Sponsor returns on utility-scale solar developments are extremely sensitive. Small changes in the price of tax equity, OpEx, amortization, property tax abatements and equipment pricing can all sway the economics of a project below a hurdle rate or into the red, but by the time assumptions are near final, sunk costs are high. Developers will spend months attempting to negotiate these expense items to the lowest extent possible, knowing that every dollar saved is one more dollar of income or a better IRR to sponsor equity. Despite this early attention to detail on many fronts, in our view, developers often fail to consider the uncapped risk potential of rising interest rate expense between financial close and term loan funding.
Interest expense on a project’s term loan is typically two to three times the entire OpEx budget. Would a developer tolerate an unknown or uncapped OpEx expense or lease payment? Of course not. Much of the industry, however, tolerates interest rate exposure until the term loan funds after substantial completion, sometimes without fully understanding it or realizing the risk mitigation strategies that are readily available to them.
It’s not that developers do not negotiate extensively for the best financing terms – including the interest rate spread. Once the index-plus-spread is established, most developers either ignore–or do not fully contemplate–the threat of rising rates during the remaining development cycle. Yes, some developers conduct interest rate shock analysis, but we find that scenario analysis is often too optimistic. This is likely the result of a decade of very low, very stable interest rates and a flat yield curve. This behavior is understandable given that low and steady rates have been around longer than the period of high-volume utility-scale solar development.
To illustrate how quickly rates can rise, consider the recent movement of 10 Year LIBOR Swap – a common index for loan pricing. As of January 1, 2018, 10 Year LIBOR Swap was 2.40%. On February 21, 2018, the index hit 2.98% – a roughly 0.60% increase. Was this increase in a project’s interest expense incorporated into the developer model in 2017? Maybe, but what if the project will not be placed in service until summer or fall of 2018? What if rates rise another 0.50%? What if they rise 1.00%? It’s quite possible that developers could be stuck with a project that they would never have green-lighted given the new economics. Can the developer mitigate this interest rate risk?
Developers of larger utility-scale projects above 100 MW typically have the financial wherewithal to access the capital markets and self-hedge. Mid-scale developers may qualify for an interest rate swap from the big banks, but only after the start of construction. This also results in the reduction the developer’s financing options since only larger banks have a swap desk.
An interest rate swap agreement may be an option for some developers, but consider the course of action a developer might take in the following scenarios:
- The developer does not meet the credit requirements for a large-bank swap
- The developer would like to lock in the rate prior to financial close and the start of the construction loan
- The developer needs additional flexibility in case project construction runs longer or costs more than expected
- A project costs less than expected and/or the resulting permanent loan is reduced due to various factors such as a lower-than-expected yield
Many of these outcomes have potentially serious financial penalties with a swap. Worse, if a developer cannot qualify for a swap or needs to lock a rate prior to financial close, few options have been available… until now.
Live Oak Bank has pioneered a long-term forward rate lock product for its utility-scale term loan borrowers. Live Oak accesses the capital markets on behalf of the developer since this type of hedge is only available to well-capitalized financial institutions. Rates can be locked at, during or before financial close. The cost is much lower than a swap – both in terms of the fee and the embedded mark-up in the rate by the swap provider. The key difference between the Live Oak Bank rate lock and a traditional swap is the requirement for cash collateral (margin) versus an unfunded liability for a swap. An unfunded liability for a swap is clearly better for the developer as compared to cash collateral, but what if the developer cannot qualify for a swap or wants to lock the rate prior to financial close? We believe the risk of rising rates outweighs the temporary and short-term utilization of cash.
To demonstrate the rate lock product, let’s a consider a hypothetical bundle of projects with the following metrics:
Total project costs: $75,000,000
Perm loan amount: $50,000,000
Estimated placed in service date: December 1, 2018
Estimated permanent loan
Funding date: December 15, 2018
Loan index: 10 Year LIBOR Swap
Current index rate: 2.88% (as of February 23, 2018)
Live Oak would be able to offer a long-term forward rate lock, based on current market conditions, with the following characteristics:
Rate lock expiration: December 19, 2018
Rate lock index: Current 10 Year Forward LIBOR Swap (December 19, 2018)
Current rate lock
Index rate: 2.99% (a 0.11% differential in the current index, but locked for almost 7 months)
Rate lock fee: $7,000
Initial margin: @ $400,000 (equal to 80 bps of the permanent loan amount and less than 55 bps of project costs)
Additional margin: @ $400,000 for each 0.25% drop in benchmark rate
Frequently asked questions (FAQs):
Question #1: Why is cash collateral (margin) required?
Answer: Live Oak enters into an enforceable contract with financial ramifications if the permanent loan does not fund within the time frame anticipated.
Question #2: Will my deposit be returned?
Answer: Yes, subject to the loan funding, regardless of market rate movement (up or down).
Question #3: Can I lose my deposit?
Answer: Yes, subject to three simultaneous events:
- The loan does not close during the rate lock period
- Rates are lower at the time of the rate lock expiration
- The rate lock is not extended
Question #4: What happens if a project’s development and construction timeline runs past the rate lock period?
Answer: A rate lock can be extended subject to a resetting of the long-term rate.
Question #5: What if market rates decline during the rate lock period?
Answer: A loan’s interest rate will be based on the forward starting index regardless of the movement in rates.
Question #6: Are there legal fees related to the rate lock?
Answer: No, subject to no requested changes in our standard rate lock agreement.
To learn more about Live Oak Bank, our rate lock option and our services for renewable energy, visit our website or contact Jordan Blanchard via email at firstname.lastname@example.org or by phone at (910)-247-4884.