One thing the solar industry doesn't do is stand still for long. A dominant product that seems to steamroll the marketplace is sure to be replaced before long with another product that's even better and cheaper for solar consumers.

That dynamic showed itself once again late Tuesday when SolarCity (SCTY.DL) announced the MyPower solar loan product. This will allow SolarCity consumers to buy solar with loans instead of leases, which obligated homeowners to pay SolarCity every month for 20 years.

Moving into loans isn't a trivial move for SolarCity, and there will be a number of ways this impacts the company and its investors. Let's take a look at how this will impact everyone involved.

Image source: SolarCity.

Loans are good for customers
Solar leases and power purchase agreements, or PPAs, were a fabulous financing option to introduce consumers to solar because it allowed them to go solar with $0 down and still save them money in the process. But as leases and PPAs grew in popularity one thing became increasingly apparent for those of us following the industry: There are more efficient ways for homeowners to finance going solar.

Leases and PPAs were able to bring solar to homeowners with $0 down, but there are a few problems with the financing structure for customers long-term.

  • In leases and PPAs the value generation is transferred from homeowners to the installer or finance company. In the case of SolarCity, Vivint Solar (VSLR), and SunPower (SPWR -1.55%) the estimated retained value per watt -- estimated discounted cash flow over 20 years -- is in excess of $2 despite the installation only costing them about $3 per watt. That's an incredibly high margin and indicates that a homeowner would be better off buying the solar system through a loan and keeping the benefits themselves.
  • Many leases included cost per kW-hr escalators that could actually lead to customers paying more for electricity in future years than they could get from the grid, something I highlighted earlier this year. With electricity price growth slowing, and even going negative in some places, this was a real risk to the leasing model long term.
  • There was growing evidence that leases or PPAs actually took value away from the home when homeowners tried to sell versus an owned system adding value. I highlighted this in June and the logic makes sense. If you go to buy a home and the sellers says, "By the way, you also have to take on this 20-year obligation for the solar panels on the roof," you may not be keen on taking on that responsibility, especially if you could install a new system at lower costs today.

In my opinion, leases and PPAs were always a bridge to a competitive future where installers compete based on the price of the installation, and financing is an option consumers have to facilitate purchasing. In that respect, buying a solar-power system should look a lot like buying a car. You can have a lease if you want, but most customers are going to choose to pay cash or get a loan.

The growing number of loan offerings is absolutely a positive for solar customers by simplifying the payment and ownership structure and should help grow adoption of solar nationwide. But the impact on SolarCity is a little less clear right now.

Systems like this one may soon be financed with loans rather than leases. Image source: SolarCity.

Giving up your high margin business
Before getting into why loans could be bad for SolarCity, I want to be clear that this is absolutely the right move long-term, and Lyndon Rive and team are clearly leading the way in the future of distributed solar. The downside is that they're giving up what could be a high-margin business for a business that will be much lower margin.

Last quarter, SolarCity generated an estimated $2.32 per watt in retained value on the lease and PPA systems it installed. This is the present value of future cash flows discounted at 6% and can be thought of as a proxy for gross margin for what they install each quarter. This is a high margin considering the installation cost of $2.29 per watt. When compared with a 2.9% gross margin for systems SolarCity sold in Q2 2014, you can see that sales are much lower margin than leases or PPAs, hence the downside margin risk. 

In a loan, SolarCity will have to be more transparent about pricing and will effectively be selling each system on a cost per watt basis. So, if you're building a typical 5 kW system, instead of SolarCity offering to finance it for $0.15 per kW-hr over 20 years -- hiding the value in the financing and generating $2.32 per watt in the process -- it will offer it to you for say $20,000, or $4 per watt.

The nearly $5,000 in gross margin will then be transferred to the income statement but you can see that gross margin of $1 per watt is less than half of what a lease or PPA generates in value. The loan itself may generate some value but the value creation per watt installed will likely go down for SolarCity because sales and loans are simply a lower margin business than leases and PPAs have been.

This is the right move long-term and something other companies are already doing, but it needs to be understood that value generation per watt will likely come down, something that I think is inevitable in solar.

Solar communities like this one are already beginning to take over parts of the U.S. Image source: SolarCity.

What SolarCity investors should do now
There will be a few impacts on SolarCity if the MyPower product takes off. First, it will have more near-term revenue and gross margin from selling systems than it did through leases. This could lead to profitability sooner rather than later.

Offering a variety of financing options will also open up options for customers and new markets for SolarCity. Loans should bring down the cost of going solar for most customers, even versus a lease or PPA, so it'll make the potential market even bigger. This should lead to continued growth for SolarCity and drive its goal of having 1 million solar homes by mid-2018.

While top line growth and installations will grow, it's likely that margins will shrink as a result of loans. This is the trade-off of loans but it's also the direction the market was headed, so it's a necessary move. But one positive that shouldn't go unnoticed is how SolarCity is setting itself up for the future. The investment tax credit for solar is due to expire for residential solar in 2017, and when it does the loan will likely be an attractive option versus leases or PPAs.

Leases and PPAs allowed companies like SolarCity to sell tax benefits to "equity investors" who could take advantage of these breaks. Often, homeowners wouldn't be able to use the same tax benefits, so it made sense for someone else to. This is even the case with MyPower today because there's a 30% balloon payment due June 1 in the year following the installation and homeowners have to be able to use the tax credit themselves if they choose to buy the system and finance it through MyPower. But in 2017 that hurdle goes away and SolarCity is setting itself up for success with this loan product because it's an offering that will endure beyond the tax credit.

At the end of the day, I think moving into loans will actually be a good move for SolarCity despite its lower margins. It will also take away some of the uncertainty that comes with 20-year agreements in this fast moving industry and move revenue from the long-term to today.

Maybe most importantly, SolarCity continues to prove its ability to adapt and change as the solar industry evolves. It's well set up for the future with a low cost structure, is advancing its technology through the Silevo acquisition, and is now creating more financing options. Those are all positives in the nearly limitless solar market where SolarCity is only adding to its competitive advantage.