iIt is the acceptability to both lessor and lessee of the combination of all the terms as a package that matters.
 
 
iIt is the acceptability to both lessor and lessee of the combination of all the terms as a package that matters.

Evaluating lease proposals

The modern lease is complex – and it needs to be so to allow lessors to take into account factors like availability, cash flow and other requirements of the lessee.


Derek Soper

Derek Soper

Derek Soper is a long-standing member of the Leasing Industry having entered the business in 1960 with the first leasing company established in the UK. He has served as Chairman of the UK Equipment Leasing Association (now the Finance & Leasing Association) and was a member of the Industry Future Council of the Equipment Leasing and Finance Association of America and the Finance House Association of Hong Kong, having also chaired a European integration committee for Leaseurope. Derek is a Fellow of the UK Institute of Directors and a Freeman of the City of London. Latterly Derek chaired AT&T Capital in both Europe and Asia returning to the UK from Hong Kong in 1998 and established International Advisory Associates and The Alta Group consultancy in Europe where he served as Principal and Chairman. Currently Chairman of IAA-Advisory he continues with close associations across the industry and throughout the world.
Derek Soper

Introduction from Executive Producer CHRISTIAN ROELOFS
The modern lease is complex – and it needs to be so to allow lessors to take into account factors like availability, cash flow and other requirements of the lessee. Derek Soper, Chairman of IAA-Advisory and of the Leasing Foundation, analyses in detail issues including primary period rental, length of primary period renewal options and variation clauses and shows now leasing can accommodate the needs of  lessor and lessee as part of our Leasing Fundamentals series.

Who should be interested in this?
New entrants to the leasing and asset finance industry, industry commentators, anyone wanting to understand the context of modern-day leasing.

 

Evaluating lease proposals

The basic commercial term in a finance lease is the ‘firm term’ rental payable during the primary lease period. In a short-term hiring agreement, rental represents simply the amount charged by the owner for the use of the equipment during a specific period of hire.  However, in the case of a finance lease, rental, although nominally related to a period of use (the primary period), is usually calculated as being the amount which over the primary lease period will recover for the owner the capital cost of the equipment together with his or her outgoings, principally interest, and profit margin, taking into account any tax charges and allowances that may apply.

On occasions rental is likened to an annuity or equalised mortgage repayment made to a building society or other lender.  From this perspective, the rentals or loan repayments comprise a capital element and an interest element and the early instalments comprise a smaller amount of principal and a larger proportion of interest than later repayments, because of the reducing amount of outstanding capital on which the interest is computed.

This “loan” analogy may be useful in understanding the general nature of  lease rentals under a “full payout” finance lease, but it can be misleading when lease quotations are being evaluated.  In a loan quotation the main considerations are simply interest rates and repayment provisions, but with a lease many additional factors influence the evaluation, several of which arise from the impact of taxation on a lease transaction. Unlike a loan, where only the interest element of the repayments is subject to tax, the whole of a lease rental is treated as income in the books of the lessor, and the rental is allowable in full against the lessee’s taxable profits. This is not true in all countries but is still a basic consideration in many jurisdictions.

Although these additional factors tend to complicate the lease evaluation, they can enable leasing companies to provide terms that are designed to fit the needs of a particular customer and the circumstance of a particular transaction.

Full-payout finance leases

In the calculation and evaluation of finance lease rates, any secondary period rentals or renewal rentals that may be payable are normally ignored.  The equipment is regarded as being fully paid for over the primary lease period.  After the end of the primary period the lease is usually terminable by the lessee at any time, and hence it would be imprudent for a lessor to rely on any secondary period income in evaluating the overall return.

In evaluating a “full payout” or finance lease, a leasing company will seek to recover out of the rentals payable during the primary lease period the whole of the capital cost of leased equipment plus a margin.  However, in certain cases, a lessor may place a residual value on the equipment and, thereby, reduce the amount of each rental.  This situation can arise if, for example:

(a) the lessor has agreed to sell, or has an option to sell, the equipment to a third party, perhaps the manufacturer or distributor of the equipment, at the end of the primary period at a prearranged price;  or

(b) the lease provides for a period or periods of compulsory extension, or extension at the lessor’s  (rather than, normally, the lessee’s) option, which effectively extends the primary lease period to include some or all of the secondary period.

