Making Money in the Equipment Leasing Business By Richard M. Contino, Esq.

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1 Making Money in the Equipment Leasing Business By Richard M. Contino, Esq. There are many ways to profit in a lease transaction. To succeed, and sometimes even survive, in the highly competitive business of equipment leasing, a leasing company must take advantage of every possible profit opportunity. The obvious areas for leasing profits are: Interest charges Tax benefits Equipment sales or re-leases. And, to the less experienced lessor, the less obvious ones are: Interim rent Prepayment penalties Casualty occurrences Insurance cost markups Upgrade financing Documentation fees Filing fees Maintenance charges Repair costs Excess use charges Equity placement fees Leveraging a Lease investment with third-party debt Commitment fees Non-utilization fees Re-marketing fees, Late payment charges Collection telephone charges Deal re-write fees Equipment redelivery charges The profit opportunity areas available to a leasing company may vary depending on the type of transaction, the level of credit risk involved, the dollar size of the lease transaction, and the business practices of its competition. For example, in the case of multi-million dollar leases of typically high residual value equipment, a substantial portion of lease profits come the equipment ownership tax benefits and the end-oflease equipment sale, or re-lease, proceeds. In small ticket transactions, such as $10,000 to $50,000 leases, the lessor often expects little or no profit from end-of-lease sales. Instead it looks to it's lease interest rate spread--the difference between its cost of funds and the interest rate implicit in the lease, and documentation and deal review charges. 1. The Basic Lease Profit Areas The principal lease transaction profit areas are interest charges, equipment tax benefits and residual earnings. Not maximizing any one can significantly reduce the potential for transaction profits. a. Interest Charges The obvious way to make money in an equipment lease is through financing profits. Financing profit, sometimes referred to as financing spread, is the difference between a leasing company's cost of money and the lease interest rate charged. The higher the interest rate charged, the greater the financing profit. 1

2 Illustrative Example--Financing Profit: Assume a lessor borrows money at a 9% per annum interest rate and charges a lease interest rate of 11%. Its financing spread is 2% per annum. By increasing the lease interest rate to 12%, its financing profit increases to 3%. Lease Marketing Tip: Prospective lessees, particularly small ticket lessees, are often more sensitive to their monthly rent cash outflow than to the lease interest charged. So, offering a longer lease term (stretching out the period of lease payments from say 3 years to 5 years) can maintain solid, or increase, financing profits and provide an acceptable lessee rent payment dollar amount. For example, assume that a lessor's cost of money is 9% per annum, and that its desired financing spread is 3% per annum. Assume also that the equipment involved will have a zero end-of-lease value. In this case, the monthly, in arrears, payment on a 3- year lease of a $400,000 lathe would be $13,286. If the prospective lessee finds the $13,286 monthly payment too high, stretching the lease term to 5 years, at the same lease interest rate (9% + 3% = 12%) would drop the monthly lease payment to $8,897. Stretching out the lease term provides an opportunity to build in higher financing profits in a lease, while still keeping periodic cash flow payment relatively lower. For example, increasing the lease interest rate charge to 15% over the same five year term would result in a monthly lease rent of $9,516. Market competition, reasonableness, and, sometimes, state usury laws limit how much financing spread a lessor can build into its lease rate. Typically, the smaller the lease dollar size, the higher the lease interest rate charged. For example, interest rates on $5,000 to $50,000 equipment transactions generally range from 12.5% to 24% per annum. As transactions approach $100,000 and over, simple interest rates are generally in the 10.5% to 13.5% range. Once the deal size hits $1,000,000, rates can run 2% to 4% below the lessee's equivalent long-term borrowing rate. In the latter case, for example, a $4,000,000, 12-year aircraft lease for a lessee that borrows longterm money at 11% per annum could run anywhere from 7% to 9% per annum, or less. Observations: A lower lease rate in a larger equipment transactions is not as bad as it may appear because greater absolute dollar profits are available. For example, a profit of 2% on a $1,000,000 lease is $20,000, whereas it is $200 on a $10,000 lease. The competitive nature of the multimillion dollar lease transaction market often forces lessor to price their lease rates with little or no financing spread profit, making them to look to other transaction aspects, such as tax benefits and equipment residual proceeds, to offset minimal, or nonexistent, cash flow. Recommendation: Although leasing companies are not generally regulated by federal or state laws, times are changing. Before setting what may be a high lease interest rate, have your lawyer check the governing state laws. 2

