Download alternative leasing arrangements

ALTERNATIVE LEASING ARRANGEMENTS
There are many types of lease arrangements, each providing the lessee with particular benefits
and obligations. This note reviews the most widely employed forms of leasing.
TYPES OF LEASES
A lease transaction involves at least two parties: the lessee (asset user) and the lessor (asset
owner). The relationship between these parties defines the type of lease.
Operating lease: A lease that can be cancelled at will by the lessee upon return of the asset to
the lessor. The term operating lease is also used (less frequently) to refer to a lease that can be
unilaterally cancelled by the lessor.
Financial lease: A long-term lease that may not be cancelled by the lessee or the lessor without
the consent of the other party. The lease term covers the major portion of the asset’s useful life
and is typically a net lease (see below).
Full service lease: A lease under which the lessor maintains the asset, and pays the insurance
and property taxes on the asset. A full service lease is common in the leasing of office space.
Also, a lessor of equipment may provide the lessee with warranties of various types (for a price).
Net lease (or net-net-net lease): A lease under which the lessee maintains the asset, and pays
the insurance and property taxes on the asset. Typically, the lessee will be charged for any asset
damage beyond what is regarding as reasonable wear and tear.
Sale and leaseback: An arrangement under which the party that owns the asset sells it to another
party and then leases it back from the buyer. There may be an option granted to the seller-lessee
under which the seller-lessee may buy back the asset after a specified number of years.
Leveraged lease: A lease under which there are three parties: a lessor, a lessee and a lender.
The lender lends to the lessor on a non-recourse basis (meaning that the lessor is not liable on the
loan). The leveraged lease is a complex arrangement. The last section of this note describes
leveraged leasing is some detail.
Closed-end lease: A lease (also referred to as a “walk away lease”) that imposes all residual
value risk on the lessor. At the end of the lease, the property reverts to the lessor. The lease is
usually on a net basis and sometimes with a purchase option; an example is automobile leases.
Open-end lease: A lease that imposes residual value risk on the lessee (lessee pays difference
between fair market value and a guaranteed residual value). These leases often contain a
purchase option and are usually on a net basis. This type of lease is sometimes used for business
vehicles and computers. Open-end leases are less popular than they once were.
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Wet lease: A full-service lease under which the lessor provides persons to operate the leased
asset.
Vendor lease: A lease offered to a customer by a manufacturer or dealer.
True lease: A lease that is treated as a lease for tax purposes.
Synthetic lease: A lease that is treated as an operating lease for accounting purposes but is
actually a purchase from an economic standpoint ( and may be treated as a purchase for tax
purposes).
TRAC lease: Motor vehicle lease with a terminal rental adjustment clause (TRAC), which
allows the lessor to receive payment by the lessee at the end of the lease if the fair market value
of the vehicle is less than what was projected when the lease rental was initially negotiated (i.e.,
an open-end lease). This lease is treated as a true lease even though it does not satisfy the usual
requirements for a true lease. Applies to vehicles used in a trade or business (automobiles,
trucks, buses, etc.) that are for highway use.
RISK MANAGEMENT AND THE LEASING AGREEMENT
Is it riskier for the asset user with lease of the asset or with purchase of the asset? That depends
on a number of factors, including the provisions in the lease, the degree of uncertainty about the
length of time that the user will need the asset, the expectations about the value of the asset in the
future, and the expectations about future lease rental rates. We first describe a case in which
purchasing an asset is riskier than leasing it, and then describe a situation in which leasing is the
riskier course. We then discuss options that are commonly included in lease agreements and that
are designed to reduce the risk exposure of the lessee.
Example of greater risk with purchase. Suppose that you are highly confident that you will need
a particular type of machine for about three years. You could purchase the machine but its
market value over the next three years is highly uncertain. So, if you buy it you incur the risk
that the machine will have a low value when you dispose of it in three years. This risk can be
very high if a significant portion of the asset is purchased with borrowed funds. You could also
lease the machine on a non-cancellation, closed-end basis for three years. Under this lease, the
rental payments are known and at the end of the lease you simply return the machine to the
lessor. Under these circumstances, leasing is less risky than purchase because the lessor assumes
the asset value risk. Of course, the lease rental will be sufficient to compensate the lessor for
absorbing this risk.
Example of greater risk with lease. Now change the scenario a bit. Suppose that you are highly
uncertain about how long you will need a particular machine, although you expect it will not be
more than three years. You could purchase the machine now and then sell it whenever it is no
longer needed. Assume that you forecast that the machine’s resale value will decline predictably
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and gradually over the years that you use it. This expectation about resale value is based on past
experience with similar machines, expected economic conditions, and your anticipated intensity
of use of the machine. Suppose that you could also lease the machine on a non-cancellation,
closed-end basis for three years. With lease, if you no longer need the asset during the three-year
period (say next year), you could return it to the lessor but you will owe a large termination fee
(perhaps equal to all remaining lease rental payments). This means that, with lease, the cost of
the asset per year could be extraordinarily high if your need for it ends soon after signing the
lease. With purchase, the cost per year would be lower because you could sell the asset in the
market. Under these circumstances, the cost of the machine could be far more unpredictable
with leasing than with purchase, in which case the low risk strategy would be to purchase the
machine rather than lease it.
The second of the above examples was not unrealistic, but was nevertheless stacked against
leasing because we assumed a non-cancelable financial lease rather than an operating lease
(which allows the lessee to return the asset with no penalty). But, that is exactly the point.
Unless a lease agreement is tailored to the needs of the lessee, leasing can create greater risk than
purchase for the asset user. Which leads us to the topic of options.
Reducing Risk Through Options in the Lease Agreement: Options in the lease agreement can
reduce the lessee’s risk of leasing. Options include the option to cancel (an operating lease), the
option to buy the asset at fair market value, or the option to sublease the asset to someone else.
But how does a lessee decide which options (if any) to include in the lease agreement? Suppose
that you are negotiating the lease of a particular asset. The lessor will, for a price (included in
the lease rental), include any combination of the following three options, [a], [b] and [c]:
[a] Option to cancel the lease whenever you choose;
[b] Option to sublease to an acceptable sub-lessee whenever you choose (with all of the
