Introduction

It’s obvious that the business case for industrial REITs to install rooftop solar power is not immediately compelling today – it is not a default standard feature for new warehouse construction. A few minutes scrolling around a satellite map shows a lot of empty warehouse roofs and documents the number of past and present decisions to not install solar panels.

However, as costs have declined, the business case has become stronger and may have reached a tipping point. There are at least three elements to the business case for commercial-scale solar power – cost, preference, and regulation:

  1. Measurable reduction in operating cost.
  2. Preference related to environmental certification and performance attributes, independent of cost, is arguably becoming more important to institutional investors and to many of the most desirable tenants. This may become a significant screening and selection criteria for REIT investors and for industrial space selection by tenants (marketed as a Green Lease).
  3. Regulatory requirements for energy building performance standards may become more common for buildings.

We will also briefly consider two related business decisions with similar business case criteria – LED lighting and LEED certification – which may offer some insight on expectations for solar power deployment.

Investment Thesis

Prologis (PLD) is the clear leader among industrial REITs in commercial-scale rooftop solar deployment today, measured by number of installations and by MWhs of power generated. It is also first in environmental certifications. As the largest industrial REIT, PLD brings advantages of scale to this effort.

As the business case for commercial-scale rooftop solar grows stronger, PLD’s experience and scale should provide significant benefits. It appears that company management has recognized and is moving to capitalize on this opportunity.

Long-term investors in commercial real estate should assess the benefits that proactive and systematic management in this area can yield.

LED Lighting

The business case for LED lighting has become compelling, primarily based on cost. Once the tipping point was reached, adoption has been rapid and should approach 100% deployment for professionally managed (i.e., REIT) warehouse space within a few years.

The Department of Energy recently reported on LED market penetration here (see particularly pages 33-35); ~17% for low-high bay lighting by 2018, a 92% increase from 2016. LED lighting is now a default standard for new industrial construction and is approaching 90% deployment in some industrial REIT portfolios.

PLD is at 88% in “efficient lighting”, and has committed to reaching 100% LED deployment by 2025. To facilitate this, it introduced LightSmart, marketed as Lighting-as-a-Service. PLD will turnkey installation of new LED fixtures and metering to document power usage and savings. The company bears the capital investment upgrade cost, and the tenant pays a surcharge.

Here’s an example PLD result from Italy, showing a 54% reduction in power usage and a 27% tenant lighting cost reduction (after including the lease surcharge for LED).

(Source: PLD Italy)

LEED Certification

LEED (Leadership in Energy and Environmental Design) is a building rating system developed by the U.S. Green Building Council. It offers a system to rate and certify a building’s energy use, among other environmental performance factors. There are several versions and types of certification. The ratings are Certified, Silver, Gold, and Platinum. Although LEED is used worldwide, there are other regional certification programs.

I would assess the business case for LEED certification as strong, if not yet quite compelling, and based as much or more on preference rather than cost. Design to LEED standards, if not actual certification, is approaching default status for new construction by leading industrial REITs.

Proponents claim lower operating costs, increased rent, and higher building value. The available studies seem to be a bit dated, and some conclusions are disputed. However, energy cost savings of up to 25% are claimed, and rental premiums from 0-17% are reported here. A 2015 Department of Energy meta-analysis of 50 studies found positive impacts.

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PLD worked with the USGBC beginning in 2014 to develop a Volume Program for LEED certification, resulting in faster, more efficient certifications with reduced fees and costs. The company has used this program to certify more than 80 buildings worldwide. PLD and Duke Realty (DRE) are corporate members of the USGBC.

On-site solar energy power generation is not required for LEED certification, but it may provide certification points (see LEED V4 for Building Operations and Maintenance, e.g. solar roofs on parking structures, temporal load shifting, meeting part of building power requirements with solar power).

The scorecard below details the results of a Gold certification in July 2020 for a PLD warehouse in Long Beach, California. Note the heavy weighting on energy management and the highlighted 0/4 score for on-site renewable energy.

(Source: USGBC)

Grid vs. Commercial-Scale Solar – Cost Parity

Commercial-scale solar power appears to have reached rough parity with grid power in the US, but is probably materially less expensive in California. That’s key to the busines case, so we’ll look at some numbers and a real-world demonstration.

We will see that the estimates are close enough, and have large enough ranges, that I think it’s fair to say prices are at parity in most states, and the particulars of a warehouse location, terms of contract with the local utility, etc. would be required to make a case-by-case decision.

