Vehicle leasing offers several benefits to fleets, but it’s not a one-size-fits-all financing product. There are myriad options to choose from when structuring a commercial truck lease that directly impacts cash flow, taxes, and vehicle replacement cycles, which can make the lease evaluation process daunting for even seasoned fleet managers.
Fleets can preserve cash to reinvest in the business, enhance debt-to-equity ratios with “off-balance sheet” financing, or structure payments and terms to fit cash flow and tax objectives.
The key to making sense of vehicle leasing is to understand the basics: What is leasing? How does it work? What should fleet managers consider before signing a lease agreement?
Lease vs. Loan
One way to understand “leasing” is to compare it with a conventional bank loan. For example, take a vehicle with a purchase price of $30,000. Here’s what the numbers could look like for a loan.
- Total truck price, including any dealer and miscellaneous fees: $30,000.
- Sales tax at 6% (or local sales tax rate, if differs): $1,800.
- Assume $0 down payment. (In many cases, bank loans will require minimum 10-percent cash up front.)
- Loan balance (plus tag and title fees): $31,800.
This $31,800 balance would then be divided into monthly payments over a term of three to six years, with interest charges applied to each payment.
How does leasing differ? Both bank loans and leases are forms of financing, but the difference lies in what they finance. Whereas a bank loan finances the purchase of the vehicle, a lease finances the use (or depreciation) of the vehicle, defined by the spread between the purchase price (capitalized cost), without sales tax included, and the residual (projected vehicle disposal) value at lease end.
So, here’s what the numbers could look like when leasing the same truck at the same price:
- Total truck price, including any dealer and miscellaneous fees: $30,000. (With leases, this is called the capitalized or cap cost.)
- Depending on state laws, the sales tax on leases is added to the monthly payment, not the total capitalized cost.
- Assume $0 cash out of pocket (or cap cost reduction).
- Adjusted cap cost: $30,000 (Since there is no cap cost reduction in this example.)
- Assume the residual (projected vehicle disposal) value at lease end is $12,000.
- Subtract the residual from the adjusted cap cost, and the total lease balance is $18,000.
(Note: A lease may also include a refundable security deposit, a non-refundable acquisition fee [see sidebar for definition] and other miscellaneous fees, which are not reflected in the example above.)
The bank loan balance is $31,800 to purchase the vehicle, while the lease balance is $18,000 to use the vehicle. That difference of $13,800 has a substantial impact on monthly payments — and thus, cash flow. Depending on the length of the term and interest rates, the monthly lease payment for the above example can be $200-$300 less than a comparable term loan.
Another difference is what happens at the end of the term. When you make the last loan payment, you own the vehicle outright. With leasing, however, you have a number of scenarios to consider at end of term, based on the type of lease and how it’s structured.
Closed-End vs. Open-End Leases
Here’s a breakdown of the types of leases typically used in the commercial truck market and what options are available at end of term.
Closed-end leases are also known as walk-away leases because they’re structured to allow you to “walk away” from the vehicle at the end of the lease. There are usually (but not always) mileage restrictions with closed-end leases, ranging from 12,000 to 15,000 miles per year, although you can build more miles into the lease up-front for a higher monthly payment.
A charge of 15-25 cents or more per mile over the limit will be incurred if the vehicle is turned in at lease-end with higher-than-agreed-upon miles. The residual value for closed-end leases is determined by the leasing company (lessor), which takes on the risk of what the actual value the vehicle might be at end of lease term.
These are the options at the conclusion of a closed-end lease:
- Turn in and “walk-away.” Pay any excessive miles and/or wear-and-tear, if applicable. Otherwise, there is no other obligation the fleet has in regards to the vehicle.
- Trade in toward acquisition of another vehicle. In some cases (not often), the trade-in value vs. residual value may make it advantageous to trade in the vehicle toward the acquisition of a new one.
- Purchase the vehicle. The “lease buy-out” price is determined upfront in the lease contract.