In both cases, the action contemplated to recover the unamortised cost at the end of the primary period prevents the lessor from granting the lessee an option to extend the lease at a much reduced secondary period rental, which is a commercial term commonplace in financial leasing in many countries.

Any under-recovery of capital cost which is acceptable to the lessor will, naturally, significantly reduce the primary period rentals payable.

Primary lease period

The length of the primary period is an important factor in evaluating a leasing proposal.  A lessee’s choice of the most suitable available period will depend on a number of factors, including the anticipated period of use of the asset and the possible need to match cash inflows(earning capacity of the assets) with outflows (lease rentals).

The length of the primary lease period is normally related to the useful life of the equipment.  A primary period of around 75 per cent of the useful life may be regarded as typical, although both the percentage and individual estimates of the length of the useful life of the equipment vary widely.  A general pattern of primary periods, ranging from three years upwards, has emerged for most types of equipment.  Five years is the most common period for many types of equipment, including plant, machinery and agricultural and transportation items.

For larger items of plant and assets, such as aircraft and ships, longer periods are appropriate and leases of 10 years and more are not uncommon.  There is no recognised maximum primary period.  Railway rolling stock has a long useful life and has in the past been regarded as suitable for 20, or even 30 year periods, although it is unlikely that a leasing company would be willing to consider a lease of that length under current economic conditions.  Aircraft and ships have been leased for periods of 15 years or more.

It is important to determine the length of the period over which the primary period rentals are payable.  An extension of only three months in the primary period results in an appreciable reduction in each primary period rental but increases the total rentals payable during the primary lease period.

In most financial leases, there will be an opportunity to extend the term of the lease beyond the agreed primary period. This and other options normally open to a lessee are discussed later.

Rental payment patterns

The variety of rental payment patterns is an area where financial leasing shows its natural flexibility.  There are several sets of possibilities.

Advance or Arrears

Leasing companies have gradually moved towards requiring rentals in advance, principally for security reasons.  This trend has also been reflected in the procedure – used by Governments in the past to control consumer spending – of specifying the number of monthly rentals to be paid in advance of supply on certain types of consumer equipment. Currently, rentals are often payable in advance, although there appears to be no longer a statutory requirement in most countries.

Frequency

Prior to the 1980s, most rentals were payable monthly.  Over the years there has been a gradual move towards less frequent payments, partly to reduce the lessor’s administration costs and partly to increase the amount paid in advance without an initial requirement for more than one rental to be paid.

Quarterly rentals are the most common today (although monthly rentals remain the most appropriate for smaller lease).  Semi-annual and annual payments are also in general use for large facilities.

The total primary lease period rentals payable for different rental frequencies reflect the reduced or additional interest, depending on whether rentals are payable in advance or in arrears, respectively, arising from the lengthening of the payment interval.

“Tailored” Rentals

In addition to the various payment patterns with level or equal rentals, there are a variety of ways in which rentals can be structured to meet the special requirements, usually based on anticipated cash flows, of individual lessees.  Schemes can be designed to meet most sets of circumstances provided the final terms are both commercial and acceptable in credit terms from the lessor’s point of view.  The most common are described below.

1. Seasonal. Inclusive tour airlines and hotels may have leased aircraft, catering and other equipment with higher rentals payable in the summer months and lower rentals in the winter. Agricultural equipment is also frequently subject to these type of arrangements.

2. Stepped.  The leasing arrangement may recognize the likely revenue increase, for inflationary or other reasons, expected to be generated by the equipment over the primary period.  This is often required by a company who is installing new technology where the anticipated income flows from the equipment is likely to increase as the customers demand increases.

3. Deferred.  Certain types of equipment do not generate revenue until some time after they are installed, or may not produce immediate cost savings.  In such cases, a lessee may wish to have the cash flow benefit of a rent free period until such time as the equipment is fully integrated into the company’s operations.  A rental moratorium significantly increases the total interest payable during the primary lease period.

