Higher interest rates drive increased interest in leasing

Wayne Forrest -- Purchasing, 10/7/2004

It has yet to return to the go-go levels of the 1990s, but leasing activity has been gathering steam in the last year and lessors see 2004 as shaping into a bullish market. As business levels and interest rates turn up, pricing for capital equipment will continue to increase as demand for that equipment spikes. The result: leasing becomes a more attractive option to companies looking to meet demand quickly.

"There is a lot of pent-up demand," says Ralph Petta, vice president of industry services for the Equipment Leasing Association (ELA). "Over the past year or so, businesses have not refreshed their technology and haven't acquired much equipment. But now we see businesses starting to spend money. When that happens, leasing generally gets its share of the financial pie."

Leasing companies generally garner about one-third of all business investment in equipment, Petta says, and that number has stayed "fairly consistent throughout the period." The ELA's estimate of the market size in 2003 is $208 billion, compared with $204 billion in 2002. The ELA's final numbers for 2003 were due to be released in September. The organization's market forecast for 2004 is $218 billion.

Petta attributes the anticipated hike this year to "very strong" originations (new business) in a variety of markets, primarily in the small ticket (leases less than $250,000) and middle ticket (leases of $250,000 to $5 million) segments. The trend for the rest of 2004, he speculates, will be "a continuation of what we've seen in the first half of the year, which is strong and robust originations and strong demand for equipment."

The weak point in the market is in the large ticket arena (leases of $5 million and greater), which has been collared by the poor economic state of the airline industry.

Jonathan Fales, a leasing industry consultant with the Alta Group, also cites pent-up demand for equipment and technology, as the U.S. economy begins to accelerate and companies try "to catch up for lost time." He cites information technology (IT), telecommunications and banking and office equipment as among the most active small market sectors.

The parallel upturn in leasing and the national economy is no fluke. Leasing traditionally has been a leading indicator and the leasing industry prospers as interest rates rise. "When the cost of capital is low, companies have a greater tendency to purchase rather than finance or lease equipment," Fales says. "As interest rates go up and the cost of borrowing becomes higher, [leasing] becomes a more attractive option."

There is no magic number that interest rates reach before leasing becomes the optimal option. Fales says that figure changes for each individual company.

"When a company spends money on an asset, it looks at a number of factors including the cost of capital and the cost of borrowing; how long the asset will be used; will it need to be replaced sooner, rather than later?" Fales says. To the extent that a lease offers lower payments or better flexibility in repayment terms, a lease may become an attractive option as the cost of borrowing rises.

There are additional benefits to leasing beyond simple dollars and cents. Purchasing any sort of asset creates an "on balance sheet" item. From the CFO's perspective, the more assets a company has, the lower its return on assets (ROA) and return on equity (ROE) ratios. CFOs of asset-intensive companies may have to wage a battle between managing and limiting their assets to improve the ROA and ROE ratios.

In many cases, leasing allows companies to treat the asset as an "off balance sheet" item. If a company can keep the asset off its balance sheet—and on the lessor's balance sheet—the above-mentioned ratios improve and create a positive impression on shareholders.

"In many cases, assets such as IT are not necessarily income-producing assets," Fales says. "They are infrastructure support assets and they depreciate quickly. CFOs may prefer to take their cash and—rather than tie up cash in those assets—use [the cash] where it generates more revenue for the company."

Buyers also must consider more than just the lowest interest rate available when evaluating the total costs of a lease. Additional expenses may include lease application or processing fees, credit check fees, and a charge if a company exchanges an asset during the lease.

"There are probably a dozen or more types of fees a lessor can put into a contract," says Fales. "In many cases, the fees help the lessor manage administrative costs. The lessee should be aware of what those fees are and factor those into the financial equation."

A lessee also may incur unnecessary costs by not paying attention to when a lease expires and holding onto an asset beyond its termination date. Some lessors will notify the lessee of its options before the end of the lease, allowing the company to purchase the asset for a mutually agreed upon price, to extend the existing lease or upgrade to newer equipment.

Leasing encourages "looking intelligently at the economic life of the asset, so that the business doesn't own the asset when the maintenance costs go up," offers Norbert J. Ore, chair of the manufacturing business survey for the Institute for Supply Management (ISM) in Tempe, Ariz. Most importantly, a company must understand its own business model to determine if leasing is the appropriate course. If a company can borrow at a low interest rate, Ore says, the decision to lease isn't a financial decision as much as it is an operating decision on how to run the business and deal with eventual obsolescence.

"Today, with interest rates down and residual values down, if leasing has always been the decision, businesses may want to do due diligence to make sure their business models are still valid," Ore says.

In the case of IT equipment—in which technology advances rapidly—Ore recommends turning over those assets as soon as possible when a lease expires. He cites an example of one company that leased all of its laptops and related equipment. At the end of the three years, the company found that it had paid full price for the equipment.

While the issue of leasing laptops is moot, because the purchase price has decreased so dramatically, the lesson is clear—analyze costs and justify when it is most appropriate to purchase an asset outright. There also are costs a company can incur at the end of the lease related to disposal of the equipment, residual value of the asset at that time, and the asset's condition beyond anticipated wear-and-tear.

The Toro Co. leases equipment to both professional and consumer markets and partners with GE Financial to arrange financing, credit and leasing programs. The professional market includes turf equipment and the landscape contractor group, which services private residences or corporate campuses. Considerations in determining the most appropriate length of lease involve reducing the total cost of ownership and maintaining the newest of available technology to enhance uptime and reduce repair costs, says John McPhee, Toro's senior marketing manager of services. The typical lease for Toro customers runs three to four years. Finance customers tend to prefer four- to five-year terms to reduce monthly payments.

"In leasing, there are many levers to pull—the cost of the equipment, residual position that the financing company takes, the cost of money and the terms in the agreement," McPhee says. "You can mix and match them in a lot of ways. You need to ask—what is my monthly payment and for how many months?"

Buyers also need to consider structuring lease payments for seasonal fluctuations in revenues. Take the example of a landscape operator or golf customer in the northern U.S., which may generate 80% of its annual revenues in a five-month period.

"You don't want to make payments those other seven months," says McPhee. "Match the payments with actual cash flow. When your cash register is ringing, that is probably the optimum time to make payments."

The lessee isn't the only party that needs to safeguard itself from taking a loss. In Toro's leases, there are return conditions that stipulate that safety features are still operational, tires are in good condition, and hydraulic and electrical systems are functioning. It is done to ensure that the customer has used the equipment without abusing it.

Based on the return condition of the equipment, the lessor takes the risk relative to the resale value of the leased equipment. "If the resale market declines at some point," McPhee says, the lessor "would have financial exposure on that side of it."