“The typical selling point on a closed-end lease is predictability, level lease payments, and no surprises at the end,” said Steve Jastrow, strategic consulting manager, GE Capital Fleet Services, an Eden Prairie, Minn.-headquartered fleet management firm with more than 1.4 million total vehicles under lease and service management worldwide. “The drawback is that it will likely cost more. When the lessor takes the residual risk, it will price it into the cost of the lease. Many times there are penalties (mileage, wear-and-tear, etc.) at the end of a closed-end lease, which are generally not discussed at the lease inception.”
Whereas, with closed-end leases the lessor sets the residual value, with open-end leases, the lessee (fleet) gains flexibility to determine the residual value at lease-end. But, this also means the lessee takes on the risk if the actual market value at lease-end differs from the residual set in the contract.
Here’s what this would look like: Using the $30,000 truck example, suppose that instead of a $12,000 residual, $16,000 would work better for monthly cash flow because it would lower the lease balance from $18,000 to $14,000, which will then reduce the monthly payment.
So, what happens to the vehicle at the conclusion of the open-end lease, if the residual is set at $16,000?
Typically, the fleet will turn in the vehicle to the leasing company, which sells the vehicle. If the proceeds of the sale exceed the residual ($16,000), the fleet receives a check for the difference. If the vehicle sells for less than the residual amount, the fleet will be billed for the difference.
As with the closed-end lease, the fleet also has the option to purchase the vehicle at the agreed-upon residual or trade it in for another vehicle.
An example of an open-end lease for commercial trucks is a Terminal Rental Adjustment Clause (TRAC) lease.
“[When structured properly], an open-end lease is the least expensive option because you pay only for the amount of the truck you use,” Jastrow said. “You don’t have to worry about penalties at the end, and it provides a great deal of flexibility in terms of turning the vehicle in, allowing you to sell off non-earning assets in downtimes or allows you to cycle and take advantage of a robust resale market. The open-end lease can also provide level lease payments during the lease.”
Some leasing companies offer additional fleet management and maintenance services that can be rolled into the lease payments. This is called a full-service or maintenance lease. The important point here is knowing exactly what’s included in the lease.
“A number of items (brakes, tires, glass, etc.) may not be included or be limited to, say, one set,” Jastrow said. “The items that are either excluded or limited [in the lease] are typically the more costly items a vehicle may incur over its life. A full-service lease will typically only cover a period of time (75,000 miles) at which point it expires. Similar to the closed-end lease, the lessor will price the risk factor, which makes this more expensive to the lessee. The benefit, however, is peace of mind to know what your [maintenance] expenses will be.”
In general, another benefit that leasing provides is the flexibility for fleets to structure leases to allow for either “off-book” or “on-book” accounting treatment, depending on what best fits the company’s objectives.
In contrast, a loan is treated strictly as “on-book,” with the vehicle value in the “asset” column of the balance sheet, and the loan in the “liability” column.
Why is this relevant? It impacts a company’s debt-to-equity ratios when applying for business loans and other forms of financing. The “off-book” treatment for certain types of leases does not show as a liability on the balance sheet, which enhances the debt-to-equity ratio.
(Consult with your accounting advisors to determine what lease structure works best for the fleet.)
Despite the advantages, leasing isn’t for every company. “It’s difficult to say what may or may not be best for an organization,” said Keith Trumbull, VP of Financial Services at PHH Arval, a global fleet leasing and management company headquartered in Sparks, Md. “A lease structured to fit one customer’s needs may not be good for another. It’s simply critical for companies to determine their risk appetite, financial goals, and other needs so that they can balance their options.”
Jastrow of GE Capital Fleet Services agreed. He offered these five scenarios when leasing may not be a good fit for a company:
- Low-mileage vehicles. “A short-term rental may be a better option if dealing with low mileage and/or low utilization assets,” Jastrow said. “This can become a bit more challenging if the need is specialized and no rentals exist, leaving fleet managers faced with a lease-versus-buy situation.”
- High-risk vehicles. “Depending on your application, leasing may not be the best fit for the lessor [the leasing company]. Situations where hazmat is a concern may limit the appetite of a lease from the lessor,” Jastrow said.
- Regulatory requirements. “There may also be regulatory requirements where the company needs to be the title holder of the vehicle to qualify for funding or tax incentives,” Jastrow said. “In those situations, you would want to own the vehicle.”
