Chapter 2 Customer Perceived Value and Its Drivers in Urban BOP in India – Getting the Best Equipment Lease Deal

CHAPTER 2

Understanding How the Equipment Leasing and Financing Business Operates

Overview

If you understand how someone you are negotiating with operates, you will have better negotiating leverage. And, that is the purpose of this chapter, to provide you with a general understanding of how the equipment financing business operates in the United States by giving you an overview of the key business elements of the leasing of equipment.

The Business Environment

The equipment financing business in the United States is mature, and competition is intense, and, accordingly, the traditional equipment financing business is not one easily entered by new companies. Mistakes are easy to make, particularly in the case of credit decisions. Something attested to over and over during the past decades by the many non-bank, and bank-affiliated, leasing company problems, closings, sell-offs, and bankruptcies from a variety of historically repetitive and obvious mistakes. Ones often the result of top management’s lack of streetwise business and operational expertise, short-sighted attempts to maintain near-term profits, risky product financings, or the desire to increase profit-based bonuses.

Key Traditional Profit Strategies

Typically, there is nothing unique from a leasing company to another leasing company in developing and pursuing basic profit strategies. There are very few, if any, profit strategy nuances from one leasing company to another. And, once you understand how they make money, you are better able to assess your negotiating position and what you need to watch out for when dealing with a leasing company. So, understanding how these companies generally make money is essential. Aside from financing profits, there can be other profit areas, many of which are not obvious to a layperson.

Valuable Assets Acquired with Customer Money

In very simple, everyday terms, how would you react if a wealthy neighbor asked you to lease her an 80,000 U.S. dollars BMW for her business use? Assume also that the lease would be for seven years, the rents would pay off any bank loan you used to pay for the BMW and provide a 200 U.S. dollars per month profit and, when the lease ended, your neighbor would have to return the car to you in excellent condition. The result: at the end of seven years, you would own what could be a cream-puff BMW, free and clear, to do with as you wish. Sell it. Re-lease it. Or, simply use it as your personal car. Sounds good? Most people would agree that it does. That is the basic business of equipment leasing in a nutshell.

Now, let us take this hypothetical example a step further. What if 10 individuals asked you to lease them BMWs under the same terms that also provided you with a 200 U.S. dollars per month profit on each car? Your profit would be 2,000 U.S. dollars a month, and you would own 10 BMWs at the end of their respective seven-year lease terms, all free and clear. Not a bad return.

While this over-simplified hypothetical may not be realistic in the automobile financing market, an extremely competitive market where finance companies have to maintain an equity, or end-of-lease residual investment in a car making it unlikely that you, as suggested in the hypothetical, would have your entire investment returned at the end of the lease term with a profit, it does put into quick perspective one basic strategy used in the leasing business, getting credit-worthy companies to pay for, and maintain, assets that can be sold or re-released at the end of the financing term for additional profit, all the while making a profit waiting for their return. All the leasing company must do, once a lease deal is put in place, is to send out the rent bill, and deposit the payment checks when they come in.

Windfall Profits: A Possibility

Now, let us assume in the prior section example that, at the end of the seven-year lease, each BMW was worth 25 percent of the original cost and the rents paid off the entire BMW purchase costs. In addition to a 200 U.S. dollars monthly profit, selling each car at the end of lease would bring in 20,000 U.S. dollars in end-of-lease, or residual, revenues.

The residual value revenue expectations, what assets are expected to be worth at the end of their lease periods, are an important part of today’s leasing business. It is not unusual for equipment residual values to range from 10 to 100 percent of the equipment’s original cost—and sometimes even higher. The residual values, of course, depend on the type of asset, its return condition, its useful life, inflation, and market demand. For example, in the past, some 10-year-old river barges were sold for prices in excess of their original purchase prices.

