Lease types and leasing
Leasing is very popular as it allows a company to keep from having to report the lease obligation on its balance sheet, although the company is contractually responsible for monthly payments similar to a debt instrument. This allows a company to show an improvement to return on assets and have lower depreciation (as the asset is not "owned" or reported but is providing income). Under FASB guidelines (Financial Accounting Standard No. 13), if the present value of an asset's minimum lease payment is equal to 90% or more of the asset's value then the lease must be treated as a "capital lease", which means that it must be reported on-balance sheet as similar to debt. If the payment is less than 90% then the lease is treated as an "operating lease", which means that it is not reported on-balance sheet. Additionally, a lease must be termed a capital lease if the term of the lease is equal to or longer than 75% of the useful life of the asset.
A synthetic lease means that a company guarantees a fixed percentage of the cost of an asset, retains operating control of the asset, is allowed the deduction for the interest expense for the cost of the asset, is allowed the deduction for the depreciation of the asset, however it is not rported on either the asset-side or the liability-side of the balance sheet.
Lessor: the owner of the asset.
Lessee: the one who is leasing the asset.
Closed-end Lease: the lessee is not responsible for the secondary market value of the asset at the end of the lease term. Since the Lessor assumes the risk for the secondary market value of the asset, lease payments will typically be higher than in an open-ended lease.
Direct Lease: An agreement in which a company or person borrows another party's real estate, equipment or other property for a specified time in exchange for payment.
Leveraged Lease: A specific form of lease involving at least three parties: a lessor, a lessee and a funding source. The lessor borrows a significant portion of the equipment cost on a nonrecourse basis by assigning the future lease payment stream to the lender in return for up-front funds (the borrowing). The lessor puts up a minimal amount of its own equity (the difference between the equipment cost and the present value of the assigned lease payments).
Open-ended Lease: the lessee assumes the responsibility for the secondary market value of the the asset at the end of the lease term. If the residual value was estimated inaccurately, the Lessee must pay either a portion or all of the short-fall to market value as an end of lease payment.
Operating Lease: the manufacturer (or lessor) continues to own the asset during the term of the lease and has a vested interest in the recovery of the residual investment. They carry a significant investment risk since the recovery of the residual investment is dependent upon the equipment values and the position of the manufacturer; A lease agreement that meets certain established criteria and therefore is not required to be reported on the balance sheet. The lessor assumes any risk associated with the residual value.
Common Equipment Lease Types: The two most popular lease types are Finance Leases and True Leases.
- Finance Leases generally call for the "Full-Pay-Out" of the total equipment cost and financing charges over the original lease term. These Leases ordinarily include a fixed Purchase Option (I.e. $1.00 or a fixed percentage of equipment cost.)
- Since the end-of-term purchase price is predetermined, Finance Leases may not meet the requirements for tax deductibility or for "Off-Balance Sheet" accounting treatment.
- True Leases do not call for full-pay-out of the equipment cost and financing charges during the original lease term. Typically, Lessees receive either no option or, at most, an FMV option to purchase the equipment.
- Since True Leases intend to provide only equipment usage, and don't include predetermined Purchase Option prices, Lessees often classify True Lease payments as operating expenses, thereby gaining any available Tax Benefits.
- Operating Leases: Some True Leases are known as "Operating Leases" because the Lessee can classify the lease payments as operating expenses on its "Income Statement". Truly leased equipment does not necessarily appear on the Lessee's "Balance Sheet" as an owned asset, nor do the corresponding lease payments appear on the Lessee's Balance Sheet as fixed debt.
Sale Lease back: Agreement in which a financial institution buys equipment from a company and leases it back to the company. This transaction allows a company to utilize the equipment without having to record any asset or liability on its balance sheet. The reantal payment schedule is carefully structured to equal a discounted cash flow that will approximate the amortized and depreciated disposable / salvage value of the asset at the end of the lease term.
- Equipment leases usually have provisions in the contract that do not allow prepayment or refinancing (the lessee must make all contractual payments upon early termination, even if the equipment is damaged, obsolete, or even if the lessor is insolvent or in default). Thus, the lease results in a stable cash flow and average life expectancy of the lease on the behalf of the lessor. The lessor has further protection if the the lease is structured as a Triple-net Lease:
- The lessee is responsible for the maintenence, operation and repair of the equipment
- The lessee is responsible for obtaining property / casualty insurance coverage at full replacement value
- The lessee is responsible for all sales, use and property taxes related to the eqipment
- Residual Valuation is an estimate of what the realizable value of the leased asset at the end of the term of the lease. The realization is obtained primarily through 3 options:
- The Lessee purchases the asset at the end of the term.
- The asset is sold to a third party (for either continued usage, refurbishment or scrap)
- The asset is leased to a new entity.
- The actual realization of the residual value is going to be influenced by the ability of the servicer to re-market or sell the asset, and whether the original book value of the asset was too high at the start of the lease. What this means in real terms is:
- What is the likelihood of the Lessee purchasing the asset at the end of the term? If the asset is essential to the ongoing business of the Lessee, and it is expensive to replace (but is not obsolete), and the Lessee will incur a loss of revenue during the replacement period, then there is a very good likelihood that the Lesse will exercise the purchase option as the less expensive alternative.
- What is the nature of the secondary market for the asset? Is the secondary market limited? This is very difficult to determine as the secondary market conditions change depending on the availability and quality assets. Also, one would think that the more specialized the equipment is the more limited the market will be. However, this is not always true: some very special equipment can have a high demand due to the limited quantities that come onto the secondary market. Similarly, very large, active markest may drive down the residual value from the original estimate due to an abundance of similar assets.
- In most cases, equipment coming off of a lease requires refurbishment. How quickly, and how inexpensively, can an asset be refurbished to get it back on the market and in a condition that it will attract a new lessee or purchaser?
- Is there an existing vendor system that can get the specific asset listed in an international or national database / system so that it can be researched quickly by prospective lesses / purchasers?
Competitors include manufacturers, banks, financial institutions, equity investors, and other finance and leasing companies.
GE Commercial Aviation Services (GECAS) is one of the largest commercial aircraft leasing and finance operations. The recoverability of each commercial aircraft in an operating lease portfolio must be tested at least annually based on existing lease terms, credit rating of the lessee and the secondary market for aircraft.
Lessor must be able to reamin solvent during the term of the lease and be able to service the lease contract / payments, and manage collections, residual value realization, recovery of equipment upon lessee default.
- Recovery from lessee default can be obtained from
- Selling the repossessed equipment to cover residual value and the costs associated with the repossession
- Re-leasing the possessed equipment
- Pursuing legal remedies under the terms of the lease
The Lessee (obligor) must be able fulfill the terms of the lease (payments and maintenence of the equipment). This requires a standard credit analysis of the company to determine sufficient cash flow to service the scheduled payments and contractual obligations (insurance, maintenance, etc.) of the lease.