The only right answer? It depends.
There are a number of reasons why a project should not be financed—not the least of which being the loss of potential returns and general impacts on a given asset strategy—but there are also any number of scenarios in which financing makes perfect sense. With many well-planned infrastructure investments there is a quantifiable cost to deferring investment (wasted energy consumption, increased operating & maintenance cost from aging infrastructure, etc.). If you are faced with pushing a project to a later budget season or simply want to enhance the cash flow of your business, financing may be worth consideration.
Let's look at a real-world example. Take Sally...
Sally owns a commercial building in DC and has been considering a solar investment (and why wouldn't she with DC being one of the most attractive solar markets in the country). The proposed solar project will cost $540,000 and because her asset is a for-profit mixed-use property for which she pays the energy bills, she will be able to take advantage of all of the tax & energy benefits. This means Sally will receive an Investment Tax Credit of 30% of the total investment and will be able to depreciate the majority of the cost of the project over a 5-year accelerated period thanks to the IRS's Modified Accelerated Cost Recovery System (MACRS). Sally has reviewed the leases made available to her and knows that if she were to lease the system or enter into a Power Purchase Agreement, she will only be able to take advantage of the energy cost savings, so she would like to consider other options.
Sally will consider three primary options...
- Paying for the project outright.
- Financing the project using PACE (Property-Assessed Clean Energy) funding [more on PACE here].
- Entering into a Power Purchase Agreement (PPA) with an Energy Services Company (ESCO)
Sally's Project Cash Flow
Do you see the difference? By PACE financing the project...
- Sally "loses" about $90,000 from her total life-cycle returns relative to paying up-front,
- BUT: Sally puts $0 down (yes, that's right), thus the project is cash flow positive $170,000 in Year 1, and she obtains life-cycle returns of over $1,200,000 for an investment that—for all intents and purposes—was zero dollars.
An important note is that because it is a Property Assessed Clean Energy (PACE) loan, only the one-year amortized value of the loan sits on Sally's books as a debt (actually as a tax burden as PACE is a special property tax viewed as a "public benefit" by the local municipality), and she can sell the building at any time with the loan automatically transferring to the new owner. A PPA (Power Purchase Agreement) or lease would offer similar cash flow benefits, but Sally would be giving up a substantial portion of her life-cycle returns to the equipment owner.
...so should Sally finance her project?
It depends.
If Sally is cash-strong, has minimum acceptable rates of return of less than the 25.93% IRR (Internal Rate of Return) of the Cash Payment option, and plans to hold the asset for the next ten years, does it make sense for her to finance? Likely not.
If Sally could use her cash toward other capital expenses (or more lucrative investments elsewhere), is unsure of her hold strategy, or would otherwise have to defer the project due to a lack of available funds, does it make sense for her to finance? Very likely.
If the latter holds true but Sally is uncomfortable with "financing", should she consider other alternate methods of enabling the project like a lease or PPA (Power Purchase Agreement)? Likely yes.
In Summary
No two assets carry identical objectives, and all aspects of a given building strategy must be taken into account before determining if project financing is worth-while. Other options not mentioned above may be best for Sally (such as rolling the investment cost into her next building loan at a lower rate than PACE).
It is important to know what options are available and—if you do not have the resources in-house—have a partner you trust to help walk you through the process. Remember: Knowledge is useless without action and action is foolish without knowledge; merge the two and your next building project will be well on its way to success.