Image source: SolarCity.

Solar leases, or power purchase agreements, have been the dominant financing method for years now in the residential solar market. And they were a great idea when the cost of a solar system could run $30,000, $40,000, or more -- few consumers had the cash to pay for a system that expensive. In the early days, few banks wanted to finance small solar projects, and even fewer homeowners could adequately use the tax benefits associated with solar in the U.S.

The solar lease was an answer to all of those problems, and it drove companies like SolarCity (SCTY.DL), Sunrun (RUN -0.96%), and Vivint Solar (VSLR) to rapid growth and the 1 million solar installations we have in the U.S. today. But the lease doesn't make sense long term, and its days are numbered, which could cause a lot of upheaval in the solar industry.

Why the solar lease is doomed

Solar industry observers have been pondering the future of solar financing for years. In 2014, GTM Research said leasing was hitting its peak in terms of market share and would eventually be overtaken by loans or cash purchases. I've been questioning the leasing model for years now. And now The Wall Street Journal is saying the future is loans.

To understand why this transformation is happening and what it means for the solar industry, let's look at a few keys to solar financing models and why loans will win long term.

  • Customers can now finance their own solar. Under lease agreements, you don't own your solar system, you often can't choose components, and customers are usually agreeing to pay for solar energy for 20 years. Loans give flexibility on components, make the process more competitive for installers, and allows for the solar system to be an asset rather than a liability in a home sale (which I'll cover in a moment). Leases were all about educating customers and providing access to go solar, and loans are all about choice, which is what will win long term.
  • Self-financing solar is cheaper than a lease. One of the reasons a small number of solar installers became very big over the past few years is because leasing requires scale. Investors providing tax equity, aggregation facilities, or securitization financing want hundreds of millions of dollars in debt to make the investment worth their while, squeezing smaller players out. Plus, installers have to cut solar systems into pieces and sell the pieces to different investors, making the value components complicated. Loans are much simpler, come with low rates (as low as 2.99% for SolarCity's new loan), and are ultimately lower cost than 20-year leasing agreements.  
  • Smaller installers can bring lower costs to rooftop solar. I mentioned large players dominate residential solar, which is very strange in any construction business. The construction industry, which is what residential solar installation business will become, is dominated by small, local companies who are nimble, have lower overhead costs, and know the local landscape. They're already starting to bring lower costs to the solar industry in many places, and that will likely continue, putting pressure on national companies with a lot of overhead.
  • Who want to buy a home with an old solar lease? Many solar companies would point to the fact that they have little trouble transferring leases today as a sign that defaults on solar leases will be low long into the future, but that's a questionable assumption. The cost reductions solar companies have experienced lately have mostly led to them expanding their markets, not passing savings on to customers. Loans will likely lead to lower costs (as I mentioned above) for customers, and as costs come down in the future, those savings will continue to be passed onto customers. Other than for the environment, if you're buying a home, why agree to take on a 10- or 15-year-old lease at rates decided when the original contract was signed and get old equipment, when you could pay less for a brand-new solar system today? Especially when you consider you have absolutely no equity in the solar lease. An owned solar system is an asset, while a lease is a liability to new homeowners. That will be a big part of the lease downfall. 

Logically, it makes sense that loans will be the dominant financing method for rooftop solar long term, just like they are with automobiles. And it'll help make the industry more price competitive, which will be good for buyers as well. 

Image source: SunPower.

Where the big boys will play a role in solar

What solar loans really do is level the playing field in rooftop solar. A small, local installer can compete with a large national company for customers, something it couldn't usually do with leases. And that's notable. It also makes pricing and component quality much more transparent, something that wasn't the case with leases.

This could be a huge negative for SolarCity and Vivint Solar, who use commodity equipment that local installers can use as well. Ironically, working with local installers was Sunrun's original strategy until the last few years, when it began building up its own installation team, something that may backfire.

I think component companies that provide differentiated solutions to these local installers will be the biggest winners. SunPower (SPWR 3.69%) has always used local installers and provides quoting tools along with fully engineered systems, making their jobs easier. About 70% of SunPower's residential installations have been cash or loan sales in recent years, so this could be a positive trend for the company. I could see Canadian Solar (CSIQ 2.41%) taking a similar strategy with micro-inverters and a more complete design solution, but it isn't quite as advanced as SunPower in that space today.

New product offerings in solar will be worth watching as well. Where a company like SolarCity or SunPower may develop an advantage is in integrating energy storage and demand response into their systems. Maybe that will be a way to differentiate on more than price?

Prepare for the end of the solar lease

If leases decline significantly over the next few years, as I think they will, it will cause a major strategic shift within the solar industry. And companies too reliant on leases could be left in the dust. That's something to consider as you look at earnings reports from residential solar companies throughout the year. Not everyone will adapt quickly enough to survive.