Valuation of Solar Assets

Overview

In the equipment leasing industry, a residual value is the leasing company’s equity investment in the lease. It is, nominally, the value of the equipment at the end of the lease, the price that the lessee will pay to buy the equipment, or, in the event of return, the equity investment in the lease that the leasing company has to recover to make itself whole on its lease pricing/economics.

What is a Residual and How is it Determined?

The lease residual is a valid and meaningful concept in the case of fair market value (“FMV”), leasing, or an operating lease. Lease accounting has undergone many transformations and evolutions over the last few years, but in general an operating lease is defined to be “off-balance sheet financing”, where the lessor takes sufficient risk of ownership of the equipment, often with a residual value of at least 20% of the equipment cost. The definition of operating lease can get quite technical, and is outside the scope of this article about residuals. So don’t quote me on this and make me put on green eyeshades.

Leasing companies tend to want to do operating leases with meaningful residuals on equipment they know well, through internal asset management analysis or by securing an outside appraisal, which is an opinion of value.

The residual is not simply a forecast of the expected future orderly liquidation value of the asset at the end of the 60 month lease term, although that thought is the best starting point. The residual is NOT the leasing company’s forecast of the value of the asset, it is the amount of equity risk that the leasing company is willing to take on the investment in the lease contract. The expected future value of the asset is the starting point to determination of the appropriate level of risk to take on the lease contract. But the bottom line decision is the leasing company’s expectation of future economic value it will realize from ownership of the residual in the contract. The leasing company will realize revenue from the lease contract at end of term through three revenue streams: purchase of the equipment at the end of the lease by the existing lessee is the most common event at end of term; the existing customer can also renew the lease for 3 months or 12 months at the end of the lease term, and those sums as well go into residual realization; finally, in the event of return the leasing company can sell the equipment to a third party on the open market. In a leasing portfolio all of these end of term revenues goes into calculation of residual realization, an important component of earnings for equipment leasing companies.

An example of common equipment that is residualized by leasing companies for their lease business is Class 8 tractors, also known as commercial heavy trucks. In order to determine the residual of a Class 8 Freightliner Cascadia 126 tractor, the appraiser or asset manager or valuer for the leasing company can use three primary valuation methods: the market approach, the cost approach, or the income approach to value. An in depth analysis of these methods is a topic for a future discussion. The most common and most intuitive method is the market approach: analyze the market to see what comparable Freightliner Cascadia tractors have sold for in recent auctions, and the current offering prices advertised for sale of these trucks. In the case of popular Class 8 trucks, it is relatively easy to collect current sales listings and recent auction results. Many used truck websites such as commercialtrucktrader.com and truckpaper.com have thousands of current sales listings for all types of Class 8 trucks – Peterbilt, Kenworth, Volvo, International, and the subject Freightliner. As of 12/24/20 there were 10,667 Freightliner Cascadias currently listed for sale just on truckpaper.com. Each listing shows year, mileage, and current offering price. Also on these websites you can get hundreds of recent auction sales results, which are actual sales and not just some truck sellers wished for listing price. It is important to analyze these sales listings and auction results properly, to determine the exact amount you should be expected to recover in the event of later sale. Appraisal of Class 8 tractors will be the subject of another article, in which we will explore all the factors that affect the value of Class 8 trucks. For now, it important to realize that you compare you subject truck – age and mileage – with the comparable sale. If your goal for the residual is to determine the value of the truck after five years and 500,000 miles, because your lease contract limits usage to 100,000 miles per year, then you adjust the comparable sales or listing to the subject. So if a 2017 Freightliner Cascadia with 600,000 miles is listed for sale for $80,000, you adjust it to five years old and 500,000 miles, by subtracting dollars for age and adding dollars for mileage, so you end up with something like an adjusted value of $85,000. Techniques and methods for market approach, cost approach, and income approach will be covered in a future blog post.

Competitive factors affect determination of residual as well as market factors. You will not be competitive in the operating lease market if you are not willing to take reasonably aggressive residuals, as you will get outbid on rate by leasing customers. Higher residual means lower lease rate, the monthly cost of the lease to the lessee customer. But if you are too aggressive and write leases with very high residuals, your earnings in future years will take hits or you may lose money in the business.

In the last decade, solar has experienced an average annual growth rate of 50%. Installations surged in 2016 ahead of potential expiration of the ITC, but an extension in late 2015 has created federal policy stability through 2021. Solar project costs have continued their rapid decline; the cost of utility-scale solar projects has declined by 80% during 2010-2018. The political environment has promoted rapid development of solar energy – the climate change crisis, the Paris climate agreement, the rapid politically-motivated closure of coal and natural gas power plants, and the increasing political incorrectness of nuclear power.