Grid Power

The Energy Information Agency reports that the average US price of grid electricity for commercial customers has been stable at about 11 cents per kWh. Price varies by state: 17 cents for California, 9 for Illinois, 8 for Texas, 10 for Georgia, 12 for New Jersey, 9 for Pennsylvania, 14 for New York, to name some of the key areas for industrial space.

We can thus make an estimate for commercial grid power prices from $80/MWh to $170/MWh, with a reasonable ballpark average of $110/MWh, except for California at $170/MWh. Actual warehouse power prices may also vary by provider and terms of use.

Solar Power

We estimate the cost of power from commercial-scale solar to be in the range of $75-150/MWh, with a ballpark average of about $110/MWh. We look at three estimates below.

Lazard’s report from November 2019 estimates the global levelized cost of commercial-scale solar power at $75-154/MWh.

(Source: Lazard 2019 Levelized Cost of Energy)

The Solar Industry Association (SEIA) 2018 whitepaper estimates commercial-scale solar power cost at roughly $60-150/MWh, based on a 20-year project lifetime.

Wood Mackenzie / SEIA separately provide current national average data on the turnkey cost for non-residential (i.e., commercial-scale) systems in the graphic below – about $1.40/Wdc – which allows us to estimate power cost.

(Source: Wood Mackenzie / SEIA U.S. solar market insight)

With a 15% DC to AC loss, we get about $1.64 million/MWac. Capacity factor is the ratio between actual and nameplate power, and SEIA reports a 17.5% experience-based capacity factor for installed commercial solar systems; we will use 18%. Note that the capacity factor will be higher in Phoenix than Chicago.

At 18%, the solar power system is essentially “on” at full power about 4.3 hours a day. In a year, we get the equivalent of about 1575 hours of full power. This gives us $1.64 million / 1575 MWh, or about $1016/MWh – for one year.

Ignoring finance costs (which gets less realistic for longer periods), over 8 years we get $127/MWh, over 10 years we get about $102/MWh, and for 20 years about $51/MWh, roughly consistent with the Lazard numbers.

PLD offers an “it depends” discussion of the economics of putting a solar power system on a warehouse. However, the company does state that the average “breakeven” point is about 8 years, which is consistent with the numbers we calculated above.

Financial analysis for solar power at each location would also need to reflect federal and state tax incentives. For example, under current law, the Federal Investment Tax Credit for commercial systems is 26% in 2020, 22% in 2021, and 10% in 2022 and thereafter.

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There are a couple of things to note here. First, the cost of PV panels had declined so much that it’s no longer the dominant system cost element (see the graphic above). In fact, if panels were free, the cost of commercial-scale systems would only decline by about a quarter, increasing the cost advantage of utility-scale solar.

Second, bigger is better – or at least less expensive. Utility-scale power is cheaper than commercial-scale power. Similarly, bigger commercial-scale projects provide cheaper power than smaller projects. SEIA reports that the average commercial system size was 250 kW at the end of 2019. All else equal, a million sq. ft. warehouse roof is a better candidate for solar than a 100,000 sq. ft. rooftop.

Target Provides A Demonstration and Benchmark for Rooftop Solar Power

Target (TGT) is ranked #1 among U.S. corporations for solar power deployment. It provides both a demonstration that solar has achieved cost parity or better, and a real-world benchmark for deployment at scale.

(Source: Target 2020 Corporate Responsibility Report)

By year end 2019, Target had 259 MW of rooftop solar panels on 516 stores and distribution centers, meeting 15-40% of each facilities power needs. That footprint covers 27% of its 1,910 stores and distribution centers, with an average size of 0.5 MW. Target added about one installation a week in 2019 – another useful benchmark. Clearly, this is not a token marketing effort.

PLD Leads Among Industrial REITs

PLD owns or manages about 2852 properties in the U.S. By year-end 2019, PLD has 134 MW of rooftop solar panels on 64 properties. Worldwide, over 200 MW is installed.

This footprint covers about 2.2% of the portfolio in the U.S., with an average size of 2.1 MW.

PLD has announced plans to double installed capacity by 2025. Assuming the same U.S./non-U.S. split, and the same installation size, that would mean adding solar power at another 64 properties, about one per month in the U.S, and reaching 4.4% market penetration.

Given that Target has already achieved a 27% footprint, we can consider a potential longer-term (i.e., 2030) goal for PLD as being solar power on 30% of its properties. The 30% goal implies about 800 more installations. Over 10 years, that would be 80 per year – a pace about 50% faster than Target’s 2019 rate.

