Understanding lease alternatives to manage scarce resources
Recognizing that cash-based capital purchases may not be necessary or the best option to acquire capitalized goods and services can help agencies maximize the value of each available tax dollar while meeting the long-term needs of the community — even in lean times. Few parts of the economy have been harder hit by the recent recession and corresponding drop in revenues than the public sector, especially municipalities. For procurement professionals whose agencies face a reduced tax base, identifying the best-value solution — or even the solution with the lowest upfront cost — is an important first step. Effective leasing practices can help every agency better manage its resources when budgets are tight (and even when they’re not).
Leasing is not a new concept, but few non-experts know that there are multiple types of leases to help stretch dollars. To provide a broader understanding of how to extend the value of expense dollars, this article will focus on two alternatives to outright capital purchases.
Operating versus capital leases
For accounting purposes, leases fall into one of two classifications, operating, also referred to as fair market value (FMV), or capital.
Operating leases tend to be shorter in length — 24, 36, or 48 months — and ownership of the asset remains with the lessor. A vital aspect of this lease is that the lessor takes a risk position on what the asset’s value will be at lease end, i.e. the residual value.
Capital leases are normally of longer duration — 60 to 72 months — and are full payout leases. The lessor does not take a residual position, and by the end of the lease the user ends up owning the asset. The user depreciates the asset over its expected useful life and is entitled to the asset’s value when sold or traded-in after the lease expires.
The tables below summarize the advantages and disadvantages associated with each form of leasing.
One advantage of operating leases is their relatively low monthly payment. As the agency is effectively paying only for the use of the equipment for the fixed lease period, its monthly payments compensate the lessor for the value of the equipment distributed over the life of the lease, the financial cost to the lessor of leasing the equipment, overhead expenses and margin. A variable unknown to the lessor — and, therefore, where their primary risk lies — is the expected fair market value of the asset at the end of the lease period. The higher the anticipated fair market value, the greater risk position a lessor can take, which, in turn, lowers the monthly payments. Therefore, when leasing high-value/long-lifespan equipment over a relatively short term, monthly payments are relatively low when compared to the cost of financing the total value of the equipment during that same period.
In addition, an operating lease makes it easy for the user to contract for a shorter period without further obligation. This goes back to paying only for use, not for ownership. At the end of the lease, the agency may return the equipment to the lessor, renew the lease at current market or purchase the equipment at the current fair market value.
Of course there are potential disadvantages to this lease model. Not all municipalities embrace operating leases, so it’s important to confirm that the jurisdiction allows for their use. And although monthly lease payments may be lower than compared to outright financing for purchase, the interest rates associated with shorter leases may be higher. However, it may be possible to offset the impact of higher interest rates if a jurisdiction provides a personal property tax exemption to the lessor who would pass that savings back to the agency.
Unlike operating leases that offer the user the opportunity to return the equipment, the lessee owns the equipment at the completion of a capital lease period. As the lessor may be able to claim tax exemption of the interest earned throughout the lease period, this savings can be passed back to the agency in the form of lower monthly payments (lower than if the equipment were financed outright using commercial rates). Further, as the financial transaction is directly with the equipment lessor, the agency may be able to quickly execute the transaction without additional bonds or referendums.
Keep in mind that capital leases are “full payout leases.” This means that the user pays the full purchase price of the asset over the term of the lease. This feature makes it financially difficult to use for shorter time periods, as a shorter term would increase the user’s monthly payment. Plus, consider how the equipment is to be used and in what environment. Understanding acceptable capitalization periods, product life expectancy and end-of-term value for a given asset are important to calculating the overall cost versus benefit over time.
A mix of alternatives
This year, tight budgets and limited capital dollars are the order of the day. Calculating the capital and the total cost of ownership is critical. The “cost of the dollar” may become a major point of negotiation and decision-making as you evaluate the solutions available to your agency. Procurement departments and the municipalities they support can help themselves by adopting a business formula that includes a mix of leasing alternatives.
About the author
Jack Asinger, Computer Acquisition Strategies (C.A.S), has been president of his own financial consulting business since 1989. Prior to that, he enjoyed a successful career in financial services and marketing with the IBM Corp. He has been consulting with The Toro Company since 2002.
Comparing operating versus capital leases
|Lower monthly payment for like term||Higher interest rate versus tax exempt rates|
|Shorter contract periods||May not be approved for use in the jurisdiction|
|Multiple lease-end options||Lessor will build in property tax costs if not granted exemption|
|Agency owns equipment at end of lease||Higher monthly payment for like term|
|Lessor often tax-exempt on interest earned resulting in lower monthly pass-through amount|
|Generally hassle-free; no bond referendums, etc.|