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3 Reasons I'm Not Buying Residential Solar Stocks

The last decade has seen a number of big solar companies come and go, exemplifying a very volatile market. SolarCity was a perfect example, riding to fame on massive growth and a hotshot investor in Elon Musk, but it ultimately its financials went south and Tesla bought it out at a modest valuation.

Today, the solar industry is a little more mature, with major players in a sustainable position -- if the world didn't change. But the world is changing, and these are the three things that would keep me up at night if I owned Sunrun (NASDAQ: RUN) or Vivint Solar (NYSE: VSLR), the two major publicly traded residential solar installers.

Row of homes with solar panels.
Row of homes with solar panels.

Image source: Getty Images.

1. Costs are no longer falling

For decades, the costs for solar installations were dropping like a rock. That's what has allowed residential solar companies to expand their markets, as more areas become economical for residential solar. Each drop in cost widens the map to more growth in solar.

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The strange thing is that costs are no longer falling -- and could be on a slight rise. According to Vivint Solar, a solar installation cost $3 per watt in Q2 2015, and $3.11 per watt in Q2 2018. That's a large increase for a company with industry's lowest costs.

A few things are going on, including a rapid rise in sales and marketing costs. Only three years ago, $0.53 per watt was spent on sales and marketing; last quarter, $0.85 per watt was spent on that. The easy customers have been reached, and each subsequent customer will be more expensive to acquire.

We've also seen the cost of a solar-power system itself stagnate. Solar panel, racking, and permitting costs aren't falling as quickly as they once were, and in some cases could be rising. Long term, it'll be tough to cut costs, which will be a headwind for solar installers.

2. Interest rates are rising

From a company perspective, low interest rates can be key to profitability. In Sunrun's case, it agrees to power purchase agreements with its residential customers, then turns around and sells some of those contracted cash flows to investors in an effort to fund operations. A rise in interest rates would mean investors are less inclined to make these investments.

You can see below that interest rates are indeed on the rise, and we may see increases through the end of the year. Since the 10-year Treasury is a benchmark for corporate bonds, this is an area investors should watch closely.

10 Year Treasury Rate Chart
10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts.

The Federal Reserve has indicated that interest rates will continue to climb in the coming year, which could be a big headwind for solar installers.

3. Small installers are more nimble

Long term, I think the biggest challenge to Vivint Solar and Sunrun are small, regional solar installers. They generally have lower costs than their larger rivals and are more nimble in changing financing offerings, particularly switching from leasing to loan financing.

Regional installers can also leverage partnerships with manufacturers like SunPower, which has a higher-efficiency product than competing manufacturers and was recently granted an exemption from tariffs. SunPower uses regional installation partners in residential solar and has been gaining market share, so if that trend continues, it would give some smaller installers a boost.

Regional solar installers can be more nimble in the solar business, and history has shown that scale may not be all it's cracked up to be.

Residential solars have a bad history

There isn't any real history of residential solar companies gaining market share, maintaining it, and making money long term. SolarCity rose to prominence, only to now be a shell of its former self under Tesla.

Vivint Solar was also once a rising star, only to drop quickly when the U.S. solar market stopped growing and financing preferences changed.

I don't think this is an industry where investors can rely on value creation from companies simply installing, and maybe financing, residential solar systems. And with costs rising, interest rates going up, and small installers growing, there's reason to be concerned long term about companies like Sunrun and Vivint Solar.

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Travis Hoium owns shares of SunPower. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.