In the early years of the leasing business, when competition was not intense and lessee customers were less sophisticated, financing rates (and financing profits) were high; what an asset was expected to be worth at the end of its lease term was almost irrelevant. A lessor had made all the money they needed from the lease transaction even if the asset had to be junked. But, as time went on, many leasing companies quickly found there was a lot of added profit potential in the sales and re-leasing of assets that came off lease. In fact, in the early years of the leasing business, many aircraft lessors made lottery-like windfall profits from selling off their end-of-lease aircraft, with some aircraft end-of-lease sale values approaching, or exceeding, the original cost. Add to that the fact that these aircraft lessors had returned, through lease term rents, all but a minimal amount (often between 10 and 15 percent of the original cost) of their invested principal, and made a tidy profit, and you had some very happy aircraft lessors. The same became true for lessors of other long-life assets. As you might expect, all leasing companies soon caught on to the aircraft and barge residual end game and began to stay alert for high residual return possibilities in other types of equipment as well. And, equipment residuals became such a major profit component that some lessors even adopted a strategy of acquiring multi million-dollar high residual value potential equipment solely for the end-of-lease sale or re-lease profits. They cut their lease term profits to the bare minimum necessary to win business, with rents often covering little more than basic transaction cost of money and overhead costs, anticipating substantial profits when the equipment came off lease. In fact, some leasing companies became so aggressive that they wrote leases that produced a loss during the lease term, counting on the possibility that after the initial lease term, the cash flow squeeze was over and yearly residual profits would provide solid bottom-line returns. Heavy reliance on residual profits is still one of the primary profit objectives in leasing today, particularly in big-ticket leases of long-life assets.

There is risk, however, in placing a primary emphasis on residual profit expectations. Lessors do incur the possibility that the equipment at lease end will not be worth much more than scrap value if there is no market demand for it or it becomes technologically obsolete. If rents just pay overhead, the potential for loss is great, particularly if unexpected costs are incurred. And, if residual revenue expectations are not met, there is little, or no, economic return for the effort. Some aircraft lessors, for instance, encountering a used aircraft market demand lull in the 1980s, had to store their off-lease aircraft and wait years for better sale or re-leasing opportunities. Today, equipment and customer industry diversification is used by lessors to reduce this type of risk.

The Customer Business Annuity

Developing an extensive customer lease and financing portfolio contact base is often a strategic business objective of every third-party and bank leasing company, something all learned early in the leasing business. Qualified prospects are valuable; customers who lease or finance, often lease or finance equipment again—at times, not even getting competitive bids. And, non-competitive bid situations can assure leasing companies of solid economic returns.

Additionally, with qualified leasing customer contacts, a leasing company has the increased possibility of readily originating new business with little expense—often a simple letter offering lease financing on new equipment acquisitions, with a follow-up telephone call, is enough to identify upcoming financing opportunities. Doing business with a good-paying existing customer has far less credit risk than dealing with a new, unknown customer. No matter how extensive credit due diligence is, it may not uncover credit potholes; financial statements and discussions with trade references and lenders, for example, rarely always tell the whole credit story. Clearly, there is no substitute for first-hand payment experience.

The Master Contract Strategy of Tying Up Repeat Customers

When dealing with new financing customers, third-party leasing companies have learned that putting a master lease or financing agreement in place pays dividends. Under a master financing arrangement, a customer can finance the acquisition of needed products through a simple addendum, cutting financing time and costs for all parties. As explained in Chapter 9, a master lease or master financing contract is a two-part ­document—the boilerplate portion containing the basic lease or other financing terms and conditions, which will remain the same from deal to deal, and an attachment, often called a schedule, which is a short (typically one to two pages in length) document that permits future business to be simply added by specifically incorporating the new product and financing payment terms under the provisions of the existing master, or boilerplate, document portion. Having only to review a one- or two-page document for lease or other financing deals allows future financings to be handled with minimal effort and expense on both sides. Financing companies with master financing contracts in place are often given a preference over competitors that do not because of the ease of documentation, in many situations, getting the last opportunity to win the business by matching the lowest bidder. In fact, in some cases, customers select an incumbent financing company even when it is not the lowest rate simply because the documentation does not need to be reviewed, making the documentation easy and the document review cost low.