- Tax Considerations. “Companies with an excessive cash position and that have tax capacity for the depreciation benefits may have a desire to own,” Jastrow noted.
- Operating Conditions. “Operating conditions that are predominantly off-highway may deter a company from leasing,” Jastrow said. “Also, cross-border operations may cause a prospective lessor to hesitate adding the vehicle to its portfolio.”
Before signing a lease agreement, Trumbull recommends fleet managers ask such questions as:
- What are the limitations, if any, on vehicle usage?
- What are the turn-in conditions (if closed-end lease)?
- What exactly does “normal wear-and-tear” mean for this vehicle?
- What are the terms and what happens if the lessee cannot meet those terms?
- What is the full pricing of the vehicle and any ancillary services associated with the lease?
- Are there hidden or undisclosed fees involved? What exactly do those fees cover?
Companies should ensure that expectations match what’s actually written in the lease, especially with full-service leases.
“Repair costs may or may not be included as contracted maintenance,” Jastrow said. “For example, a road-hazard damaged tire may not be considered part of the maintenance cost. If it’s billed back to the customer, what input, if any, will the customer have on the repair decision? This can translate into unpredictable additional expenses.”
The Bottom Line
The most compelling advantage to leasing — its flexibility — can also present its greatest challenge.
How does a fleet manager make sense of all the available options to properly structure a lease? Work closely with your leasing company, with input from your accounting department, to tailor a lease that best supports your company’s financial objectives.
Is Leasing a Good Fit?
Leasing makes financial sense for companies that:
- Want flexible terms. Leasing offers flexibility with length of term and payment options (monthly in advance, quarterly in advance, monthly in arrears, quarterly in arrears, and even skip payments for someone in a seasonal business). Leasing also allows you to match cash flow to your lease payment.
- Have relatively short vehicle replacement cycles. If it’s a high-visibility type of vehicle (used as a marketing tool) with high customer recognition, companies can use trucks as rolling billboards. These companies are more apt to replace their vehicles more often to keep them looking good, which makes it more conducive to leasing.
- Would benefit from leasing company value-added services. These include vehicle acquisition, vehicle specification, tag and titling, remarketing, and relocation (the flexibility to transfer the unit from one state to the other).
Key Leasing Terms to Know
Several leasing terms are key to a fleet managers vocabulary, including:
- Acquisition fee: A charge included in most lease transactions that either is paid up front or included in the gross capitalized cost. This fee usually covers a variety of administrative costs, including those associated with obtaining a credit report, verifying insurance coverage, checking accuracy and completeness of lease documentation. It may also be referred to as a bank fee, administrative fee, or an assignment fee.
- Gross capitalized cost: The agreed-upon value of the vehicle at the time you lease it, which generally may be negotiated, plus any items you agree to pay for over the lease term, such as taxes, fees, service contracts, insurance, and any prior loan or lease balance.
- Capitalized cost reduction: The sum of any down payment, net trade-in allowance, and rebate used to reduce the gross capitalized cost. The cap cost reduction is subtracted from the gross cap cost to get adjusted cap cost.
- Net cap cost or adjusted cap cost: The amount capitalized at the beginning of the lease, equal to the gross capitalized cost minus the capitalized cost reduction.
- Residual value: The end-of-term value of the vehicle established at the beginning of the lease and used in calculating your base monthly payment. The residual value is deducted from the adjusted capitalized cost to determine the depreciation and any amortized amounts.
- Depreciation (and any amortized amounts): This refers to the total of (1) amount charged to cover the vehicle’s projected decline in value through normal use during the lease term and (2) other items paid for over the lease term. This amount is a major part of the base monthly payment.
- Money factor (or lease factor): A number, often given as a decimal, used by some lessors to determine the rent charge portion of the monthly payment.
- Disposition fee (or disposal fee): A fee often charged by a lessor to defray the cost of preparing and selling the vehicle at the end of the lease if you do not purchase the vehicle, but, instead return it to the lessor or assignee.
- Security deposit: An amount you may be required to pay, usually at the beginning of the lease, that may be used by the lessor in the event of default or at the end of the lease to offset any amounts you owe under the lease agreement. Any remaining amount may be refunded.