Frequently Asked Questions on Equipment Leasing
- The Basics
- The Wonderful World of Residuals
- Residual Value: the Big Unknown Unplanned obsolescence?
- Unplanned obsolescence?
- Why should I care about the residual?
- Why are there such divergent views as to residual values?
- How do different residual assumptions affect the lease rate quotation?
- What is meant by the terms "running rate" or "effective rate"?
- The Documents
- To Lease or Not to Lease
The Basics…
What is an equipment lease?
Essentially, a lease is a rental agreement in which one party (the lessor) maintains ownership of an asset and another party (the lessee) uses it in its business activities. In today’s world, most leases are.
What is a "net lease"?
A net lease means that the lessee pays for the equipment's maintenance, utilities or taxes related to usage (sales tax, property tax, etc.).
What kind of equipment is leased?
Just about any kind of equipment can be leased from automobiles and computers, to telecommunications equipment and industrial machinery. Leasing organizations are now estimated to finance some $250 billion of equipment per year in the USA alone.
How long does a lease last?
Typically assets which have a long useful life (such as railcars, barges and the like) have relatively long lease terms, often ten years or more. At the other end of the scale, assets, which tend to become quickly obsolete (such as computers) usually have lease terms of two to five years. Some lease terms are driven by how long the lessee wants to use the assets without moving on to newer equipment or technologies. Other lease terms are based on accounting issues which limit the length of certain leases to no longer than 75% of the equipment's useful life.
Is a lease always for a fixed term?
Most leases do not have rights of cancellation, so you are stuck with the equipment for the duration unless you can work something out with the lessor. Some leases allow for "assignment", where you can pass along the usage to another lessee (called a sub-lessee) with the permission of the lessor, but you may or may not still be "on the hook" if that sub-lessee were to quit making payments.
In an effort to provide increased flexibility for the lessee, some lessors now allow for fixed Early Buy Out clauses, which permits the lessee to purchase the equipment part of the way through a lease for a specified amount. Similarly, Technology Refresh clauses are increasingly being offered in high technology leases, which give lessees specific rights to upgrade to newer technology at relatively fixed costs. If you think about how much PC’s have changed over the last few years, you can see why a company may desire this type of additional flexibility
The Wonderful World of Residuals…
Residual Value: the Big Unknown
The residual value is the "wild card" in the whole equipment leasing industry. Residual value is the value of the equipment at the end of the lease term. In most cases, a significant portion of the lessor's yield in a transaction is based on realization of residual values as originally assumed when initial pricing was set. If they thought that they could sell your old computer in three years for 10% of the initial value and they can get nothing at all for it after that time, they lose yield (and real money). If they can get 20% residual values, however, then they receive higher yields than originally anticipated.
Since residuals are the biggest unknown in any transaction, lessors often tend to specialize in specific types of equipment where they can accumulate more market expertise. Such expertise can mean greater access to the used and refurbished equipment marketplace so that they can reduce their residual related risks, and perhaps increase profits. A lessee who hooks up with the wrong lessor for the type of equipment they wish to lease could end up paying more than they need to.
Unplanned obsolescence?
All equipment is subject to either functional or technical obsolescence (or both). Functional obsolescence means that the equipment simply wears out over time or loses structural integrity. Technological obsolescence means that there is something new and improved in the market that renders the older technology less desirable. The desktop computer you bought five years ago is still just as fast as it was when it came out of the box, but is now essentially useless for most real-world business applications and therefore worthless in the used equipment marketplace.
Why should I care about the residual?
The higher the residual risks that the lessor takes, the lower your lease payment. Much of lease financing involves the concept of "present value", meaning the cost today of the future stream of lease payments discounted (brought back to today’s value) at a specific interest rate. If you enter into a lease with 36 monthly payments of 2.84% per month of the original equipment value, then the present value at a 9% discount rate is about 90% of the original equipment cost. Since the lessor has to pay for the equipment, he will have an investment into the residual of at least 10% right now and will need to realize a net residual value of 15% or more at the end of the lease to absorb business overhead and still receive a decent return on his investment. Typically the greater the risk of obsolescence (functional or technical), the greater the targeted rate of return desired on the investment which is entirely dependent upon residual realization.
Why are their such divergent views as to residual values?
A used equipment dealer with a lot of refurbishment and remarketing skills can generate much higher residuals in the secondary market than can a typical lessee who resells by virtue of an occasional newspaper ad or web site auction. Like junked cars, it is often true that the parts are worth more than selling the assets in their entirety.
Frankly, a lot of the variation in the lease rates quoted will be because of different levels of knowledge and different tolerances for risk as to the residual value. When in doubt, a lessor will guess low as to residual and you will probably end up with a higher lease payment.
How do different residual assumptions affect the lease rate quotation?
The economic yields to the lessor depend upon (1) the lessor's cost of funds, (2) residuals realized, and (3) tax benefits of ownership. The lessor's cost of funds is largely a function of your credit quality and not the lessor's. In most cases, tax benefits aren’t that great, but late in the tax year they can sometimes make a significant difference in the quotes you receive for certain asset classes.
Obviously, the biggest variable is residuals. In the example several paragraphs above, with 36 monthly payments at 2.84% of the initial asset cost, the lease payment could be lowered to 2.63% if a lessor was willing to assume a 25% residual (rather than the 15% used in the example). This represents a significant cash flow savings each month for the lessee.
What is meant by the terms "running rate" or "effective rate"?
