Particularly with information technology, equipment obsolescence can be a problem because of short asset life cycles, typicall no more than three years. When equipment is purchased, the cost is capitalized, and depreciation expense can linger after obsolescence. When it is leased, so the theory goes, this threat of obsolescence before the equipment is “paid for” is eliminated.
Asset finance using equipment leasing is also alluring because—if the equipment is returned on time and additional costs beyond base rent are mostly avoided— a leasing approach to asset finance can result in equipment procured for less than the cost of purchasing.
The Risk is Real
Efficient asset refresh and lower equipment costs are the ideal outcome of equipment leasing, and it is possible to achieve these benefits. But success is predicated on the lessee’s ability to limit risk in the lease agreement. If all-too-common leasing risks aren’t capped, a leasing asset finance strategy can backfire, resulting in far higher “all-in” equipment costs than if the equipment had been bought.
Notice Requirements
Equipment leasing companies usually seek to include contractual requirements for lessees to provide notice at various points throughout the lease. These requirements stipulate that lessees must provide notice for certain events (e.g., when equipment is moved, modified, or damaged) or pay penalties. Often, a lessor will require notice for the intention to return equipment, and if the lessee fails to make the notice, the result is lease extensions that add to the total equipment cost. Many lease agreements contain language that make complying with the notice requirements so burdensome that non-compliance is likely.
Interim Rent
An often overlooked cost when considering asset finance options is the rent that is charged for equipment that is delivered before the official commencement date of the lease. Most lease agreements allow lessors to charge prorated rent at the base rental rate of the lease for this time period. Not only should this additional cost be factored into asset finance decisions; the amount of interim rent that is permitted should be limited in the lease agreement.
Lease Extensions
When the end of lease arrives, often the lessee is not in a position—for various commonplace reasons—to return the equipment. This scenario occurs often in the equipment leasing industry, leading to lease extensions that dramatically escalate costs for the lessee.
Fair Market Value
Lessor-favorable language regarding FMV at the end of the lease is one of the ways in which lease agreements can result in lessees losing leverage. Lessees may want to purchase some of the equipment at the end of the lease (and return and refresh the rest), but if the lease agreement’s definition of FMV calls for "all but not less than all" equipment to be returned or purchased, then this option essentially disappears. Additionally, many FMV definitions result in valuations that are above the actual market value. Even if the lease calls for mutual agreement on FMV, the lessor has leverage because it’s receiving lease extension payments during the negotiations.
Default/Casualty Terms
Lease agreements should be carefully evaluated for the risk of default, and any terms that increase the likelihood of default should be recognized as such and properly factored into asset finance choices. Likewise, casualty values should be explicit and reasonable, and their effect on risk should be considered.
Conclusion
It’s understandable why financial managers are attracted to equipment leasing, but the benefits they hope to gain—including well-managed asset refresh— can only be achieved if risk is sufficiently limited in the lease agreement and managed during operations. If the risks common to equipment leasing are left unchecked, the leasing option can prove to be a costly mistake.
