SolarCity (NASDAQ:SCTY) has become the dominant player in the U.S. residential solar market, and it is now eyeing the commercial solar market for future growth. Zep Solar, a racking company SolarCity acquired last year, has introduced a snap together racking product for commercial installations that the company says can improve installation efficiency the same way Zep did for residential solar.

It's a big step into a competitive commercial market and may have some interesting impacts on investors in the future.

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SolarCity's ZS Peak product. Image source: SolarCity

The competitive landscape
The major challenge for SolarCity is that commercial solar is already a more competitive market than residential solar. SolarCity is often doing more education in residential solar than competing on price, and financial success has been about building a financing structure (lease) that's easily understandable for those consumers. But commercial solar has well-established competitors and far more sophisticated buyers.

SunPower (NASDAQ:SPWR) already has a big presence in commercial solar with over $1 billion in its project pipeline. With a high efficiency panel it's also able to squeeze more power out of a rooftop than the panels SolarCity uses.

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SolarCity's commercial installation at eBay's headquarters. Image source: SolarCity

There are also companies like NRG Energy, RGS Energy, and even First Solar that likewise have their eyes on this booming market. The bottom line is that dominating commercial solar will be far harder than residential solar.

Commercial solar is a different beast than residential
On the surface, residential and commercial solar are very similar. They're both installed on rooftops at demand sources and can be owned or leased by building owners. But the commercial market is laid out very differently from residential solar and will have different impacts on SolarCity.

First, many commercial solar projects are purchased by the company commissioning them. Companies like Wal-Mart or IKEA, two of the largest commercial solar owners in the U.S., look at solar as both an energy cost savings as well as a way to take advantage of solar tax breaks. To maximize both, they're likely to buy systems in the future as solar loan and operating & maintenance options open up to the market. In residential solar, when customers lease systems these tax advantages are sold to equity investors and SolarCity owns the system for 20 years or more. This long-term ownership allows SolarCity to create around $2 per watt in estimated "retained value" over the life of a system.

Commercial solar installations are much larger, making the dollars involved more significant, and buyers are more sophisticated and can even get their own financing. SunPower has told me in the past that most commercial systems it builds for private companies are purchased for this very reason.

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Wal-Mart distribution center with a SolarCity rooftop installation. Image source: SolarCity

The public sector is different because capital is less available for a school or government building who may be looking for cost savings from solar. They also don't have the same tax advantages that a third-party owner may have. So, not all commercial solar will lean toward purchases but a majority of the market will.

None of this is to say that SolarCity won't be able to compete in commercial solar; it has already done so very well, but margins won't be nearly as high. A residential solar system may generate $2 per watt in retained value for SolarCity but a commercial installation may generate $0.50-$1 per watt in gross margin. That context needs to be understood by investors.

Foolish bottom line
Despite challenges, making a splash in commercial solar is absolutely the right move and a logical next step for SolarCity. This was at least a $4 billion market in the U.S. last year and it should grow 10-30% per year for the next decade.

Investors need to know that margins won't be as high in commercial solar as they are in the residential market, so retained value or margin per watt will see downward pressure as a result. That's not a bad thing; it's just the reality of entering a highly competitive market with sophisticated buyers.

Travis Hoium manages an account that owns shares of SunPower and is personally long shares and options of SunPower. The Motley Fool recommends SolarCity. The Motley Fool owns shares of NRG Energy and SolarCity. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.