The running rate is obtained by computing the interest rate of the lease payments over the term of the lease, using the cost of the equipment as present value in the calculation. Since it doesn’t include the return that the lessor hopes to earn from the asset’s residual value, the running rate will generally be quite low and in certain cases may even be negative.
The effective rate means different things to different people. It usually means the interest rate being paid by the lessee, similar to the way running rate is calculated, but including a reasonable assumption as to what the ultimate residual value of the equipment may be at the end of the lease term. Since residual value estimates tend to vary, the estimated effective rate for the same transaction will also tend to vary, depending upon who is trying to come up with the rate.
The Documents…
How do I find a "standard" lease document?
Unfortunately, there is no such thing. To make matters worse, the terms and conditions of the lease and related documents are getting to be at least as important as the amount of the lease payment itself. Some leases are very lessor-friendly, some are more lessee-friendly, and some are rather balanced between the interests of the two parties.
The terms and conditions can make a large difference to the economics and overall desirability of a particular lease finance transaction. Sometimes this wide variety of terms and conditions makes it very difficult to choose a lessor, since the decision usually involves a certain amount of "apples to oranges" comparisons.
Why don’t I just use my own lease document?
Actually, you might want to do this, although many lessors will insist on you using their document. Sometimes this is because they know their document has terms and conditions heavily weighted to their favor, but often it is just because they don’t want to spend the time and money to have their legal counsel review your lease. If your company is large enough (say, Fortune 500) you can probably force them to use whatever documents you wish. Failing that, you might have to go along with their choice of paperwork.
Why should I care about documentation language?
Let's use an example. If you have a fair market value (FMV) purchase or lease extension option at the end of the lease term, it may not do you much good if the lease language allows the lessor alone to decide what constitutes "fair market value." Essentially, this kind of language only gives you the right to buy the assets for whatever you are told they’re worth.
Some lessors will give you a lower lease payment because the end of lease return options are unbelievably difficult, making getting out of the lease very costly. Others effectively force you to finance any upgrades with them, without the benefit of any competition for the follow-on business.
Many other examples could be cited, but suffice it to say again that the lease payment itself is only a part of the equation as to what lease is the best for your firm and your current situation. "You can pay me now or you can pay me later" applies to more than just automobile maintenance.
Are end of term options fairly standard?
While the concept of including options to purchase or extend the lease at fair market value is quite standard, there is always the issue as to what exactly constitutes "fair market value" and who determines this. Although most lessors will seldom offer it, it is also becoming somewhat more popular to cap the fair market value at a maximum amount, although doing so can affect the lease rate. A lessor will usually not object to a reasonable cap, for while it is important to compensate the lessor for having taken the initial residual risk, it is also important for the lessee not to have to buy out the lease at an unconscionable level.
As an alternative to an FMV cap, many lessees are beginning to demand early buy out options, which give them the ability to cancel the lease by virtue of buying ownership of the equipment sometime prior to the end of the initial lease term. While there may be a slight premium for this flexibility, it does allow for more asset control on the part of the lessee without resorting to fair market value caps.
Are fixed purchase or lease extension options allowed?
Yes, however, if they are set too low they may change the characterization of the transaction by virtue of a "bargain purchase option" (see under definition of capital lease).
What are "technology refresh" options?
In this world of high technology, being "state of the art" usually lasts about as long as it takes to install the equipment! As a result, many lessees are beginning to insist on technology refresh clauses, which give them some defined alternatives as to upgrading technology, adding additional assets, etc., without having to renegotiate and then rewrite the entire lease transaction.
To Lease or Not to Lease…
How do I decide if leasing fits my company’s needs?
The first step is to decide what equipment you may want to own "forever" and what might be more practical to lease. If you do this objectively, you will probably find a relatively small pool of "must own" stuff. For example, many people are surprised to learn that the major US airlines lease most of their aircraft. The airlines have decided to save their cash and borrowing power for operating requirements.
If you are considering a large lease transaction, you may want to do a formal "lease versus purchase analysis", which compares after tax cost of ownership for the two alternatives and estimates the residual value required for your firm to be neutral as to which choice is made. Many lessors will perform this service for you for free but be sure to check their math, as they are usually going to be predisposed towards the leasing alternative.
One caution: as a casual liquidator of assets into the used equipment marketplace, it is difficult to get anything approaching full value. Therefore, it may be that a lessor can assume more residual value than what you should assume for the purchase side of the lease versus purchase model.
Are there accounting benefits to leasing?
The biggest benefit is the ability to get certain leases off the balance sheet by virtue of compliance with the FASB 13 tests. Such lease obligations are typically not on a firm's Balance Sheet but are listed in the footnote section of the financials. This treatment can not only improve financial ratios, but other performance criteria such as Return on Assets, etc.
For most high technology assets, a lease also tends to avoid future accounting surprises that can result when purchased assets are sold for less than their current book value. In other words, leasing high technology equipment tends to track with real costs / market values better than the depreciation tables, which were set up many years ago. This is even true when accelerated depreciation such as MACRS is used.
Are there tax benefits to leasing?
According to the new tax deduction limits for equipment set out in section 179 of the US tax code, in some cases as much as 100% of the equipment cost, up to a specified limit, can be immediately deducted from your taxable income.
The relative benefit to leasing versus purchase will vary depending on the depreciable life of the equipment, the lease term and payment structure, the marginal tax rate for your company, etc.