3 A few states have enacted, or are considering implementing, rules which protect lessees. For example, unconscionable profit laws, referred to as usury laws, originally designed to protect individuals have, in Texas, been extended to corporations in installment sale-type financing. Included are low fixed price purchase option leases. If your lease runs afoul of state law, a lessee may be able to cancel the lease agreement and walk away without penalty. If you discover after you've entered into a lease that you've inadvertently charged a lease rate higher than governing law permits, it's always a good idea to approach the lessee with an offer to reduce it, using a plausible business excuse, such as you have decided to make financing rate adjustment to certain preferred customers. b. Equipment Tax Benefits Very often, particularly in multi-million dollar equipment leases, the tax benefits available to a lessor are a critical component in computing anticipated transaction profits. In fact good credit companies considering the multi-million dollar lease transactions typically demand that lease rates reflect, and therefore pass through to them in the form of relatively lower rent charges, at least a portion of the transaction tax benefits. Determining how to take into account the transaction tax benefits is very complex--and, fortunately today, there are many lessor profit (sometimes referred to as "yield") analysis software programs which make the job considerably much easier. By leasing equipment a lessor, as equipment owner, has the right to claim equipment ownership tax benefits, such as depreciation and any available investment tax credits. In addition, in the case of leveraged lease transactions, there are certain other tax write-offs, such as the interest charges on the long-term equipment loans. A lessee, on the other hand typically cannot claim any equipment ownership tax benefits, but is entitled to deduct for the rent payments as a business expense. Observation: By taking into account equipment-related tax benefits, a lessor is able to offer lower rents while maintaining its profit objectives. For example, typically a lessor offering an annual lease rate of 10%, could reduce its lease interest rate to 8% without reducing its economic return by incorporating deprecation benefits into its rent pricing. c. Residual Earnings In pricing a lease transaction (setting the lease rents), an ideal lessor objective is to have sufficient lease term rents to return its entire equity investment, repay any equipment loans, and provide a solid profit, with any end-of-lease sale or re-lease (often referred to simply as "residual:) earnings simply as windfall profits. In other words, to set the lessee lease rents using a zero equipment residual assumption. In small ticket equipment transactions this is typically possible. In multi-million dollar equipment lease transaction, largely due to market competition, its typically not possible. 2. Additional Areas of Potential Lease Profit. 3

4 A leasing company can earn significant profits from less obvious transaction aspects, such as interim rent, prepayment penalties, casualty occurrences, insurance cost markups, upgrade financing costs, documentation fees, filing fees, maintenance charges, repair costs, excess use charges, equity placement fees, debt costs and placement fees, commitment fees, nonutilization fees, re-marketing fees, late payment charges, collection telephone call charges, deal re-write charges, and equipment redelivery charges. Paying attention to each potential profit area can produce attractive additional economic returns. a. Interim Rent One way many lessors build in extra profit dollars is providing for interim rent. Sometimes called pre-commencement, or stub period, rent, it is rent that is payable for a period running from the start of the lease to the beginning of its primary, or main, term. For example, a seven-year lease transaction might provide for the primary term to begin on the first day of the month. If the equipment is not delivered and accepted under the lease contract on the first of a month, there will be an interim rent period. If equipment was delivered, for instance, on the 7th of January, the seven-year period would begin February 1st, with an interim term of running from January 7th through January 31st. If the lease rents are computed on the basis of the primary term rents, the stub period rent is a windfall profit. b. Prepayment Penalties A typical net finance lease may not be canceled for any reason--thus guaranteeing the lease profits, subject, of course, to a rent payment default. Some prospective lessees, however, want the right to terminate a lease early in if the equipment become obsolete or surplus to their needs. This request can be an opportunity for profit. Generally, when a right to terminate a lease early is granted, it is permitted only upon payment of an amount equal to a predetermined termination value. By ensuring that the amount which a lessee must pay upon any lease termination not only makes a lessor economically whole, but also has a premium built in, say 5% of equipment cost, the benefit of the original bargain can be preserved-- with a profit. Generally, when an early lease termination right is granted, the lessor incorporates a termination payment schedule into the lease, each applicable termination payment expressed as a percentage of equipment cost for each rent payment period when a termination could be exercised. Payment of the appropriate termination value amount on any permitted rent date allows the lessee to terminate a lease as of that time. For example, a monthly lease might provide for a termination payment of 85% of equipment cost when the sixth rent payment is made, 83% of equipment cost when the seventh rent payment is made, and so on. Properly structured, payment of a lease termination value will return the entire remaining equipment investment, with its anticipated profits at least to the date of termination, provide funds to pay off any equipment purchase loans, and add an additional profit, the exercise penalty. 4

