Shopping for Leases

June 1, 1999
Leasing, like many other industries, has gained much popularity in the current economic expansion cycle.Modern day leasing first began to take hold in

Leasing, like many other industries, has gained much popularity in the current economic expansion cycle.

Modern day leasing first began to take hold in the 1950s and 1960s as tax benefits resulting from accelerated depreciation and the Investment Tax Credit became widely popular. Although tax legislation over the years curtailed these benefits, leasing remains today a viable means by which to acquire goods and equipment. Its use is no more evident or applicable than in the acquisition of rental equipment inventory.

Leasing can take on many different shapes and forms. To better understand the use of leasing within the equipment rental industry, you must know that there are not only different types of leases but that some may not meet certain tax and/or financial reporting requirements to be characterized as such.

Leases, for tax purposes, fall into the categories of taxable and nontaxable - these designations determine the issue of ownership and whether the lessor or lessee is entitled to the tax benefits. For financial reporting purposes, you can classify a lease as either an operating lease or a capital lease; the latter is nothing more than a different name for a conditional sales contract or loan agreement.

For many rental businesses today, the tax advantages of leasing may not be great enough to warrant a decision based solely on the tax treatment of the transaction itself. Structuring a lease with a residual or purchase option at the end of the term may provide some cash flow benefits to the lessee because monthly payments on leases with residuals are usually lower than monthly payments on conventional loans or leases without residuals. The overall cost (total of all payments) of a residual lease, however, is generally greater than the overall cost of the other financing methods mentioned.

You and your rental company should give more consideration to the length of time you desire to keep the equipment in your inventory and the subsequent means of disposal when you are done with it.

For example, if the plan of a rental business is to keep equipment in its inventory for three years (or less) and then trade it in on newer equipment, then a residual lease with a fair market value purchase option is worth considering. Such a transaction could provide the lowest monthly outlay.

In addition, your taxable income would be less through the expensing of the lease payments versus the depreciation of the acquisition cost. The same would be done with the depreciation under a conventional loan or nontax effected lease.

Another important element in this type of transaction is determining who will bear the risk of the option price at the end of the three years. If the risk is borne by the rental business, then the cost associated with that risk needs to be calculated, as well.

Too often, the lease structure gets more emphasis than the equipment being leased. No matter what the economic justification of the transaction type being considered, you should finance short-term assets at terms different from long-term assets.

If a piece of equipment has an anticipated inventory life of three years, then you should not finance it over a five-year term. Also, the type and use of the equipment may warrant acquiring the goods via a standard loan rather than a lease. Party goods is a prime example where many of the inventory items become disposable after only a few rentals.

Consolidation within the rental industry has brought a greater awareness of the entire equipment-acquisition process. Pricing, distribution and financing are being reassessed by both buyers and sellers. While in the past the acquisition of equipment was based largely on price, today buyers demand not only the best pricing, but also flexible and competitive terms for acquiring the equipment. Buyers are also demanding that the acquisition/financing process be as effortless as is possible.

Manufacturers have for many years offered their own financing plans or subsidized the plans of a finance partner. Today, many are aggressively promoting financing. Some manufacturers will even offer to purchase the equipment at the end of a lease term - thus bearing the burden of equipment disposal with the hope they can sell their own new equipment to replace it.

Buyers in the past have tended to be short-term thinkers when it came to acquiring equipment. The major concern was the financial impact today, not the ramifications midway through the contract's term. Today's savvy buyer is now asking questions about what will happen next year and the year after. What are the options for disposing of the equipment before the end of the scheduled lease term? Are there any prepayment penalties for paying it off early?

As competition continues to intensify, what used to be a simple act of acquiring equipment will require a lot more due diligence on the part of equipment buyers. Just as it was impossible to predict the current sustained economic expansion, any impending downturn in the overall economy will come as a surprise to many. Therefore, prudent matching of asset life to finance term and having an abundance of options during the term and at contract termination will be critical in the future.

David Pauley is vice president of Dallas-based Associates Commercial Corp., which specializes in financing construction equipment.