sublease rental going to you); and
[c] Option to purchase the asset from the lessor, whenever you choose to, at the asset’s
then prevailing fair market value. [If the purchase price is substantially less than fair
market value, the lease agreement may be treated for tax purposes as a purchase rather
than a true lease. We are assuming here a true lease for tax purposes.]
To decide which of these options is best, one has to determine the benefit from each option (or,
more precisely, the benefit of each possible combination of options). To get a sense of how to
approach this, imagine that you are a few years into a lease and you want out (you no longer
need the asset). Which kind of option ([a], [b] or [c]) do you wish that you had?
Ability to Terminate the Lease at Will: If, as a lessee, you simply want to have the ability to
terminate the lease when it is advantageous, the option to cancel ([a]) is better than the option to
purchase ([c]). With an option to purchase, you could buy the asset from the lessor at fair market
value and then sell it at fair market value. But this involves a lot of trouble (expense), much
more than simply canceling the lease, which would be possible under [a].
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Now let’s compare [a] and [b]. Suppose that the lease rental that you are paying is $50,000 per
year. Consider situations I and II in the exhibit below.
Situation I
Situation II
Sublease rental
$40,000 per year
$65,000 per year
In Situation I, you would prefer the option to cancel the lease ([a]) to the option to sublease ([b]).
With cancellation, you return the asset and the $50,000 rental obligation disappears. With
sublease, you can sublease for $40,000 per year but still owe the $50,000 per year under the
primary lease, leaving you with a deficit of $10,000 per year.
In Situation II, you would prefer the option to sublease ([b]) to the option to cancel ([a]). As
before, with cancellation, you surrender the asset and the $50,000 rental obligation ends. But
with sublease, you can sublease for $65,000 per year and continue to pay the $50,000 per year
under the primary lease, leaving you with a profit of $15,000 per year.
The upshot is that, when negotiating the lease, the lessee must try to anticipate the likelihood of
Situations I and II in deciding which option to include. If the expected cause of no longer
needing the asset is recession and shrinkage of the company, it may be that Situation I is more
likely that Situation II (implying a preference for an option to cancel). But if the reason that the
lessee might not need the asset is economic boom and growth of the company, it may be that
Situation II is more likely than Situation I (implying a preference for an option to sublease).
In the above discussion, we assumed that the sublease option allows the lessee to garner the
$15,000 difference in Situation 2. The sublease option may instead provide that, if the sublease
rental exceeds the underlying lease rental, the lessor gets the difference (the $15,000). This
would obviously make the cancellation option superior (for the lessee) to the sublease option.
Subleasing Costs and Benefits: Subleasing is not trouble-free and the costs for the lessee of
finding, negotiating with, and monitoring a sub-lessee must be factored into the analysis. The
sublease option will also provide that the lessor must approve the sublessee (although the lessor
may not be arbitrary in making this judgment). These factors bias in favor of an option to cancel
over an option to sublease.
Ability to Control the Leased Asset: Sometimes there is a competitive advantage in controlling
the leased asset. The author of this note knows of a major grocery store chain that chose to
sublease rather than terminate the lease of retail space (that it no longer needed) because the
company did not want a competitor to move into that space. An option to sublease or purchase
allows the lessee to continue to have some measure of control over the asset, whereas
cancellation of the lease does not.
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Ability to Purchase the Leased Asset: When would an option to buy at fair market value ([c]) be
attractive to a lessee? If an asset is designed specifically for the user, and the user does not want
to renegotiate with the lessor at the end of the lease, an option to buy can be attractive. In this
case, the fair market value of the asset may be less than what it would cost to replace the asset.
An option to buy would also be potentially attractive if the lessee has a sound reason to be more
optimistic than the lessor about the future value of the asset; in this case, it is possible that a
mutually attractive purchase option arrangement could be negotiated between the lessor and
lessee.
Weighing the Costs and Benefits: The benefit of having an option (to cancel, sublease or
purchase) must be weighed against the cost (the price charged by the lessor for the option). The
lessor is worse off providing an option to the lessee because it means surrendering some portion
of control over the asset. For example, if the lessee chooses to cancel in a situation in which the
lessor cannot lease out the asset to another party for at least the existing rental, the lessor is
disadvantaged by the cancellation. Also, if the lessor borrows against the asset (which is
typically the case), the lender will take into account both the price charged by the lessor for the
option (that is, the enhanced income to the lessor), and the negative consequences for the lessor
from providing the option rights to the lessee. These negatives for the lessor must be offset by a
fee (either a higher lease rental or an up-front charge in return for the option).
LEVERAGED LEASES
A leveraged lease involves a lessee, one or more equity participants, and one or more lenders
who provide (on a non-recourse basis) a majority of the funds to buy the asset. It is usually
confined to large assets. A leveraged lease is always a true lease for tax purposes.
Types of Assets: Because of their complexity and significant legal and monitoring costs,
leveraged leases are usually used only for high cost assets or projects. Leveraged leasing is
sometimes also used for smaller assets that are repetitively acquired. Assets that are common
candidates for leveraged leasing are transportation equipment, manufacturing equipment, and
even entire projects (e.g., an Anaconda aluminum reduction mill).
Structure of Leveraged Lease: Usually, the leased asset is placed in a trust. The traditional
practice is to have an owner trustee who is selected by, and represents, the equity participants;
and an indenture trustee who is selected by, and represents, the lenders. It is increasingly
common for one trustee (called a owner trustee) to represent both the equity interest and the
lenders. Whether there is a single trustee or both an owner trustee and indenture trustee, the
owner trustee records and holds title to the leased asset (for the benefit of the equity participants)
subject to the debt, acts as lessor, issues the debt securities, and collects and disperses the rental
payments. The owner trustee issues trust certificates to the equity participants; these certificates
are evidence of the equity participants’ beneficial interest as owners of the asset. The owner
trustee issues bonds or notes to the loan participants. The indenture agreement sets forth all of
the loan provisions. The equity participants indemnify the owner trustee for any costs or
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liabilities that arise from the transaction. The figure on the last page shows the relationships
between the Trust, the equity participants, the loan participants, and the lessee.
Characteristics of the Participants in a Leveraged Lease:
Equity Participant:

