how does leasing work?

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july 2005

There are many types of leasing but, fundamentally, all fit one of two categories:

  • direct lease. You identify the asset (and negotiate the price) and arrange for the leasing company to buy it from the manufacturer (if new) or the previous owner (if used) to lease it to you.
  • sale-and-leaseback (also called purchase leaseback). You sell an asset you already own to the leasing company for fair market value or book written down value (whichever is less) and then lease it back.

In both cases, the lessor owns the asset, not you, and leases it to you. As with any other lease agreement, you return the asset at the end of the lease to the lessor. Some leases grant you an end-of-lease option to renew the lease at a minimal cost (secondary period) or to gain title of the equipment for an agreed amount.

Often equipment manufacturers themselves act as lessors or have an affiliated leasing company. This allows them to more easily help their customers finance transactions. The other two groups of lessors are banks and independent leasing companies.

types of asset finance

We can generally distinguish three major types of leasing: finance leasing, operating leasing and contract hire. Although strictly speaking not a type of leasing, we also include hire purchase in the following discussion:

  • finance leasing (full payout lease) - you effectively acquire all financial benefits and risks without actually acquiring legal title. The leasing rate is computed to collect the full value of the asset (plus finance charges) during the contract period. At the end of the lease, the asset is sold to a third party and you can receive a share of the sale proceeds (if the lease is not being extended). Generally, you will not be able to become the owner of the asset at any time - unless a private arrangement is made with the third party. However, you usually have the option to extend your lease and as you will have paid for almost the full value during your initial lease period, the rental payments for subsequent periods will be minimal (sometimes referred to as "peppercorn rental")
  • operating lease - often with a shorter time frame than financial leasing (always significantly shorter than the working life of the asset), operating leasing is more like a regular rental. The lessor expects to be able to either sell the asset in the second-hand market or to lease it again and will therefore not need to recover the total asset value through lease payments. There may be an option to extend the leasing period at the end (this negotiation can only take place at the end of the initial rental period). As with finance leases, you will not be able to become owner of the asset at any time but, contrary to financial leases, you will not share in the sale proceeds
  • contract hire - a form of operating lease (often used with cars and other vehicles) that includes a number of additional services such as maintenance, management or replacement if asset is in repair
  • hire purchase - this is an agreement for the hiring of an asset with an option to purchase. The legal title will pass to you when all payments have been made. The term of a hire purchase must be significantly shorter than the working life of the asset. You are able to claim capital allowances as if you had purchased the asset outright, gaining immediate use of it. Hire Purchase agreements are typically written for domestic users, not so much for business users

end of lease options

At the end of the lease term, you have various options. Lease contracts can stipulate that you:

  • return the asset
  • have the right to act as an agent to sell the asset to an independent third party

and/or

  • can renew the contract or enter into secondary periods

It is important for you to anticipate your future needs as each option has its advantages and disadvantages and will affect your monthly payments.

Seek the assistance of a professional advisor if you feel you need help!

the advantages and disadvantages to leasing:

advantages

  • better cash flow - leasing gives you access to the asset with minimal up-front payments and spreads the cost over time. You to pay for the asset with the income it generates while minimising the drain on your working capital
  • no debt - an operating lease preserves your credit options and does not influence your credit limit as it is generally not classified as debt but as expense (note that this advantage does not apply to finance leases!)
  • maximise financial leverage - your lease can often finance everything related to the purchase and installation of the asset and may free up cash flow to pay for items such as training
  • simplified cash flow management - lease payments are usually flat, making cash management more predictable and easier than with a variable rate loan. The fixed interest rate of a lease also helps if interest rates rise
  • tax advantage - operating lease payments are generally tax deductible just like depreciation charges but are made with pre-tax money. Cash purchases, in contrast, are made with after-tax money. Hire purchase agreements allow the lessee to claim capital allowances
  • flexible time frames - leasing contracts can be structured to fit your requirements. Use an asset as long as you need it without owning it forever
  • hedge against obsolescence - depending on your end-of-lease option, just return the asset to the lessor. You will not have the hassle of selling the used asset or run the risks related to residual value and (technical) obsolescence
  • additional advantages - some leases offer additional advantages such as cancellation options or asset maintenance.

disadvantages

  • more expensive - a finance lease is usually more expensive than an outright cash purchase as the payments include finance charges. However, leasing may cost less than other forms of financing. Also consider the tax advantages when making this calculation
  • additional guarantees - depending on the credit rating of your company, the lessor might require additional guarantees. These may be provided by you, your partners or your bank and could affect your personal credit rating or your standing with your bank
  • fixed term - it may be impossible, or at least costly, to terminate a leasing contract early
  • fixed interest rates - interest rates are usually fixed throughout the lease which may prove a disadvantage in times of falling interest rates

things to watch out for:

  • return of asset conditions - if you choose to return the asset at the end of your lease, the condition in which and the place where it must be returned are important aspects to consider carefully
  • notice period - if your lease includes the option to renew take note of any time periods in which to give notice in case you do not want to renew the contract. Some leasing companies will automatically renew the contract if you fail to give notice
  • purchase rights - if negotiating the right to purchase the asset at the end of your lease, a predetermined fixed price offers more value as the 'fair market value', which theoretically is always available to you
  • maintenance responsibility - clarify which service and maintenance programs are included in the lease. If you are responsible for service and maintenance, make sure you do not have to provide an unreasonably high degree of it.

faqs

what kind of equipment can be leased?

Lease almost anything, from equipment valued at a few thousand pounds to assets worth millions.

what is the lease rate or payment?

It is the regular "rental" payment you make under the lease agreement to gain access to the asset. The lease rate or payment is primarily determined by the total cost of the asset, the duration of the lease and the interest rate level.

what is the lease term?

The period of time you agree to rent the asset from the lessor

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Cabot Asset Finance provide specialist asset finance facilities to business users for the acquisition of almost all types of capital equipment.

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