Making Money in the Financing Business

There are many ways to profit in a lease or other financing transactions, some of which have already been suggested. The obvious areas for leasing profits are equipment ownership tax benefits and, as suggested earlier, interest charges and end-of-lease equipment sales or re-leases. The less obvious ones are interim rent charges, penalties for early prepayment, casualty occurrence payments, insurance cost markups, product upgrade financing charges, documentation fees, filing fees, maintenance charges, repair costs, excess use charges, late payment and other collection charges, and equipment re-delivery charges. The same is true for non-lease, or loan, financing, but the financing company does not have available the equipment ownership tax benefits and end-of-financing term re-sale or re-lease profit components.

The intent of the following discussion of leasing and financing profit areas is to simply identify for you all key money-making aspects so that you know where in your lease transaction there might be items you can negotiate.

The Basic Financing Profit Areas

The principal lease transaction profit areas are interest charges, equipment tax benefits, and end-of-lease equipment re-leasing or re-sale (residual) earnings). Not maximizing any one can significantly reduce the potential for transaction profits. As also stated earlier, for a conditional sale or other loan type financing, a financing operation would not have available any equipment tax benefits or end-of-contract equipment residual earnings.

Interest Charges

The most obvious way to make money in an equipment financing transaction is through financing profits. Financing profit, sometimes referred to as financing spread, is the difference between a financing company’s cost of money and its overhead and the lease or other financing interest rate charged. The higher the interest rate charged, the greater the financing profit. For example, assume a lessor sets their base cost rate at 9 percent per annum, which included their cost of funds, and their allocated overhead, and charged a lease interest rate of 11 percent. Their financing spread is 2 percent per annum. By increasing the lease interest rate to 12 percent, their financing profit increases to 3 percent.

Market competition, reasonableness and, sometimes, state usury laws, even for commercial customers, limit how much financing spread a financing company can build into its lease or financing rate. Typically, the smaller the equipment lease or financing dollar size, the higher the financing interest rate that can be charged, with customers often looking only to the monthly payment amount, not the implicit financing, or interest, rate charged. For example, lease rates on 5,000 to 50,000 U.S. dollar equipment transactions at the time of this writing can typically range from 10 to 24 percent per annum, depending on the financing term and dollar amount involved. As transactions approach 100,000 U.S. dollars and over, financing rates move lower, generally in the 5 to 9+ percent range. Once the deal size hits 1,000,000 U.S. dollars, apparent lease rates can run 2 to 4 percent below the lessee’s equivalent long-term borrowing rate. In the latter case, for example, a 4,000,000 U.S. dollar, 12-year aircraft lease for a lessee who borrows long-term money at 6 percent per annum could run anywhere from 1 to 4 percent per annum, or even less, depending on the equipment ownership tax benefits available and the end-of-lease residual value assumed (invested) by the leasing company. And, if the leasing company has an arrangement with a product vendor in which it can get a blind product discount (a discount that the customer is not aware of), the apparent lease rate can approach zero or even less, depending on deal structuring. A good example is in automobile leasing, where 0 percent financing is often offered, where the financing company affiliated with or owned by the car manufacturer provides an undisclosed car price discount in connection with the financing.

Equipment Tax Benefits

Very often, particularly in multimillion-dollar equipment leases, the tax benefits available to a lessor are a substantial component in computing anticipated transaction investment return, particularly when investment tax credits are available. In fact, companies with excellent credit considering multimillion-dollar lease transactions typically demand that lease rates reflect, and therefore, pass through to them in the form of relatively lower rent charges, at least a major portion of transaction tax benefits. The tax aspects of equipment leasing are explained in detail in Chapters 4 and 5.