Owns the asset

Provides equity capital equal to 20% to 30% of the asset’s cost.

Receives the residual cash flow after the debt is serviced (see below) and administrative
and other costs are covered (e.g., legal and trustee fees)

Receives all the tax benefits from depreciation and any other tax credits

Receives the terminal value of the asset (less any amount still owed on the debt)

Is most often a commercial bank, independent finance company, captive finance
company, or corporate investor
Loan Participant:

Provides debt funding equal to 70% to 80% of the asset’s cost

Lends on a non-recourse basis (lender cannot turn to the equity for repayment if there is
default on the loan). The collateral on the loan is the asset and the lease rentals. There
may also be a guarantor of the lease obligation, which may be the parent company of
the lessee, an interested third party, a bank under a letter of credit agreement, or a
government agency. (However, the lessee may not guarantee the debt on the asset for
the lease to be a true lease under IRS rules.)

Receives interest and principal that are paid from the lease rentals; lender is paid before
any payment is made to the equity participants


Interest and principal payment is usually due shortly after the lease rental is due

Debt payments may be monthly, quarterly, semi-annual or annual

The debt is usually amortized over the term of the lease (which can be up to 25
years or more, but is always less than 80% of the expected life of the asset so as to
retain true lease status for tax purposes)

Debt is usually at a fixed interest rate, but may be floating
Is most often one or more (if a consortium) of the following, roughly listed in declining
order of frequency: insurance company, commercial bank, profit-sharing plan, pension
plan, finance company, savings bank, domestic leasing company, foreign bank, foreign
leasing company, foreign investor, or institutional investor (e.g., a foundation or
university). Sometimes the borrowing is from a supplier, a governmental unit, or from
the public debt markets.
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Lessee:

Selects the asset and negotiates its price and warranties

Uses the asset

Makes the lease rental payments. Payments are usually level, but may vary over the
lease term. The payments may be monthly, quarterly, semi-annual or annual.