5 c. Casualty Occurrences An equipment casualty occurrence brings a lease to its end. In the same manner as an lessee-elected early lease termination, provision must be made for the protection of a lessor's investment, and profit, at least to the date of the casualty occurrence. Typically, leases contain casualty loss provisions that require that the lessee pay a predetermined casualty value payment. These payments are usually prescribed by formula in a lease provision or in a casualty payment schedule. They, like termination payments, are designed to make a lessor economically whole, including payment for loss of anticipated residual profits. For example, a monthly lease might provide, in the event of an equipment casualty occurrence during a specified rent payment period, for the payment of a casualty value amount equal to 98% of equipment cost anytime during the second rent payment period, 96% of equipment cost anytime during the third rent payment period, and so on. In structuring an equipment casualty payment obligations, the lessor can build in a reasonable profit to compensate for loss of its long-term investment opportunity. When casualty payments are expressed as a percentage of equipment cost in a casualty payment schedule, one way to do this is to increase rock-bottom casualty loss payments by a small percentage, say 2% of equipment, added on each specified casualty value percentage. d. Insurance Cost Markups Equipment insurance is a must in any equipment lease, and, generally, the lessee is required to provide the coverage through its insurance carrier. Although care must be taken by a lessor not to run afoul of any insurance regulations, providing the insurance itself, and passing the cost on to the lessee, with a markup, can create another lease profit opportunity. For example, a lessor might charge $14 a year for a $2,000 casualty insurance policy costing $8 a year, making a $6 profit On a $20,000,000 equipment portfolio, this means $60,000 annually. A lessor with insurance volume purchasing power can offer equipment lease insurance at a markup, while still providing rates equal to or lower than that available to most lessees. There is another added benefit to a lessor providing the insurance coverage; doing so eliminates the need to administratively track compliance with the insurance coverage requirement of a lessee. e. Upgrade Financing Equipment upgrades, when a lessee adds to or modifies existing leased equipment, can provide an opportunity for leasing profit. If the upgrade is not readily removable or has no stand-alone value, generally the existing lessor is the only one willing or able to finance it. In these situations, the lessee has two choices: To purchase upgrade with its own funds, or agree to whatever lease rate the lessor offers. If, as is the case in many situations, the upgrade is deemed, under the terms of the lease, to become the property of the lessor 5

6 because, for example, it becomes an integral part of the leased equipment and can't be removed without damage to the existing equipment, paying a higher financing cost may still be cheaper than purchasing an upgrade which automatically becomes the lessor's property. f. Documentation and Filing Fees Many lessees, particularly those leasing small ticket items of equipment, such as fax machines and small telephone systems, will pay, with little or no objection, transaction processing, documentation preparation, and security interest filing fees. Small lease transaction documentation fees generally run from $50 to $200 per transaction. Security interest filing fees, such as state Uniform Commercial Code filing fees, are generally nominal, ranging from $15 to $25. The more fees a lessee pays, the less a lessor's profit erosion. g. Equipment Maintenance and Repair Charges Requiring a lessee to pay for all normal equipment upkeep, such as maintenance and repairs charges, protects a lessor's investment by ensuring that the lessor's profit is not eroded by unexpected maintenance and repair costs. A lessor able to shift the full cost burden of equipment maintenance and repair to a lessee in effect creates profit by eliminating re-sale or re-lease rehabilitation expenses when the lease term ends. In a typical finance lease arrangement, the lessee assumes all equipment upkeep expense. In other types of equipment leases it is a matter of negotiation. Lessors willing, and able, to provide equipment maintenance and repair service, even in connection with a finance lease, can an opportunity for additional profit. Many computer vendors, for example, offer these types of services and have created substantial collateral lease revenues. Very strict equipment maintenance and return provisions are another way to help ensure the highest potential profits. Provisions that require the lessee to return equipment in good operating condition ensure that end-of-lease equipment sale or re-lease values are the highest possible. h. Excess Use Charges The better the condition leased equipment is in when returned, the greater the potential for the highest possible end-of-lease sale or re-lease profits. One way to ensure the best possible return condition is to put use restrictions on the equipment, which, if exceeded, call for penalty charges payable at the end of the lease. Automobile lessors typically have annual mileage limitations, which, if exceeded, require the lessee to pay additional rental charges to make up for potentially reduced end-of-lease sale or re-lease value. Leased aircraft are also often subject to use restrictions. Excess use charges can produce extraordinary profits. i. Equity Placement Fees A lessor able to sell a portion, or all, of its equity investment in a lease to another equity investor can earn a fees for providing the investment opportunity. 6

