LPRS Blog: Leasing911

The Myth is that IT leasing companies are somehow staffed with magicians. They can – in the case of IT leases for example – take 5 year old servers – refurbish them and sell them for 20-30% of original equipment cost to cover their residual exposure at end of lease along with their various costs and earn a nice profit. Sure leasing companies can make some money selling used and refurbished gear but almost always not enough to cover their residual exposure on the lease and earn a satisfactory net profit. Often a lessor’s refurbishment operations are separate profit and loss centers from the lease origination group. The lessor‘s core finance operation makes a profit on its own – most commonly based on extensions, interim rent and other charges. Many lessors simply outsource refurbishment and resale activity.

The reality of rapid technology obsolescence raises important questions regarding the role of leasing, specifically: which of the parties (Lessor or Lessee) in a lease transaction processes the most financial and technology risk as a result of technology obsolescence and how does this compare to the risks a Lessee may process if the equipment was purchased instead of leased. In this installment of Lease Myth Busting we take a common sense based approach to examining how leasing affects technology risk and financial risk for Lessees relative to Lessors.

“Fair Market Value,” or FMV, is often referenced, and frequently capitalized in lease documents and therefore looks like a defined term in a contract. Most lessees reading a lease contract which contains FMV assume it’s defined in some reasonable and straightforward manner. In many leases, FMV is not defined and when it is defined it is often defined in a manner which is extremely lessor-favorable. Many apparently benign elements of the definition such as “as mutually agreed” actually create material risk for the lessee and can result in extensions since the lessor’s incentives are affected by the fact that monthly rents continue to be paid while negotiations go on. Other contractual approaches to more tightly defining FMV like hiring an appraiser or a few appraisers have similar risks – the whole process leads to extensions since these definitions rarely include a time frame. The bottom line is that while FMV can be well structured to reflect the lessees understanding of Fair Market Value –this is almost never properly addressed in lease documentation from the lessee’s point of view. If you want to put your FMV definition to the true test– just ask your lessor for an FMV quote on all of your remaining leases and see what you get back. If the number is surprising you may need help from an expert.

With a few very notable exceptions – every Lessee-defined lease document deal we have reviewed had at least these 3 characteristics in common:

1. Lessees spend significant time developing their own master lease and very little time developing a schedule document.
2. The documents often contain “standard” language which could have been made significantly stronger to reduce risk
3. The documents are almost never signed without material changes demanded by lessors. These changes reintroduce many of the risks that the entire exercise of developing the document was intended to eliminate.

In addition, many lessors will sign a company’s proposed Master Lease document without many changes but since the schedule is the governing document in case of conflict of terms – the lessor will insert their own schedule which contains the definitions and triggers which create risk for the lessee and drive the lessor’s profit.

Example: The following section was inserted into a standard lease doc created by a company at the request of the lessor. On its face it seems like a common sense addition which triggers Default if the Lessee fails to fulfill any obligations under the lease. Since the Lessee has every intention of fulfilling its obligations this seems reasonable.

“The failure of Lessee to perform any other term, covenant or condition of this Lease Agreement, any Lease Schedule or any other document,
agreement or instrument executed pursuant hereto or in connection herewith which is not cured within ten (10) days;”

However the definition of what triggers a default is v

One of the fun parts of negotiating leases is collecting the war stories. The negotiations often produce revealing and humorous moments.

While it is true that IT and other assets experience such a steep reduction in value that repossession is less attractive to the lessor than other options in the case of client default, virtually all equipment leases contain numerous attractive options, and combinations of options in addition to repossession, for the lessor in the event of default. In addition “cross default” provisions create additional risks of default the implications of which are not commonly appreciated.

The fundamental myth is that end of lease (month-to-month and longer) extensions are in any way unusual. In fact most lessees struggle to return leased equipment and end up paying some version of extension rents on the majority of their equipment leases. Lessors know, at lease inception, that some extensions are likely. Lessees – if they have evaluated the all-in cost of leasing would also know this and could include an estimate of extensions in their lease versus buy analysis. However each lease extension is commonly viewed as a one-off unique event – which is a costly mistake.