Determining how to effectively take into account the transaction tax benefits is complex, but, fortunately today, there are many lessor profit (sometimes referred to as yield) analysis software programs, which make the job considerably much easier. One such widely used program, SuperTRUMP, is offered by Ivory Consulting Corporation of Walnut Creek, California (https://www.ivorycc.com/). The reader is referred to Chapter 7 for a discussion of the lessor yield analysis approach.

In the case of a lease transaction, the lessor, as equipment owner, has the right to claim the equipment ownership tax benefits, basically depreciation and any available investment tax credit. In addition, in the case of a leveraged lease transaction, the equipment cost of which is financed in part using third-party debt, there is another tax write-off available, the interest charges on the long-term equipment loan. In a lease situation, the lessee cannot claim for tax purposes of any equipment ownership tax benefits. It can, however, deduct the rent payments as a business expense. In the case of an equipment conditional sale arrangement, only the equipment user is entitled to claim the equipment ownership tax benefits.

End-of-Term Equipment Residual Earnings

In pricing a lease transaction (setting the lease rents), a lessor’s ideal objective is to have sufficient lease term rents to return their entire equity investment, repay any equipment loans they have used to finance some of the equipment cost and provide a solid profit, with any end-of-lease equipment sale or re-lease (residual) earnings simply as windfall profits. In other words, setting the lessee lease rents using a zero-equipment residual value assumption. In small-ticket equipment transactions, this is typically possible. In a multimillion-dollar equipment lease transaction, largely due to market competition, this is typically not possible.

Additional Areas of Potential Lease Profit

A leasing and financing company can also add to its leasing and financing profits from less obvious transaction aspects, aforementioned, which include interim rent or financing charges, prepayment penalties, casualty occurrences, insurance cost markups, upgrade financing costs, documentation fees, filing fees, maintenance charges, repair costs, late payment charges, collection charges, deal re-write charges, and, in the case of a lease, excess use charges, re-marketing fees, and equipment re-delivery charges.

Interim Lease Rent

One way many lessors build in extra profits is providing for interim rent. Also called pre-commencement, or stub period, rent, it is the rent that is payable for a period running from the start of the lease to the beginning of its primary, or main, term. For example, a seven-year lease transaction might provide for the primary term to begin on the first day of the month. If the equipment is not delivered and accepted under the lease contract on the first day of a month, there will be an interim rent period running from the day it was accepted for lease to the first day of the following month. If equipment was delivered, for instance, on the 7th of January, the seven-year period would begin February 1, with an interim term running from January 7 through January 31. If the lease rents are computed based on the primary term rents, the stub period rent, typically a pro rata portion of the primary term rents, is a windfall profit. Although not typically found in an equipment loan-type financing, other than possibly a lease that is in effect a conditional sale arrangement (where there is a one U.S. dollar purchase option), it is possible to structure the arrangement to provide for an interim interest charge.

Recommendation: Interim rent charges are often negotiable. So, before you make an award, make sure in the proposal (other considerations aside) the lessor waives any interim rent charge and starts the lease term on the date the equipment become subject to the lease.

Prepayment Penalties

A typical net finance lease may not be canceled for any reason—thus guaranteeing the lease profits, subject, of course, to a lease default. Some prospective lessees, however, want the right to terminate a lease early if the equipment become obsolete or surplus to their needs or simply for convenience and negotiate that right. The same may be true for equipment subject to a loan arrangement.

Generally, when a right to terminate a lease, or loan, early is granted, it is permitted only upon payment of an amount equal to a
predetermined termination value, typically stated in a termination schedule. The termination payment is usually expressed as a percentage of equipment cost for each rent or loan payment period when a termination can be exercised. For example, a monthly lease might provide for a termination payment of 85 percent of the equipment cost when the sixth rent payment is made, 83 percent of the equipment cost when the seventh rent payment is made, and so on. Properly structured, the payment of a lease termination value will return the entire remaining equipment cost investment, with the lessor’s anticipated profits at least to the date of termination, and include funds to pay off any equipment purchase loans, any tax benefit recapture for taxes claimed but not fully vested, and add as additional profit an exercise penalty. A similar result, as applicable, can be obtained with a loan prepayment.

