Sponsor returns on utility-scale solar developments are extremely sensitive. Small changes in the price of tax equity, operating expenses, principal amortization, property tax abatements and equipment pricing can all sway the economics of a project below an acceptable rate of return. But by the time assumptions are near final, sunk costs are high. Developers will spend months attempting to negotiate these items, knowing that every dollar saved is one more dollar of income or a better Internal Rate of Return (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 rates between financial close and term loan funding.
Interest expense on a project’s term loan is typically two to three times the entire operating expense budget. Would a developer tolerate an unknown or uncapped O&M contract or lease payment? Never. Much of the industry, however, tolerates interest rate exposure until at or after substantial completion, sometimes without fully understanding or realizing the risk mitigation strategies that are readily available.
It is not that developers do not negotiate extensively for the best financing terms including fixed tenor and interest rate spread, but 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 current historically low rates and limited Fed discussion of rates increasing any time soon, but there is risk over the lengthy period of a solar project operating life.
To illustrate how quickly rates can rise, consider recent, actual, extreme changes for the 10 Year LIBOR Swap – a common index for loan pricing.
- March 9, 2019: 0.62%
- March 18, 2019: 1.07%
- Change: 72% in roughly one workweek
- May 29, 2020: 0.65%
- June 5, 2020: 0.88%
- Change: 35%
- August 4, 2020: 0.51%
- August 27, 2020: 0.75%
- Change: 48%
Were these increases in the project interest expense incorporated into the developer model prior to finalizing the capital stack and hitting NTP? Maybe, but what if the project will not be placed in service until summer or fall of 2020/21? What if rates rise another 0.50%? What if they rise 1.00%? It is quite possible that sponsors could be stuck with a project that they would never have green-lighted given the new economics.
Developers of larger utility-scale projects above 100 MW typically have the financial wherewithal to access the capital markets and self-hedge. Conversely, mid-scale developers may qualify for an interest rate swap from the big banks, but typically only after the initial disbursement of the construction loan. This also results in the reduction of the developer’s financing options since only larger banks have a swap desk.
An interest rate swap agreement may be an option for smaller and mid-size 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 or would like to avoid burdensome collateral requirements
- The developer would like to hedge the interest 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
- Debt need is less than expected resulting in a technical prepayment of the loan and potential swap-termination penalties
Many of these outcomes have potentially serious financial consequences. Worse, if a developer cannot qualify for a swap or needs to hedge a rate prior to financial close, few options have been available… until now.
Live Oak Bank has pioneered a long-term forward rate collar for its renewable energy developers. A rate collar caps the increase, and decrease, of the term loan interest rate based on the date of the rate collar settlement date. The rate collar can be in any increment desired by the applicant, but 1.00% for less sensitive projects and 0.50% for more sensitive projects seem to be the two most popular options. The narrower the collar, the higher the cost, so developers should model various rate scenarios to determine which combination of cost and protection is right for their situation.
As an example, assume lender and applicant negotiate a permanent loan rate of 4.00% if the loan were to fund at the time of negotiation (12 months+ prior to COD). The applicant chooses to collar the term loan rate for a period of 15 months based on a desired collar of 0.50%. The starting rate of the permanent loan would not exceed 4.50% as long as the loan was funded within the 15-month negotiated period. Conversely, the rate would not be able to fall below 3.50% (hence, the collar).
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 collared at, before, or after financial close. The risk is much lower than a swap since there are no potential termination penalties if the loan does not fund or is modified in some way. There is a one-time fee for a rate collar but no additional cost, risk, reserves or accounting of an unfunded liability. Live Oak is able to negotiate any level of collar.
To learn more about Live Oak Bank, our rate collar option and our services for renewable energy, visit our main webpage or contact Jordan Blanchard via email at email@example.com or by phone at (910)-247-4884.