As of Q2 2020, PLD has 453 properties in Southern California and 262 in the San Francisco Bay area, facing among the highest grid electricity prices in the U.S.

It’s interesting to note the emphasis that PLD places on ESG; it gets one of the dozen or so slides in the company’s recent investor slide decks, specifically calling attention to its solar power efforts.

(Source: PLD Investor Presentation, September 2020)

PLD’s 2019 ESG report summarizes goals and status on several fronts, highlighting achievements and goals for LEDs, LEED, and solar power.

(Source: PLD 2019 ESG Impact Report)

As of year-end 2018, PLD had 139 million square feet of sustainably certified (e.g. LEED or similar) spaces across 374 projects in 18 countries. The company provides data on many of these buildings. A number of examples of solar installations on PLD buildings, with power output, are shown here.

Finally, PLD has experience with an alternative approach; leasing the rooftop to a third party, as described in Commercial Property Executive here. PLD has been doing this since at least 2010, when it leased 4.8 million sq. ft. of rooftop space to Southern California Edison (EIX).

In the Kona solar project, a third party leased 3 PLD warehouse rooftops, installed and owns the solar equipment, and sells the power to the local utility. This 1.3 million sq. ft. lease supports 6.2 MW and outputs 9.8 million kWhs per year (i.e., an 18% capacity factor).

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Ballpark Numbers for a Warehouse

Finally, we would like to take a brief look at ballpark numbers for an actual warehouse. SEIA data estimates warehouse electricity demand at about 5.2 kWh per sq. ft. per year. Food Logistics reports that at 6.1 kWh for non-refrigerated warehouses.

For our ballpark estimate, we will assume 6 kWh per sq. ft. per year. This would be about 66 cents/sq. ft. per year with our average grid power price, or about $1.02/sq. ft. per year with California grid rates. It’s enough to matter.

A large 1,000,000-sq. ft. warehouse would use 6,000 MWhs per year – $660,00 per year at average grid rates, $1,020,000 per year at California rates.

We can also estimate using the numbers above the investment required to generate 6,000 MWhs per year of AC power – about $5.6 million.

Of course, it’s more complex than that. The economically optimum amount of power generation would depend on how the local utility treats excess power generated by the warehouse, among other things. The warehouse is not grid-independent and will need to buy power from the grid during dusk-to-dawn hours.

The Other Industrial REITs

None of the other industrial REITs show up among in the rankings for companies with solar installations. A review of 2019 10-K and recent investor presentations provides a snapshot of their activities and intent (and to my mind, highlights the relative maturity of PLD’s efforts).

Duke Realty Corp. (DRE) and EastGroup Properties (EGP) are building to LEED standards. Rexford Industrial Realty (REXR), unique among industrial REITs in being 100% in Southern California, offered the only economic analysis of building standards but is silent on solar power. STAG Industrial (STAG) has public plans for solar deployment, with 3 solar rooftops installed, 4 underway, 5 scheduled, and 15 identified for 2021 or later. Fully implemented, those plans would cover about 6% of their current portfolio and generate 52 MW, about 1.9 MW per solar facility.

Conclusion

We suggested three elements for the business case for commercial-scale solar power: cost, preference, and regulation. Cost parity appears to have been reached, as supported by both analysis and observation of actual large-scale deployment. Preference is anticipated by LEED adoption, becoming nearly a default standard. Regulation is limited today, but the ratchet on that will go only one way.

PLD already leads in commercial-scale rooftop solar power deployment among industrial REITs, in terms of installations and MWs. Yet, the deployment footprint covers only about 2% of the U.S. portfolio. PLD has announced plans to double that by 2025, while Target’s current 27% footprint suggests a much larger economic limit. It seems reasonable to expect that PLD’s footprint could reach 30% (15X current deployment) within a decade.

PLD can leverage both scale and experience in this effort, as demonstrated in its LEED Volume program. PLD’s characterization of its ESG efforts as “building for the future” nicely captures intent – it appears management recognizes and intends to exploit its opportunity here.

Investor Takeaway

My perspective is that of a long-term investor; I’ve owned PLD since 2008.

ChartData by YCharts

I offer no opinion on the stock’s short-term performance. With a P/FFO of 29 per Seeking Alpha, it’s hard to argue that PLD offers an attractive entry point today.

However, I believe PLD’s leadership with solar power deployment demonstrates exactly the kind of focus on long-term value creation that a best-in-class company should provide. As a long-term investor, this is a business I am happy to own.

Disclosure: I am/we are long PLD, DRE, STAG, FR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com