Recommendation: The best time to address any early termination right is in the lease proposal, prior to an award. So, if this is a right you need, ask for it in your request-for-bids letter so that it is included in the lessor’s proposal, allowing you to easily compare any termination exercise amounts provided from various lessors participating.

Casualty Occurrences

An equipment casualty occurrence, in effect, ends a lease. Typically, leases contain casualty loss provisions that require that the lessee pay a predetermined casualty value payment. These payments are usually prescribed by formula in a lease provision or in a casualty payment schedule, often expressed as a percentage of equipment cost, all specified to be backed up by property damage insurance, which must be taken out by the lessee. Casualty value payments, like termination payments, are designed to make a lessor economically whole, including payment for any remaining unpaid invested funds as well as the loss of anticipated residual profits and tax benefits. For example, a monthly lease might provide, in the event of an equipment casualty occurrence during a specified rent payment period, for the payment of a casualty value amount equal to 98 percent of the equipment cost anytime during the second rent payment period, 96 percent of the equipment cost anytime during the third rent payment period, and so on.

In structuring an equipment casualty payment obligation, a lessor can build in additional profits to not only compensate for loss of its long-term investment opportunity, but to add more profit than planned through rents. When casualty payments are expressed as a percentage of equipment cost in a casualty payment schedule, one way they do this is to simply increase rock-bottom casualty loss payments by a percentage, say, 2–4 percent of equipment cost, added onto each specified casualty value percentage.

Recommendation: As with termination values, the best time to address any stipulated loss value provisions is in the proposal, prior to an award. So, you should request that they be supplied in your request-for-bids letter so that they are included in the lessor proposal, allowing you to compare any stipulated loss values from various lessors participating.

Insurance Cost Markups

Equipment insurance is a must in any equipment lease or loan, and, generally, the lessee, or borrower, is required to provide the specified coverage through their insurance carrier. Although care must be taken by a lessor not to run afoul of any insurance regulations, providing the insurance itself, and passing the cost on to the lessee or borrower, with a markup, can create another lease profit opportunity. For example, a lessor might charge 14 U.S. dollars a year for a 2,000 U.S. dollar casualty insurance policy costing eight U.S. dollars a year, making a six U.S. dollar profit. On a 20,000,000 U.S. dollar equipment portfolio, this means 60,000 U.S. dollars annually. A lessor with insurance volume purchasing power can often offer equipment lease insurance at a markup, while still possible providing rates equal to or lower than that available to most lessees or borrowers.

Recommendation: Identify during your lease proposal negotiating process if the lessor can make available lease required insurance, and if so, ask the lessor for the cost for comparison against what your insurance company charges.

Upgrade Financing

Equipment upgrades, when a lessee or borrower adds to or modifies existing leased or financed equipment, can provide an opportunity to lessors for additional profit. If the upgrade is not readily removable or has no standalone value, generally the existing lessor, or lender, is the only one willing or able to finance it. In these situations, a lessee, or borrower, has two choices: to purchase the upgrade with their own funds, in which case, in a lease situation, the upgrade may belong to the lessor at the end of the lease, or agree to whatever lease or financing rate the lessor or lender offers. If, as is the case in many lease situations, the upgrade is deemed, under the terms of the lease, to become the property of the lessor because, for example, it becomes an integral part of the leased equipment and cannot be removed without damage to the existing equipment, paying a higher financing cost may still be more advisable than purchasing an upgrade, which automatically becomes the lessor’s property.

Recommendation: If you believe that the equipment your company wants to lease may require upgrades before the end of the lease term, be sure to have that addressed, including the upgrade financing and rate, in your lease proposal before accepting it.