4. Ballooned.  On occasions, one of the parties may wish to limit the length of the primary lease period to less than might be regarded as usual, taking into account the useful life of the equipment;  but it is considered acceptable for rentals payable during the primary period to be based on the recovery of less than the whole capital cost.  In these circumstances, it is possible to have a lump sum balloon rental payable on the expiry of the primary period; there is an opportunity to review the arrangements at that time with a view to a possible rephasing of the lump sum rental over a secondary period.

Commitment Fees

A lessor, in entering into a lease, agrees to provide lease finance for a specific item of equipment or a group of items, selected by the lessee. There will be occasions, when a lessee decides not to proceed with the acquisition of an item of equipment (because, for example, of an unforeseen reduction in demand for the goods produced by the equipment concerned) and wishes to cancel the arrangements rather than proceed with the lease. Alternatively, a lessee may have arranged a ‘shopping basket facility to be utilised by a set date for an agreed total value of equipment but because of delivery delays, may no longer need the full amount of the facility.

In these circumstances the lessor will have allocated certain resources, funds and taxable capacity or capital to support a committed facility for the lessee’s use and may require compensation for the cancellation of the facility; particularly if it is not possible to redeploy the resources elsewhere. There are two main ways of providing for such compensation.

Firstly, the leasing terms can include a commitment fee payable at the time of setting up the facility, which is non-refundable.  In this case the lessor receives just the same cash return if the facility is drawn down in full or not drawn down as he retains the initial fee in compensation. The amount of the commitment fee may be reflected either in a corresponding reduction in the amount of the first rental or treated simply as an additional payment, the subsequent rentals being reduced accordingly.

Alternatively, a fixed commitment fee pay be payable either at the time of cancellation or on expiry of the facility, in addition to the normal rentals payable.

Renewal options

Finance leasing agreements in many countries do not include an option for the lessee to acquire title to the leased equipment either at a nominal price or at an agreed reduced purchase price, although such options are a normal feature of financing arrangements in some countries and are still referred to as leases.

Where a lessee has an option to extend the lease beyond the end of the agreed primary lease period at a much reduced rental, which is fixed at the time of the original negotiations on the lease agreement this is referred to as a ‘renewal option’.

In some cases the ‘renewal’ is referred to as a ‘secondary period’ and is usually for an agreed number of years, although it may be an indefinite period. There may be an option providing for the extension of the lease for a given secondary period or the secondary period may run on a year-by-year basis, or indefinitely until the giving of a pre-arranged notice period by the lessee.  In large- ticket leases, there may be more than one renewal period, the secondary period being followed by a tertiary period with yet lower rentals, and so on.

If a lessee no longer wishes to continue to use the leased asset in his or her business on or after the expiry of the primary period,  the equipment may be returned to the lessor to be sold, re-leased, or scrapped.  Alternatively, it may be sold, in some countries by the lessee acting as he selling agent of the lessor, without the equipment physically passing into the possession of the lessor.   There is unlikely to be any additional rent payable when a lease is terminated during a secondary period; however, on the other hand, it is unusual for there to be a specific refund of rent paid in advance for a year’s renewal when a lease is terminated during the course of a year.

Provided that a lessee has fulfilled all the obligations under a leasing agreement, the majority of leasing companies will pass on to the lessee the major part of any sale proceeds in the form of either a rebate of rentals or, less commonly, a commission for handing the disposal of the equipment.

Where the lessor is prepared to renew the lease at a less than economic rent and/or rebate a proportion of the sale proceeds, he or she is foregoing the opportunity to use a major part of the value of the equipment as a source of profit after the end of the primary period.  The initial leasing arrangement is being regarded as a financing activity which is expected to last the whole or most of the useful life of the equipment.  The leasing company sees its reward as principally the excess of primary period rentals over the capital cost of the equipment, interest and expenses (taking into account tax allowances and charges).  Renewal rentals and the lessor’s share of the residual value may be considered as the additional consideration necessary for the lessor to provide finance by way of a leasing facility and to take the inherent risks of ownership for the whole of the lease period.

If a lessor is prepared to grant one of these favourable options, there is no particular reason why a lessee should not enjoy residual value benefits, provided that there are no adverse tax consequences.