Provides credit standing to the transaction. The cost of the borrowing to purchase the
asset, and the level of the lease rental, will depend on the credit strength of the lessee.
Analyzing a Leveraged Lease: The lease can be analyzed from the perspective of the equity
participants, the lenders, and the user-lessee. Let’s look at each.
Analysis by the Equity Participants: The unique feature of the leveraged lease is the nonrecourse nature of the debt. The most that the equity has at risk is the investment it has made in
the asset, generally an amount between 20% and 30% of the asset’s cost. This investment is
somewhat like purchasing common stock (with its limited liability, and its stream of cash
“dividends” from the trust), and in other ways like purchasing a depreciable, productive asset
(since the equity receives the depreciation tax benefits, any tax credits on the asset, and the
asset’s terminal value).
The proper approach for analyzing the equity interest in the asset is to compute the net present
value of stream of after-tax cash flows that can be expected to result. The initial equity cash
flow is the investment to cover 20% to 30% of the asset’s costs. The future equity cash flow is
the return on that initial investment; it can be expressed as in equation (1) below.
Interest and
Asset sale
After - tax
Lease
Trust
proceeds
 Taxes
cash flow = rental  principal payments  expenses +
to Equity
(in last period only)
on debt
(1)
The magnitude and risk of the equity cash flow (ECF) depends on the level and risk of each of
the ECF components. Below are three relevant points to consider.

The fact that the debt is non-recourse means that the future equity cash flow cannot be
negative unless the equity participants voluntarily invest further capital (an exception is
the relatively minor out-of-pocket costs that are incurred directly by the equity
participants in dealing with the parties). The only required negative equity cash flow is
the initial outlay.

The level and risk of the lease rental depends on the credit worthiness of the lessee and
any lease guarantees provided by another party (see earlier discussion). The riskier is
the lease rental payment (that is, the greater the chance of default by the lessee), the
higher will be the lease rental that is stipulated in the lease agreement.
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
The depreciation tax shield (tax savings from depreciation) depends both on the
amount of depreciation and on the tax position of the equity (the equity’s marginal tax
rate). The equity taxable income (ETI) from the leveraged net lease is:
Equity taxable income
= Lease  Debt  Trust
rental interest expenses
(ETI)
Gain on sale
Tax depreciati on
of asset

+
on leased asset
(in last period only)
(2)
In the last period, ETI also includes any taxable gain or loss on the sale of the leased
asset. Notice from (2) that, in periods in which the depreciation on the leased asset is
very high, the ETI from the lease can be negative (a tax loss). This usually occurs in the
first few years of the lease because accelerated depreciation is typically used. This tax
loss (the negative ETI) can be used as a tax shelter against the equity participant’s other
income. For example, suppose that the equity participant is a bank that has a tax rate of
35%, and assume that the leveraged lease ETI in 2004 is  $2 million. Then the bank
could use this $2 million loss on the leveraged lease to reduce its taxable income from
its regular banking operations, producing a tax saving of $700,000 (= .35  $2,000,000).
On the other hand, if the bank has no other taxable income (e.g., if it had an operating
loss on its banking activities), there would be no tax savings generated by the leveraged
lease in 2004 (unless the loss could be carried back; if not, the loss would have to be
carried forward, which is not as good because of the time value of money). The
implication is that equity participation in a leveraged lease is generally appropriate
only for high tax bracket investors with taxable income to shelter.
Analysis by the Loan Participants: The lenders will adjust the interest rate to reflect the loan’s
risk. The loan is non-recourse, and the lender is compensated for this fact with a higher interest
rate than would apply if the loan provided for recourse against the equity participants in the event
of default on the debt. The asset and the lease rental income represent the collateral on the loan
and the source of repayment. The risk of repayment will therefore depend on the likelihood that
the lessee (or its guarantor) will honor the lease commitment, on expected alternative lease
opportunities for the asset if the initial lessee defaults and the asset is repossessed and re-leased,
and on the anticipated market value of the asset over its useful life.
Analysis by the Lessee: The lessee evaluates the leveraged lease like any other financial lease
with similar obligations on the part of the lessee. Leasing the asset is compared with purchasing
the asset taking into account all the associated cash flows, including tax effects. Any costs
incurred by the lessee in obtaining a guarantee of the leveraged lease would be treated as one of
the expenses associated with leasing.
5/20/04
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