Leveraged Leasing vs. Buying: Equipment Finance Explained

Introduction: The Lease vs. Buy Decision

Jennifer Schiff (2005), in "Buy vs. Lease: What You Need to Know," argues that answering the question of whether it makes more sense to buy or lease requires consideration of a number of factors, including but not limited to cash flow, cost, depreciation, tax ramifications, and company forecasts. During her research, Schiff explored decisions made by two fast-growing small businesses—one that chose to buy and one that chose to lease. In addition, Schiff interviewed executives at Dell Financial Services and HP Financial Services for their perspectives on the buy vs. lease question. In light of contemporary debates relating to the lease vs. buy argument noted by Schiff and others (Brady & Ingram 2006; Hamill, Sternberg & White 2006), this paper presents a sampling of relevant information, with a particular focus on leveraged leasing.

Two primary points Schiff (2005) asserts from her study include:

1. When a business focuses on cutting-edge technology, buying may make more sense (Schiff 2005).

2. When a business's primary concern is controlling cash flow, and the owner or manager does not have time to invest in equipment-related matters, leasing may prove to be the better option (Schiff 2005).

In "The Lease vs. Buy Dilemma: Which Option Is Best?," Marc Newman (2008), CPA, suggests two rules of thumb for determining which option is best. First, consider that the use of equipment—not its ownership—contributes to operating profits. The leased equipment generates funds for lease payments, a particularly relevant point "when the useful life of the equipment is the same or shorter than the term of the lease" (Newman 2008). Second, although not universally true, "buy what appreciates and lease what depreciates" serves as another traditionally solid guide (Newman 2008).

Types of Leases and Key Considerations

Leases may be negotiated while simultaneously providing a range of rights applicable to contracting parties. James R. Hamill, Joel Sternberg, and Craig G. White (2006) define a lease essentially as "the purchase of the use of an asset over a specified period of time" (Grenadier, as cited in Hamill, Sternberg & White 2006, p. 43). "These rights provide differing opportunities for flexibility to the lessee and are key to the valuation of the option portion of the contract" (Hamill, Sternberg & White 2006, p. 43).

Ensuring cash will be available during slower months may prove critical for some seasonal operations. Newman (2008) asserts that businesses comparing the options of leasing and buying equipment need to consider: (a) the amount of cash the business can afford to disburse upfront, either from a credit line or the business's liquid assets; (b) whether the business will be able to continue paying its operating expenses and cover unforeseen expenses after expending a lump sum; (c) the percentage of the business's credit line a purchase would consume; (d) the effect of depleting the business's capital by, for example, $24,000 at once versus $245 per month for a preset period; and (e) whether lease options such as skip-payments could benefit the business (Newman 2008).

An operating lease constitutes a rental agreement stipulating that equipment may be returned at the end of the lease or purchased for a specific price. A capital lease specifies that the lessee may either purchase the equipment or, at the end of the lease term, pay a nominal amount to own the equipment (Newman 2008). When leasing appears to be the best option, the individual or business must determine which type of lease best fills the need. The following six considerations are relevant to that determination:

1. The anticipated lifespan of the equipment. "For tax purposes, the IRS considers most equipment (other than passenger vehicles) to have a useful life of seven years" (Newman 2008).

2. At the end of the lease term, whether the equipment's residual value constitutes a factor in the purchase option.

3. Whether EPA and/or other community guidelines affect the disposal of old equipment, which may mandate consideration of a purchase option.

4. The business's perception of the equipment's status.

5. The real cost, over time, of leasing the equipment, including finance costs and cost of lost liquidity, "compared to the cost of purchasing the equipment, for example, lost interest or lost liquidity" (Newman 2008).

6. The impact of the decision on the business's financial statements. Contrary to purchased equipment, according to traditionally acknowledged accounting rules, leased equipment and lease debt may not need to be listed on a business's financial statement (Newman 2008).

The Concept of Leveraged Leasing

Numerous corporations utilize the leveraged lease product to finance capital equipment acquisitions. Deborah Brady and Paul Ingram (2006) explain in "A Leveraged Lease Primer" that commercial aircraft, vessels, railcars, and manufacturing lines are assets commonly acquired using this vehicle. With its optimized structure and inherent tax benefits, leveraged leasing constitutes an attractive financing option. Frequently, during the course of an accountant's work in the financing and accounting areas, that work will encompass leveraged leasing. To critically and effectively examine such transactions, the accountant must ensure he or she understands leveraged leasing.

In "Leveraged Leasing," Ashook Roy (1990) explains: "A leveraged lease is a long-term lease in which a major part of the purchase price of the to-be-leased asset is financed by a third party." The lessor combines his or her own funds with borrowed money to purchase an asset that requires large capital expenditures. After the purchase is completed, the lessor leases the asset to another party (Roy 1990).