These renewal terms give the lessee economic, as opposed to legal, ownership of the equipment; the lessee has the opportunity to use the equipment for most of its useful life, and can share substantially in its residual value.  This is important to lessors as well as to lessees.   The lessee has a much greater incentive to maintain the equipment in good repair if he or she is to receive a share of the proceeds, thereby enhancing the lessor’s security interest in the equipment during the primary period, and perhaps, reducing any risk arising through the use of the equipment while defective.

Timing differences

So far we have illustrated the flexibility of lease periods, and primary rental payment patterns with reference to the inherent flexibility of a lease. These examples serve the purpose well enough, but it is necessary now to take account of the factors which relate to the tax influences on lease evaluation.  In considering the effect of varying these factors we must recognise that, strictly speaking, it is the maintenance of the lessor’s “after tax rate of return” on the transaction, rather than the nominal interest rate, which is essential to the lessor’s evaluation.  In a number of cases the difference between rentals required to maintain the nominal rate and to maintain the after-tax return will be insignificant, and for simplicity’s sake, therefore, reference will continue to be made to the maintenance of the nominal rate where the difference is immaterial.

This difference between nominal rate and the after tax rate of return is important only in those countries which have substantial tax incentives for new capital equipment investment and where the lessor is a profitable and substantial local business. In these circumstances the date of the acquisition of equipment, or, more precisely, the date the expenditure on the equipment is incurred, may influence the rental a lessor is prepared to quote.  Leasing companies in these circumstances may quote different rentals for expenditure taking place at different times during their financial year. The reason for the timing difference is the variation in the length of time before a lessor obtains tax relief on the expenditure and the time when he starts paying tax on the incoming rental stream. The difference can be significant to a lessor’s return

Variation clauses

Depending upon the jurisdiction the lessor may find that the parameters used in the calculation of the rentals, such as tax or the cost of money may have significant effect on the rate of return if changed during the course of the agreement. Some of these variations are covered by including a variation clause into the agreement – in these cases the rental can be changed to reflect the effect of changes to the lessors rate of return.

Agreements may also provide for adjustment to the amount of the rental for several other factors, including the following:

Entitlement to tax relief on new equipment purchase. Rentals may be arrived at on the assumption that the lessor is entitled to tax relief on any expenditure on leased equipment. This assumption may prove to be invalid because of a change in the system of allowances, the tax rate or because the expenditure is regarded as ineligible for one reason or another. The effect of such a clause is complex to calculate and administer for a portfolio of small leases, and the uncertainty involved would be commercially unacceptable both for lessor and lessee.  With a large lease, however, a variation clause of this type is not unusual.

Taxation System A change in the basis of taxation may materially affect a leasing company’s return.  A provision in a lease agreement requiring an adjustment to rentals for any such change may be included by a lessor in contemplation of a change in the whole structure of the corporation tax system. A lessor may also wish to limit the risk of a loss arising from other, less extensive, taxation changes, such as changes in the due dates for payment of tax.

Exchange Rates A lease may include an arrangement for the rental to be adjusted to reflect any gain or loss on exchange in cases where a lessor intends to finance the acquisition of a specific, normally large-valued item of equipment by way of borrowing in a foreign currency.

Cash Flow Profile For large-value leases, rentals are frequently calculated on a provisional basis by reference to a preliminary set of assumptions agreed by the lessor and lessee.  Once the actual figures are known, an adjustment is made (either on a lump sum basis or to future rentals) for any of the assumptions that are not fulfilled.  The range of assumptions will vary between individual leasing facilities, but may include the dates of progress payments, the maximum expenditure in any one financial year , the amount of interest incurred  in the pre-delivery period or the start date of the lease. In making an adjustment to rentals for a change in any of the assumptions initially used in their computation, a lessor is effectively putting a lessee in the position of being the purchaser of the equipment when the consequences of a change in taxation or other factor would fall directly on the lessee.  It is not possible to specify in a leasing agreement the amount by which rentals would vary for any general change in the basis of taxation or for changes in some of the other assumptions described above.  In such circumstances, the lease terms will generally require that the rentals are increased, or reduced, by such amount as is appropriate in order to maintain the rate of return on the lessor’s investment at the same level as it would have been, had the change not occurred.  The difficulty for lessees lies in the number of possible methods by which a lessor can measure the rate of return on an individual lease.  Many leasing companies are not prepared to divulge the details of the basis of their calculation, but some leases include a provision whereby the accuracy of any rental adjustment is certified by a firm of chartered accountants, usually the lessor’s auditors.

