Equipment lease rates can be deceiving. Businesses in need of commercial equipment may be attracted by the low “sticker price”—the stated periodic rental rate and corresponding payment.
But this rate doesn't tell the full story. In order to properly evaluate equipment lease rates, the high level of risk that is present in many lease agreement must be quantified using historical equipment leasing performance data. These historical costs can then be used to project the future costs of various risks, allowing for a more accurate lease vs. buy analysis and comparison of leasing options.
However, while the notion of accounting for risk is basic financial management, many businesses don’t sufficiently understand or value the causes of risk that escalate “all-in” equipment lease rates beyond the stated rate.
Businesses can overcome this lack of lease risk awareness with a systematic approach to lease risk evaluation. There are five key steps to take to ensure risk is properly identified and weighted in making a decision about the best procurement method.
1. Determine how much interim rent the lease allows. Interim rent is charged for the period between when equipment is delivered / accepted and when the lease schedule officially commences. If this period isn’t limited, the actual cost of leased equipment can escalate significantly.
2. Consider how difficult notice and default conditions will be to meet. When a lessee fails to meet notice requirements or goes into default, the lessor is in a favorable position to encourage lease extensions that can dramatically increase the all-in cost of the equipment. Yet many lease agreements contain notice and default conditions that are burdensome or difficult to meet. For example, many lease agreements require notice for seemingly trivial events that occur on a regular basis.
3. Make sure casualty rates are in line. If casualty rates aren’t reasonable—in favor of the lessor—then lessees can obviously end up paying more for damaged or lost equipment than it was worth. The mistake that many lessees make is assuming that not enough equipment will be lost or damaged to make any significant cost impact. Another frequent error is overlooking the notice requirements for lost or damaged equipment—an oversight that can result in the possibility of default. The casualty rates also provide a small glimpse into what the lessor may be expecting as a minimum gross profit upon end of lease.
4. Gauge how easy it will be to return equipment to avoid lease extensions. Being able to return equipment on time is essential to making equipment leasing more cost-efficient than purchasing. But many lease agreements contain terms that make compliant return difficult. A typical example is “all-but-not-less-than-all” provisions that require every piece of equipment in a population (as defined the lease) to be returned or else full rent continues for the entire population. Lessees also need to be honest with themselves about the likelihood that they will be able to return equipment when the lease ends.
5. Insist on a quick, fair mechanism for determining fair market value (FMV) for buyout at end of lease. Many leases will allow lessees to purchase the equipment at the end of lease if they are unable to return it, but sometimes the mechanism for determining FMV isn’t spelled out. In some cases, lessors essentially set the price—which of course can lead to higher equipment cost if the price is above the actual residual value. In other cases, lessees negotiate the fair market value, but they’re continuing to pay rent as the lease is extended during negotiations.
Conclusion
Lease agreements are complex documents, usually prepared by lessors that are very familiar with the intricacies of leasing risk. To adequately determine all-in equipment lease rates and protect their interests, it’s crucial for lessees to follow the five key steps above, often with the assistance of third-party equipment leasing experts.
