Investors are finding value in establishing "landcos" to own project sites and lease them to project companies.

Investors are in it for the returns. This is especially true in the renewable energy market, where a crowded group of lenders and investors faces tightening margins.

Developers are also using landcos to separate ownership of project sites from the rest of the project, even where there are no outside investors on the landco side of the transaction.

Attractions

Landcos represent an unusually secure investment for outside investors. Landco owners are spared many of the investment risks that project owners customarily accept.

Project owners typically finance their projects with third-party debt and, when doing so, pledge all of their rights to the project as collateral. Project cash flow is used to pay debt service, but it can fall short in various circumstances, many of which are outside of the control of the project owner. If there is a default on the debt, the project owner risks losing the project in a foreclosure.

Even when there is no default on the debt, the project owner's access to equity distributions from the project can be limited or blocked. The share of project revenue available for distribution to the project owner can be reduced by cash sweeps in favor of the lender. Project owners typically accept springing distribution blocks if certain conditions are not satisfied—including, for example, if the project fails a minimum debt-service-coverage-ratio test.

If a share of project revenue is paid as rent for use of the site and thus routed through a landco, the landco owners are generally spared those risks.      

Site rent payments are treated as an operating expense. Operating expenses are usually paid ahead of debt service.

Even where a lender forecloses, rent payments are likely to continue for as long as the project requires access to the site.

There are scenarios in which site access may no longer be needed, such as after a catastrophic casualty where a decision is made not to restore the project. Such scenarios are remote. A landco owner wishing to limit its downside in such a scenario could negotiate provisions to do so in the lease.

Landco investors will be able to hold on to the site even if the project is thrown into foreclosure. Project financiers will require the right to use the site to be pledged as part of a project financing and thus be subject to foreclosure after a debt default. If the project owner merely leases the site, its leasehold interest is likely to be transferred as part of the foreclosure, but ownership of the land will remain with the landco.

Opportunities

A developer who is short on cash can identify sites for its projects, but find an outside investor who is interested in owning sites through a landco that leases the sites to the developer.

For developers who already own—or are in a position to acquire—sites for future projects, the landco opportunity has further dimensions.

By introducing a landco into its structure, the developer gives itself the option to raise capital against the project and site in unrelated transactions. The developer can retain the project company but sell the landco, or vice versa, or retain and finance both in separate transactions with unrelated counterparties.

For example, the developer could approach one of the real estate investment trusts or other active landco investors with an offer to sell the site.

Alternatively, a developer could borrow against a portfolio of landcos to pay other costs. For example, the landcos can be used as collateral to secure the obligation to prepay letters of credit that the developer must post to satisfy obligations to utilities under power purchase agreement or to grid operators for interconnection while projects are still in the development stage. Project finance banks have an incentive to provide letters of credit. It is a way to enhance their relationships with the developer while also giving the banks visibility into the developer's future project financing needs.

Holding a project and the project site in separate entities increases the aggregate economic value of both assets. The developer creates a rent stream that is effectively "preferred" project revenue, while eliminating the risk that the project site will be foreclosed on after the project is financed.

The developer has broad flexibility to select, via the rent payment terms, how much project company value will be allocated to the landco and thus what value the "preferred" project revenue stream will have.

The rent can be fixed in amount, such as a flat amount per acre or it can have variable elements, such as being tied partly to project gross receipts.

Whether it is fixed or variable, the rent can remain constant throughout the lease term, or it can include pre-set or contingent escalators. It can start high and ratchet down after a lessor rate of return is achieved. It can start low and ratchet up after a project company return is reached.

The rent can be structured as a fixed-income stream uncorrelated with project performance or it can be structure to approximate project equity-like returns, or any desired point in between.

The market is just starting to focus on the opportunities in rent design. Investors are starting to look beyond fixed rent streams in search of investments offering a balance of risk and reward that eliminates competition from bank lenders and justifies the returns the investors seek.

Developers also see opportunities. For example, a developer planning to sell a project, but wishing to retain a small stake in the equity returns, could create a landco rent payment stream that approximates equity-like returns, which the developer would continue to collect after the project is sold.