Interest Variation Leasing companies use several bases for calculating interest adjustments, apart from the broad approach of maintaining the rate of return.

1. Rentals may be fixed in relation to a specified lending rate at the date of expenditure on the leased equipment.  Once determined, rentals would remain at the same level throughout the lease period.  Lending rates prescribed include London Inter-Bank Offered Rate (related to a specific loan period for funds such a one year) and the base rate of a bank specified by the lessor.  A lease including provisions of this type is generally described as “variable up to drawdown”.

2. The facility may provide for a specifically calculated period adjustment for the difference between the actual lending rate and the rate of interest initially assumed for the purpose of calculating rentals.  Such adjustments are usually made quarterly, semi-annually or annually in arrears either by applying:

(a) the average difference in interest rates over that period, or

(b) the difference in interest rates on the first day of each quarterly, six monthly or annual period (depending usually on rental frequency).

to the amount of the lessor’s cash investment in the lease from time to time.

3. There may be a formula setting out the amount by which the rentals are to vary for each 1 per cent change in the average lending rate over the primary lease period.  In some cases, the amount of the percentage adjustment is fixed throughout the term; in most cases however it varies year by year, reflecting the lessor’s reducing cash investment over the primary period of the lease.

In conjunction with any of these methods, the lease may stipulate either a range of interest rates inside which there is to be no rental adjustment or a maximum and/minimum lending rate above or below which rentals are not to be adjusted.  The possible permutations demonstrate the different ways in which both lessors and lessees appraise leasing arrangements, and the different funding arrangements available to the lessor.

Ignoring taxation allowances and a lessor’s overheads, an interest variation at the start date of the lease would increase or decrease, as the case may be, the effective interest rate of a rental by the same amount as the change in the prescribed lending rate.  Subsequent changes would have a proportionately similar impact.  However, to the extent that tax timing differences (allowances claimed and rentals charged) are taken into account in calculating the lease rentals, the effect of interest variation clauses will not necessarily alter the nominal interest rate of the lease by 1 per cent for every 1 per cent change in interest costs.

Once the lessor’s cash investment has been reduced to nil at some point during the primary lease period the cost of money is no longer directly relevant and interest variation clauses based on maintaining the lessor’s return cease to be operative.  In theory, the adjustment during the remainder of the lease period, the reinvestment or cash surplus stage, should be in reverse.  Any increase in interest rates in this period over that assumed for the purpose of calculating the rentals increases a lessor’s earnings from the lease – the leasing company receives more interest on its cash surplus.  Similarly, a reduction in interest rates decreases a lessor’s earnings.

Tax Variation To take account of changes in the rate of corporation tax, lease agreements provide for rentals to be adjusted either by stating that the lessor’s rate of return is to be maintained, or by reference to a formula. The formula shows the amount of increase or decrease for each 1 per cent change in the rate of corporation tax applicable to each fiscal year, part or all of which falls within the primary lease period.  Some leasing companies make the adjustment by applying a specified factor to a

Index Linking One form of rental variation that has not yet appeared in financial leases is index linking.  It is found in several types of operating leasing, such as computers, with rentals being fixed annually either directly or implicitly by reference to a suitable index, such as the replacement cost of the type of equipment being leased.  For finance leasing, the introduction of index linking of rentals may depend on developments in the indexing of interest rates.

Progress Payments The acquisition of equipment can involve progress payments to the manufacturer or supplier.  In some cases, the pre-delivery period is a few months, but in others, particularly for large valued items such as ships and aircraft, the construction period of the asset may stretch over several financial years.  There are a number of possible methods of arranging progress payments.

