary in age in a patchwork fashion.  It is unusual to replace an entire roof at one time.  Instead, replacement is done in sections in order to manage the capital costs year-to-year.

So roofs are a big issue for Kimco, and they are one of the reasons that solar projects do not get done.  It would be helpful if a structure could evolve that would bundle some of the re-roofing costs into the overall scope of the solar project.  That would make many more projects work for us.  That is something we are trying to work our way through right now.

Potential for US REITs

MR. MOLCHANOV:  I'd like to add a macro level observation.  There is a reason why historically 90% of the world's solar installations have been outside the US, and that is because the US has the cheapest electricity of any industrialized country. 

So, by definition, the economics of both rooftop and ground-mounted solar are better in any other OECD country than the US.  In the US, we pay 8¢ to 12¢ per kilowatt hour for residential, with commercial rates less than that.  Europe pays 50% more.  Japan pays double.  The US market is on the tail end of where the economics are.

MR. BANK:  What are your thoughts about the various structures -- not only REITs but also others like master limited partnerships and yield cos -- that are being talked about in the industry?  Do you think they ultimately will have the desired effect of reducing the cost of capital for renewable energy projects?

MR. MOLCHANOV:  If they can pass legal muster in the case REITs or political muster in the case of MLPs, then there would certainly be demand for them. 

Let me put it this way.  Ten years ago MLPs were in two categories.  There were pipeline MLPs and there was timber MLPs, and that was it.  Now there are MLPs that make fertilizer, MLPs that own refineries, MLPs that own gas stations and MLPs that own offshore drilling rigs. 

If investors can gravitate to those assets, there is no reason why they would not gravitate to assets that, at a minimum, have less risk.  Solar projects by definition do not have much operating and political risk.  There are no oil spills to worry about and no need to obtain drilling permits.  As we have tragically seen recently, fertilizer plants sometimes have accidents.  Solar projects do not.  For this reason, I absolutely think there would be investor appetite for these structures.  The challenge is that they first have to get past the legal and political hurdles.