7 To ensure this option is available, a lease agreement must explicitly permit the sale of some or all of the lessor's interest in the equipment and the lease without consent by the lessee. j. Leveraging A Lease Investment With Third-Party Debt. At times, leasing companies borrow a portion of the funds necessary to purchase the equipment from a thirdparty lender in transactions referred to as leveraged leases. By properly leveraging a lease investment with thirdpart debt, a lessor can increase its economic return. The key to being able to do this is to ensure that the lease agreement explicitly permits the assignment of the lessor's interest in the equipment and the lease to a third-party lender without consent by the lessee. k. Commitment and Non-Utilization Fees Commitment and non-utilization fees are another area for leasing profits. Lessors frequently ask lessees to pay a commitment or non-utilization fee when equipment is to be delivered in the future. Commitment fees, non-refundable in nature, are designed to compensate a lessor for holding funds available. These fees help reduce the risk of lessor yield deterioration through adverse changes in its borrowing cost. Commitment fees are typically imposed when equipment deliveries are more than six months away, but many lessors ask for them when deliveries are not that far off. A fee of this nature must be paid up front and can range anywhere from 0.5% to 2% of equipment cost. Non-utilization fees are, in effect, a penalty for not using the lease funds that a lessor held available for future delivered equipment. This type of fee can be less onerous, because it is payable only if the equipment is not leased and because it is due when the commitment period is over. For example, a lessor may require that the lessee pay a fee equal to 2% of the available funds unused at the end of, say, five months. If all committed funds are used, the lessee owes nothing. l. Re-Marketing Fees Equipment re-marketing fees are a way for equipment lessors to increase lease profits. For example, a lease may require that a the lessee pay a predetermined fee to the lessor if the lessee elects to terminate a lease early, or at the end of the lease, in connection with the lessor's re-marketing (the sale or re-lease) of the equipment. These fees are in addition to any other charges which may be payable, such as termination penalties, or costs to repair equipment to the condition required under the lease agreement. m. Late Payment Charges Leases should always incorporate lessee late payment charges. If, for example, rent is not paid when due, there should be a penalty added to the late payment. Lessee often tolerate penalties in excess of the actual time value of money cost. In fact some late payment penalties as high as 5% to 10% of the rent charge. n. Collection Telephone Charges 7

8 Although not strictly a profit opportunity, requiring lessee to pay for any cost of ensuring timely lease payments, many lessors, particularly small ticket lessors, require lessees to pay telephone charges on collection calls. Anything that reduces overheard is indirectly a lessor profit item. First Lease Advisors, No reprint without permission. o. Deal Re-Writes A lessee requesting a change in the structure of a lease, referred to as a deal-re-write, may agree to pay a deal re-write fee for the privilege, for example, of having its lease extended. This can provide substantial profits, particularly in small lease transactions. p. Redelivery Charges Equipment re-delivery charges are another are of profit opportunity. It is not unusual for a lessee to agree to return the leased equipment at the end of the lease to a designated return point, free of charge to the lessor. And it is not unusual for a lessor selling or re-leasing the equipment to a third party to obtain a delivery fee from the third party from the lessee's location of use. Some lessors get lessees to agree to pay for all such shipment charges regardless of where in the world the equipment is designated to be shipped by the lessor, and then get the purchaser, or new lessee, to pay a delivery charge, as well. For more information on how to make money in equipment leasing, contact Richard Contino at (914) , or visit the web 8