A common decision for business owners planning to go solar is whether to apply for an operating lease or a capital lease. This is a critical decision as there are numerous tax-implications and financial benefits in each product. The first step is to understand the fundamental differences between the two products.
A Capital Lease is an “on-balance sheet” transaction in which the borrowing entity owns the system. As a result, they wholly utilize the tax benefits associated with ownership. These tax benefits include depreciation of the asset (which can be accelerated per section 179), monetization of the 30% solar tax credit (ITC) and annual interest expense. The system is classified as both a long-term asset and a long-term liability. Additionally, the capital lease is deemed as 100% financing due to the minimal purchase option at the end of the term (3% of project amount being the most common buyout.)
An Operating Lease, also known as a Tax Equity Lease or Off-Balance Sheet Lease, is structured so the lender is the owner of the system. In contrast to the capital lease, the lender captures the depreciation and 30% tax credit. In exchange, the borrower accepts a discounted monthly payment equal to as much as half of the monthly payment on a capital lease. The borrower still receives SRECS income due to the fact they are still operating the system. The end of term is a key difference in both lease options. For the operating lease, the borrower has a pre-arranged option to acquire the system when the term matures for anywhere from 15% to 30% of the original system cost. In the example of a $1MM system, the purchase option ranges from $150,000 to $300,000 pursuant to the lender and term (a capital lease purchase option would be more like $30,000). Every operating lease we facilitate, the borrower intends on exercising their purchase option.
The financial reporting aspect of an operating lease is that it stays off of the balance sheet and is applied on the income statement as a rental expense. This is an attractive feature for borrowers who have pre-existing lenders who have imposed covenants restricting the addition of long-term debt. I see this from mortgagees and line of credit providers.
So, the obvious question, which program is better? That depends on who you are. It’s like asking if you prefer the beach or the mountains. In my experience, it boils down to if the borrower knows they have the tax appetite to utilize the tax credit and depreciation. Many of these clients are successful, high net worth and high earning individuals who are punting away hundreds of thousands (millions even) of dollar to Uncle Sam. These clients should apply for a capital lease. The monthly payments are higher than an operating lease but after utilizing the tax credit and accelerating the depreciation in year 1, the borrower will be massively in the green from a cashflow standpoint. They also have a much smaller buyout ($30,000 vs. $300,000 on a $1MM lease) so there is not a looming buyout 7 year down the line.
This client is also going to have more scrutiny towards rate and the implied rate of a capital lease is several hundred basis points more aggressive than an operating lease. The reason is that the lender doesn’t bake in the risk of being unable to monetize the credits or the added admin work of monetizing them. Higher risk = higher rate.
There are also significantly more lenders willing to finance a capital lease since they don’t have to deal with the tax credit monetization. Some borrowers think, who cares, my credit is amazing, no matter who the lender is I’ll qualify. The difference is every lender has different criteria and requirements of which may or may not fit the borrower’s needs. For example, some banks require monthly ACH, some want 15% down, some want a notarized property waiver from the mortgagee, some require all shareholders to guarantee regardless of role in the business, some offer early payoff some don’t. When there are more available lenders, it is easier to find the right fit for the borrower. It also increases borrower’s power. I have installers who push the operating lease product and express constant frustration over lenders inability or unwillingness to successfully underwrite the projects.
While the Capital Lease is superior in rate, credit, and structural flexibility, there is a place for the Operating Lease. It is practical for the borrower who is unsure if they will be profitable enough to utilize their credits over the next several years. Plus they are leasing a system that pays for itself, meaning the utility savings generally mirror the monthly lease payments. Though there is the caveat of the lump sum buyout, the borrower is acquiring a system that pays for itself for 7 years, then they execute a purchase for 1/3 of the original cost. One side note… I frequently receive inquiries about the available of operating leases for non-profit organizations and from every lender I’ve interacted with on this product, that is not and will not be an option.
At the end of the day, both products have value and due to the 30% tax credit being offered by our federal government, it’s going to profit either way. In either scenario, you are reducing your expenses, increasing your property value and helping the environment while you’re at it. Regardless the path to going solar, the destination is well worth it.
Alan Johnson is a Senior Account Executive and Solar Specialist at Providence Capital Funding in Brea, CA. He has funded over $40MM in solar leases ranging from $50,000 to $3MM. He can be reached at (714) 985-6207 or emailed at Alan.Johnson@Providencecapitalfunding.com