The solar industry is booming, with reduced prices for solar installations driving a lot of the growth and causing a lot of the growth through increased economies and reduced manufacturing costs. These 40-year assets are an attractive place for leasing and investment. Valuation of solar assets, facilities and projects, is best accomplished by the income approach, as the production of the commodity of power can be relatively straightforward to value – discount the value of the megawatts of power produced for 7-10 years and the value emerges.

PV solar projects are designed to produce power for 25+ years. Due to the newness of this industry long term data is not yet available. Traditionally solar developers had assumed at the outset of a new project annual degradations of 2.0% in solar project DC output, but recent studies have demonstrated that this level of degradation assumption had been far too conservative. Studies of 20 and 30 year old solar panel output have shown degradation only on the order of 0.5% per year or less. As the industry matures, it is becoming apparent that the average economic useful service life of solar arrays is 30+ years.

While PV solar panels are available for purchase on eBay and on other equipment sales websites, the sale and redeployment of mature operating solar arrays is actually quite common. Sale as an operating project is the only reasonable outcome for a large project. Power is a commodity with readily determinant value. Many large developers commonly purchase operating facilities when the offtaker goes bankrupt or otherwise has no further need for the project. Solar farms generally stay in place and stay in operation. Most solar projects have PPAs, which are easily transferrable to the new owner, so that the value of the project is specifically spelled out by the 25-year PPA pricing schedule. But for the fewer project without PPAs, the value of the future power is pretty easy to compute. Developers will discount the value of the future 7 or 10 years of power by 6-7% and that is how much they will pay for an operating project.

Solar Asset Valuation

Capital assets such as construction equipment and trucks and trailers are most typically valued by the market approach, by examination of the sale of comparable forklifts, cranes, or class 8 tractors which are widely available in the market. Solar assets are generally not subject to valuation by market comps. A typical 1.5 megawatt (“MW”) solar project consists of $525,000 of solar PV panels plus $1.2 million of racking, inverters, electrical installation, engineering costs, and profit for the developer. There is some market developing for used PV solar panels, but the highest and best value is sale of the system as is, one big operational project since you can’t sell electrical installations and big metal racks.

The developer is the primary manager of the project and is usually the project operator as well. The “offtaker” is the entity using and paying for the power and the entity that hires and pays the developer. Almost all solar projects have underlying “PPAs”, or power purchase agreements, which are 25 year contracts by the utility to purchase the power for escalating prices.

The total value of the renewable energy market has been in the $230 billion – $310 billion range in the last ten years, with the peak of $312 billion occurring in 2016 as US tax credits were threatened to expire on 1/1/2016. The credits were extended for at least another five years, and the growth has resumed. Over 10 GW of new solar capacity has been added in the US in each of the last four years 2016-2019. In 2008, new solar projects were being built for over $7 per watt, now under $1.50 per watt. The US solar market is now at approximately $30 billion, the majority of which is project financed. Banks, investors, developers, and other stakeholders have a need for appraisals of these projects.

Cost Analysis for PV Solar Project

A typical 1.5 MW PV solar project built in 2019 might cost $1.95 million, or $1.30 per watt. The nearby chart shows project cost, the value of power in California, the host state, and other basic facts about the project. When valuing the solar project it is important to understand and verify that the costs are reasonable and customary. Overpaying for an asset does not make it more valuable.

Two important cost items to review are cost per watt, the bottom line cost of the project, and soft cost percentage. Soft costs are typically 15% – 25% of the cost of a solar project, and includes the considerable cost of the electrical contractors to install the PV panels, the string of inverters, and other power components of the system. The PV panels, leading OEMs including Jinko, Canadian Solar, Trina, and Hanwha, generally comprise a third of the cost of a PV solar installation. “BOS” stands for “balance of system”, and this cost includes the electrical work, developer profit margin, and other costs.

Here is the cost breakdown for that typical 1.9 MW PV solar project:

The future value of a PV solar project can be estimated by value of the components on the secondary market, and by value of the power produced by the project – the income approach. Because most developers and off-takers are not efficient taxpayers and the huge 30% tax credit is there, most solar projects are lease financed. It is important to have an efficient taxpayer there to monetize the tax credit. The typical tenor of an operating lease financing, one that leaves ownership of the asset in the ownership of the big bank and not the small developer, is 7-12 years. The asset must stay in place for 5 years for the ITC to remain valid. The lessor takes the ITC and applies it to the lease payments. 90% of projects have a PPA in place.

