Leasing as a Source of Capital
Leasing or renting an asset is an effective source of debt-based capital. The most common example is leasing office space. Instead of tying up cash in purchasing a building or investing in leasehold improvements, most companies simply execute a lease with a landlord.
For example, an e-commerce retail company was growing rapidly and needed additional warehouse and distribution space for the company’s products. Adjacent space was available but needed a number of improvements to be workable.
Instead of making the improvements itself, the retail company negotiated with the landlord to make the improvements and then simply increased the rent proportionately to cover the additional costs. This arrangement allowed the retail company to utilize cash internally and finance the building improvements over the life of the lease (which was at a very reasonable rate).
Leases are most commonly structured with assets that have an extended life, such as buildings and capital equipment (manufacturing equipment, furniture, computers, autos, and so on). Structuring leases for capital equipment are also used extensively in the business community and provided by numerous financing or leasing companies.
Before diving headfirst into leasing, brush up on the following key concepts and risks:
Risk of ownership: Most equipment leases are structured to transfer the risk of ownership to the lessee, so insurance, property taxes, maintenance, and so on all fall on the shoulders of the party leasing the equipment. But the leasing company has a secured interest in the asset being leased (to protect their interests).
In other words, in most cases, the leasing company retains legal title to the assets being leased. If the business (lessee) defaults on terms of the lease, the owner (the lessor) can repossess the asset.
Real financing cost: Understanding the true cost of a lease in terms of the implied interest rate being charged is important.
Leasing companies use all types of tricks and tactics to improve their returns, including requiring payments to be made in advance (for example, on the first day of the month rather than the last), having the first and last months’ lease payments made in advance, structuring fair-market value buyout options, and so on.
Used versus new equipment: Leasing is best utilized when the equipment is new rather than used, because the interest rate charged and the amount of lease financing provided will be most favorable to the lessee. That’s because the value of used equipment doesn’t provide the lessor as much collateral as new equipment. Attempting to secure lease financing on used equipment is difficult and expensive.
The bottom line in equipment leasing is similar to traditional borrowing. The leasing companies generally take on higher levels of risk than a bank and, as such, demand higher returns (so leasing tends to be more expensive than other forms of debt).
But leasing companies often extend leases based on 90 to 100 percent of the equipment’s new value, so instead of having to place 20 percent down on the asset (with a traditional bank loan), more cash can be conserved inside the business when using leases.
Making a decision about leasing
In every debt-based financing decision, the borrower needs to make a critical decision based on the trade-off between higher financing costs and access to additional capital or cash. In other words, if the excess cash can be invested or used in the business to generate returns greater than the costs of the financing, then using more-expensive and flexible financing programs is appropriate.
One mistake commonly made by businesses is that they’re so consumed with making sure they get the lowest interest rate available that they don’t consider the impact the loan agreement may have on restricting available borrowing levels and access to cash. In a number of cases, paying a little extra for higher loan balances and/or access to cash is well worth the added expense.