Contrary to an ordinary lease, which involves only two parties—the lessee and the lessor—three parties participate in a leveraged lease: the lessee, the lessor, and the term lender. Roy (1990) further explains that a leveraged lease is essentially a long-term lease in which a third party finances the primary part of the purchase price of the future leased asset. The lessor uses a combination of its own funds and borrowed money to purchase the asset, which is later leased to another party.

Conclusion: Benefits of Leveraged Leasing

In leveraged leasing, the equipment and its use—as lenders in this industry understand—generates fast and easy approvals. It preserves the lessor's credit lines while also offering distinct tax benefits. As a result, a number of accountants attest that leasing may be in their customers' best interests.

The literature (Brady & Ingram 2006; Sharp 2006) confirms that leveraged leasing provides a powerful equipment finance tool. Most lessors are reportedly not well capitalized, and frequently offer leveraged leases to their customers. The lessor determines the amount of equity he or she perceives as appropriate for a transaction based on an estimate of the equipment's value at the lease's end, and then invests that amount into the lease. Next, the bank provides the "debt side" of the transaction to the lessor by lending—on a nonrecourse basis—the difference between the equipment cost and the equity, and takes an assignment of the lease payments from the lessee along with the underlying equipment as collateral (Sharp 2006).

For example, when a lessor wants to purchase equipment costing $1 million and determines that the equity amount to invest—based on the estimated residual value at the lease's end—is 10%, the lessor will invest $100,000 into that transaction. The lessor then petitions the bank to discount the flow of rental payments from the customer. If the bank agrees, it supplies the balance of the remaining costs, secured both by the underlying equipment and by the assignment of rental payments from the lessee (Sharp 2006). According to Sharp (2006), the legal documents involved in a lease transaction are not particularly complicated. Sharp also stresses that leasing equipment, unlike buying, frees money from tied-up cash balances so that funds may be readily utilized for other purposes, including research and development.

Banks' decisions to provide loans are based primarily on creditworthiness (Sharp 2006). "Both lessors and lessees must maintain the highest investment-grade credit ratings possible." Having a high credit rating reassures both lessor and lessee; however, even companies that may not merit the highest ratings can also qualify for loans. For unrated companies, a number of banks will consider current interim figures as well as full three-year audited financial statements.

A number of components make leveraged leasing attractive. One benefit for the lessor is the "non-recourse" basis, which means the term lender does not have any legal recourse against the lessor should the lessor fail to meet debt repayments, other than recourse to the security—namely, an assignment of the lease rentals and a chattel mortgage over the lease. Another benefit is that "the lessor contributes 15%–40% of the purchase price of the asset and claims the tax benefits of ownership of the leased equipment along with any surplus rents after debt repayments have been met" (Roy 1990). The lessor also receives the resulting tax benefits, accelerated depreciation deductions, interest expense deductions for interest paid to the term lender, management fees paid to the packager and others, and any applicable investment tax credit (Roy 1990).

For the lessee, the benefits include lower interest rates (2–3%) relative to orthodox leasing; for the term lender, a greater rate of return relative to conventional loans (Roy 1990).

One of the most significant benefits for both lessors and lessees is the requirement—and resulting assurance—that they maintain the highest investment-grade credit ratings possible. Banks' decisions to provide loans are based primarily on creditworthiness. The question introduced at the outset of this paper—does it make more sense to buy or lease?—does not demand a simple yes or no answer. As in numerous decisions that individuals and businesses must make, the most important point to remember is that each decision merits careful, concentrated, and credible consideration of the specific circumstances involved.

Brady, Deborah & Ingram, Paul. (2006, May). "A leveraged lease primer." ELT. Equipment Leasing Association of America.

"Capital equipment: Lease vs. buy." Wood Digest. Cygnus Business Media. 2007.

Hamill, James R., Sternberg, Joel, & White, Craig G. (2006). "Valuation of the embedded option in a non-cancelable lease: theory and application." Journal of Applied Business Research, Third Quarter, Volume 22, Number 3, p. 43.

Newman, Marc. (2008). "The lease vs. buy dilemma: which option is best?" Real Estate Weekly. Hagedorn Publication.

Roy, Ashook. (1990). "Leveraged leasing." The National Public Accountant. National Society of Public Accountants.

Schiff, Jennifer. (2005, July 28). "Buy vs. Lease: What You Need to Know." Jupitermedia Corporation.

Sharp, Arthur G. (2006). "Banking & Finance: Equipment leasing." Smart Business Chicago. Smart Business Network.

Shapiro, Mary Finn. (2001). "Leasing 101: Basics on what marketers should know when thinking about equipment financing." National Petroleum News.