1. Sale and lease-back before use.  The prospective lessee places the order for the equipment, makes the progress payments, and sells his or her interest in the equipment to the lessor immediately before the asset is brought into use.

2. Pre-delivery rentals.  The lessor places the order and makes the progress payments.  The lessee pays periodic pre-delivery rentals related to the interest incurred by the lessor during the pre-delivery period. The primary period rentals, commencing on the date of delivery of the equipment, are calculated in relation to the capital cost of the equipment.

3. Capitalising interest.  The pre-delivery interest is “rolled-up” or capitalised by the lessor.  (This is sometimes described as “rentalised).  As in “Pre-delivery rentals”, the lessor makes the progress payments and a sum equal to the total interest incurred by the lessor on the progress payments up to the date of delivery of the equipment is added to the cost of the equipment for the purpose of calculating primary period rentals.

Lessor’s Outgoings

A leasing company often incurs out-of-pocket expenses in setting up a leasing facility, particularly in relation to large-value leases.  Such costs may include fees for legal, taxation and accountancy advice, insurance premiums, survey and valuation charges, and commitment fees and other expenses in connection with any loan being arranged by the lessor, such as under the ship mortgage or export finance schemes.  A lessor may also pay a commission to a broker for the introduction of business, although often an introductory or consultancy fee is settled directly between the lessee and the broker or adviser.

There are three ways in which a lessor generally recovers outgoings:

1. The lessee makes a separate payment to the lessor for any expenses incurred.

2. The lessor “capitalises” the expenses for rental purposes by adding them to the cost of the equipment to arrive at the principal amount on which the rentals are to be calculated.

3. The lessor quotes rentals which include an element for any outgoings. Under this arrangement any over-or underestimate of expenses is for the lessor’s account.

Early Termination

Lessors and lessees enter into finance lease agreements with the intention of continuing the leasing of the equipment for the whole of the primary lease period.  A finance lease is normally unlikely to be attractive to a lessee contemplating termination soon after the start date, and leases do not generally contain specific provisions for voluntary early termination, although provision is made for termination due to a total loss of the goods or following default by a lessee. However, leasing companies are normally prepared to agree to a voluntary early termination during the course of the primary period.

There are various ways of calculating the amount of the terminal payment to be made by the lessee on a voluntary termination, or following a total loss of the equipment.  In some cases, the basis is the same as that stipulated in the lease for a termination following a default by the lessee. Although there is no necessity for the provisions to be similar, it is unusual for prescribed voluntary termination arrangements to be significantly more favourable to a lessee because of the possible implication that the payments required to be made on default constitute a penalty in law.

The most common method of calculating the termination payment is to discount future rentals from their due dates back to the proposed date of payment.    The rate at which rentals are to be discounted for calculating the terminal payment varies, but is frequently around 4-5 per cent per annum..

An alternative, more often found in facilities for large-valued items, is for the leasing company to compute a series of termination payments for each month or quarter of the primary lease period using a computer programme and taking into account the main lease terms, the required rate of return and the assumed sale proceeds of the leased equipment. These amounts, expressed as a percentage of the cost of the equipment and sometimes called “stipulated loss values” are then set out in an appendix to the lease agreement.  If the lease includes a rental variation clause, the amounts of the termination payments are normally also subject to adjustment for the same factors as the rentals.  The appendix may also be subject to variation depending on the actual sale proceeds realised on disposal of the equipment.

The Package

The lessee’s choice of the most suitable of the various terms described in the previous sections depends on their availability, cash flow and other requirements. A leasing company is not necessarily prepared to offer prospective customers all the various alternatives and may insist on adhering to its standard terms. It is not difficult to separate a lessor’s leasing quotation into its component parts – rate of primary period rental, length of primary period renewal options, variation clauses, etc.  Individual lessees will assess the relative importance of the various financial terms differently on the basis of their own requirements, and the equipment or project concerned.  Although in certain cases one or more of the terms may be crucial, it is generally the acceptability to both lessor and lessee of the combination of all the terms as a package that matters for the conclusion of a satisfactory transaction.

CC BY 4.0 Evaluating lease proposals by Derek Soper is licensed under a Creative Commons Attribution 4.0 International License.