Documentation and Filing Fees

Many finance customers, particularly those leasing or financing small-ticket items of equipment, such as small computer systems are asked to pay stated transaction processing, documentation preparation and security interest filing fees. Small financing transaction documentation fees generally run from 50 to 500 U.S. dollars per transaction. Security interest filing fees, such as state Uniform Commercial Code filing fees, are generally nominal, ranging from 15 to 25 U.S. dollars. The more fees a lessee or borrower pays, the less a lessor’s or lender’s profit erosion.

Equipment Maintenance and Repair Charges

Requiring a lessee to pay for all normal equipment upkeep, such as maintenance and repair costs, protects a lessor’s investment by ensuring that the lessor’s profit and collateral value are not eroded by unexpected maintenance and repair costs if the equipment is returned. Simply, shifting the full cost burden of equipment maintenance and repair to a lessee eliminates or substantially lessens any necessary re-sale or re-lease refurbishment expenses if the equipment is returned at lease term end. This is a common provision in net finance leases.

Excess Use Charges

The better the condition leased equipment is in when returned, the greater the potential for the highest possible end-of-lease sale or re-lease profits. Another way a lessor sometimes ensures the best possible return condition and ensures profits is to put use restrictions on the equipment, which, if exceeded, provide for penalty charges payable at the end of the lease, referred to as excess use charges. Automobile lessors typically have annual mileage limitations, which, if exceeded, require the lessee to pay additional rental charges to make up for potentially reduced end-of-lease sale or re-lease value. Leased aircrafts are also often subject to use restrictions in the form, for example, of remaining engine hours before the next required maintenance cycle or prescribing a maximum number of takeoff and landing cycles, which, if exceeded, impose added charges.

Re-Marketing Fees

Equipment re-marketing fees is another way for equipment lessors to increase lease profits. For example, a lease may require that the lessee pay a predetermined fee to the lessor if the lessee elects to terminate a lease early or decides not to renew the lease, and return the equipment at the end of the lease, to cover the lessor’s cost to re-market (sell or re-lease) the equipment. These fees are in addition to any other charges that may be payable, such as termination penalties, or costs to repair equipment to the condition required under the lease agreement.

Recommendation: Re-marketing fees are typically negotiable and something, if there is a concern, you should address during your lease negotiations.

Late Payment Charges

Leases and other financing contracts always incorporate late payment charges. If, for example, rent is not paid when due, there will be a penalty charge added to the late payment. Lessees often tolerate penalties in excess of the actual time value of money cost. In fact, some late payment penalties are as high as 5 to 10 percent of the rent charge.

Recommendation: High interest charges are typically negotiable and something, if there is a concern, you should address during your lease negotiations.

Collection Charges

Although not strictly a profit opportunity, requiring lessees or borrowers to pay for any cost of ensuring timely lease or loan payments, many lessors or lenders, particularly small-ticket lessors or lenders, require that lessees or borrowers pay telephone charges on collection calls, as well as other collection charges, which could include the cost of a collection agency. Leases or loan arrangements can also include charges incurred for attorney collection fees. Anything that reduces business operating costs is indirectly a lessor or lender profit item.

Redelivery Charges

Equipment re-delivery charges and return location are another area of lease profit opportunity. It is not unusual for a lessee to agree to return the leased equipment at the end of the lease to a lessor-designated return point, free of charge to the lessor. This enables a lessor selling or re-leasing the equipment to add a small profit amount by also charging the new user a delivery fee from the lessee’s location of use. And, at times, some lessors get lessees to agree to pay for all such shipment charges, regardless of where in the world the equipment is shipped.

Recommendation: Re-delivery charges and location are typically negotiable and something, if there is a concern, you should address during your lease negotiations.

Summary

There are many components in product financing arrangements that can add profits, ranging from financing rates to end-of-lease term sales and re-leasing. Understanding what they are will enable your company as a lessee to better negotiate your lease document.