PPA – Guaranteed Income for the Project

A PPA, power purchase agreement, is a contract between the offtaker and the local utility for the utility to purchase the power, usually for an escalating price, for, say, 25 years. It is like guaranteed income for the project. The PPA buyer receives stable, low cost electricity and the ability to claim green bragging rights and fulfill any government contractual requirements to be “renewable”. Importantly, the PPA income stream stays with the project and is transferable to any new owner. PPAs are allowed in most states but are explicitly prohibited in a handful of states including Florida, Alabama, Oklahoma, and Kentucky. In some states, there are certain restrictions on municipalities with respect to PPAs.

PV Solar Array – Determination of Value

The first step in valuation of solar assets is to understand the project and to ensure that it is a viable, economical project. Many firms, including developers, do engineering studies of solar projects which project detailed costs and exact power output by month and by hour of each day. The “PVsyst” is a commercial software system that accepts all the project inputs – latitude/longitude, average temperature, elevation, illumination intensity – and computes the likely project output in watts per day, per month, and per year. The PVsyst run is only as valid as the quality of the inputs, and so must be carefully evaluated for reasonableness. The PVsyst is used by developers, architects, engineers, researchers, and investors to evaluate the project value.

The PV solar project is a 30+ year asset. The appraiser must consider the ownership and control of the land the project sits on. For a 10-year lease, the appraiser should ensure that the offtaker has control of the land for at least 20 years – and the appraiser should review the lease to make sure this is true.

One way to recover value, and to determine value, of the solar project is through the sale of the PV panels independent of the operating project. The fair market value in exchange of a PV solar module is a concept that is emerging as the industry begins to mature. Some projects go bust, real estate deals go bad, and sometimes panels are sold. You can go to eBay right now and buy used solar panels, and independent value for used solar panels is beginning to have some meaning. Prices for used solar panels on eBay and on other equipment trading websites have come down as the price of new solar panels has come down. The price of new solar panels has come down drastically over the last ten years – a 315 watt panel that cost $7 seven years ago can now be purchased for around $0.62 per watt, so used prices have to come down as well. The price per watt for a new solar project is leveling off at around $1.00 – $1.25 per watt, so the dramatic price declines of the past will not be repeated. Since the price of the panels are only about a third of the price of the total PV project, if the used price of the panel is 30% of the original price of the panel then the total amount recovered will be about 10% of the cost of the project. A more realistic approach to valuation is to value the whole project, using the income approach.

PV Solar Project – Valuation of an Operating Solar System with PPA

Power is a commodity – everyone needs it and the grid has an insatiable need for more power. Developers own and operate large portfolios of projects, employ central monitoring stations to track performance and problems with projects in real time. As such, there is a robust and active market for sale of operating solar projects. Active developers will calculate the value of a project by taking the PV of the power over the next 7 or 10 years, then discount by 7% – 10% and that’s how much they will pay. The value of the power if covered by a continued PPA is easy to calculate; if no PPA then the value of electricity in that state is pretty well known, from 10 cents per watt in some states up to 20 cents per watt in New England.

Here is an example of valuation of an operating 1.5MW PV solar project. Estimate how much power will be produced each year, using the PVsyst estimates, and multiply by the value of the electricity. Select or negotiate the term to determine the exact value.

PV Solar Project – Valuation of an Operating Solar System – Market Pricing

When there is no PPA, the value of the power is calculated using average electricity prices for the subject state. The following example values the output from a 1.5MW solar facility based on the present value of 7 years of power, a typical planning horizon for a developer investor.

Conclusion

The solar market is experiencing strong growth, and production of electricity by coal continues to fall. Investors, banks, and leasing companies have a need to evaluate the value of the project to compute the appropriate financing rates. The value of an operating PV solar project can be calculated in the developer market by estimating the value of the power which will be produced in the next 7-10 years, then discount at the investor’s / developer’s required return rate to present value.

Mr. Nugent is an Accredited Senior Appraiser of the American Society of Appraisers. He holds a BA in Statistics from the University of California, Berkeley, and an MBA from Santa Clara University.

BlueChip Asset Management is an appraisal and asset management services company which serves the ABL, banking, equipment finance, legal, and turnaround industries. Members of TMA, ELFA, and CFA. Contact us for asset valuation assistance at 415-515-1110, www.bcamasset.com, or schedule a free 15-minute consultation.

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