Bundled transactions

The landco structure does not prevent a developer from deciding later to finance or sell both the project and the landco in a single transaction.

In circumstances where the land is already owned by a landco and it is undesirable to transfer ownership of the land to the project company, a bundled financing can be done by putting the project company and landco under a single holding company and having that holding company act as the borrower under the financing. The project company and landco would provide subsidiary guarantees of the debt.

Where that structure is used to finance a renewable energy project, the presence of a landco has been shown to increase, modestly, the amount of debt that the project can support.

Debt in the typical renewable energy deal is back-levered. A tax equity investor co-owns the project company with the developer, and the lender lends against the cash distributions that the developer expects to receive over time. Typically, the financed cash distributions consist solely of amounts payable to the developer on account of its ownership interest in the tax equity partnership. The landco structure creates a second source of distributions, re-routing project revenues (in the amount of rent) from the project company to the landco, and from landco to the developer. Developers have successfully argued that the re-routed cash is more likely to be received by the developer and, thus, the developer should be permitted to borrow more, on a proportionate basis, against such cash.

Put another way, developers financing renewable energy projects and project sites in bundled transactions have been able to increase, modestly, the amount of back-levered debt that can be borrowed by running part of the cash that will be used to repay the debt through a landco.

Impact on financeability

Developers often ask how a landco structure will affect the financing of a project company on a standalone basis, meaning unbundled from the landco.

The primary impact is a reduction in the amount of debt the project company can borrow. Cash is being diverted from the project company to the landco to pay rent. This reduces the cash that the project has to borrow against.

There are ways to mitigate the impact. For example, rent payments could be structured so that they decrease during periods when the project company is at risk of failing its debt-service-coverage-ratio test, with catch-up payments later. If the rent amount is tied to project performance, such adjustments are automatic.

As a secondary impact, if the land is not owned by the project company, it opens a discussion with the lenders as to whether the land acquisition costs should be counted as funded equity, or "skin in the game," for purposes of calculating the project's debt-to-equity ratio.

Landco arrangements typically have a negligible impact on tax equity financings. In most current tax equity partnership structures, most of the cash generated by the project is distributed to the developer. Thus, while project revenue projections affect the amount of tax equity that can be raised, reduced revenue projections typically have a modest impact on the tax equity investment.

Care must be taken to avoid making rents a share of net income earned by the project company. That could cause the landco to be considered a partner in a larger partnership with the developer and tax equity investor.

In cases where an investment tax credit will be claimed on a project, there may be a benefit to keeping items like land, that do not qualify for the investment credit, out of the project company so as to allow the tax equity investor to claim an investment credit on a larger percentage of its investment.

Developers considering rent payments linked to project performance for projects on which an investment tax credit will be claimed should ask the appraiser what effect the rent stream will have on project valuation. If it reduces the valuation, then the amount of tax equity that can be raised will also shrink.

Finally, section 467 of the US tax code limits the extent to which rent can fluctuate in a lease. The section 467 tax consequences may have an effect on project economics.

Lease terms

Lenders and investors will want to ensure that the landco structure does not create exposure to any unusual or off-market risks.

A developer negotiating a lease between a project company and an affiliated landco should look consider the lease terms from the perspectives of both future lenders and investors. Future counterparties may feel compelled to take a particularly close look at the lease terms given that they were "negotiated" between affiliated companies.

Site leases used in precedent transactions may not be suitable, especially from the lessor perspective. While sites leases of financed projects have usually been vetted by sophisticated counsel to ensure adequate protection for the project owner, they may not have been reviewed as rigorously on behalf of the site lessor. Even if they were, it is unlikely that the precedent lessor sought the full scope of rights and protections that a developer would need to maximize the value of its landco.

Where possible, developers planning to finance or sell projects and sites separately should ask both sets of counterparties to sign off on the form of site lease before closing either transaction, since the developer's ability to address unanticipated counterparty comments through edits to the site lease will be significantly constrained after the initial closing.