# Types of Leases - Financial Management

Leases are classified in a number of ways. “True leases,” which are the primary focus of this chapter, are traditional leases in which the lessor is considered to hold the legal title to the leased asset. The asset user, the lessee, has no ownership interest in the asset. Operating leases and various types of financial, or capital, leases are subcategories of true leases.

Operating Leases

An operating lease, sometimes called a service or maintenance lease, is an agreement that provides the lessee with use of an asset on a period -by -period basis. Normally, the payments under an operating lease contract are insufficient to recover the full cost of the asse for the lessor. As a result, the contract period in an operating lease tends to be somewhat less than the usable economic life of the asset, and the lessor expects to recover the costs (plus a return) from renewal rental payments, the sale of the asset at the end of the lease period, or both.

The most important characteristic of an operating lease is that it may be canceled at the option of the lessee as long as the lessor is given sufficient notice. Even though the lessee may be required to pay a penalty to the lessor upon cancellation, this is preferable to being compelled to keep an asset that is expected to become obsolete in the near future. For example, many firms lease their computers under an operating lease arrangement. (Of course, the lessor charges a rental fee that is consistent with expectations of the asset’s economic life.) Most operating leases require the lessor to maintain the leased asset. In addition, the lessor is normally responsible for any property taxes owed on the asset and for providing appropriate insurance coverage. The costs of these services are built into the lease rate.

Financial or Capital Leases

A financial lease, also termed a capital lease, is a noncancelable agreement. The lessee is required to make payments throughout the lease period, whether or not the asset continues to generate economic benefits. Failure to make payments has serious financial consequences and could eventually force the lessee into bankruptcy.

With financial leases, the lessee is generally responsible for maintenance of the asset. The lessee may also have to pay insurance and property taxes. The total payments over the lease period are sufficient to amortize the original cost of the asset and provide a return to the lessor. Some financial leases provide for a renewal or repurchase option at the end of the lease; these renewal and repurchase options are subject to IRS regulations. A financial lease may originate either as a sale and leaseback or as a direct lease.

Sale and Leaseback

A sale and leaseback occurs when a company sells an asset to another firm and immediately leases it back for its own use. In this transaction, the lessor normally pays a price close to the asset’s fair market value. The lease payments are set at a level that will return the full purchase price of the asset to the lessor, plus provide a reasonable rate of return. The sale and leaseback is advantageous to the lessee for the following reasons:

• The lessee receives cash from the sale of the asset, which may be reinvested elsewhere in the firm or used to increase the firm’s liquidity.
• The lessee can continue using the asset, even though it is owned by someone else.

A good illustration of a sale and leaseback transaction was Public Service of New Mexico’s decision to sell and lease back its partial interest in Palo Verde Nuclear Plant Unit 1 for $325 million. This transaction reduced its annual mortgage payments by one-half, to$40 million per year for the next 15 years, and its total cost by $375 million. Sale and leaseback financing has been popular among financial institutions (e.g., banks and insurance companies). The institutions are subject to regulation concerning their financial condition (capital position and asset quality). Financial institutions with weak capital positions have sold headquarters buildings for a price greater than their book value, recorded a gain on the sale, thereby bolstering the capital account, and leased back the building under a long -term, generally noncancelable lease. The resulting increase in the institution’s capital accounts reduces regulatory pressure to increase capital via the sale of new equity (common stock). First Republic Corporation, a Dallas -based bank holding company, engaged in this type of transaction before it failed and was taken over by BankAmerica. These types of transactions are poorly motivated and do not change the fundamental value or risk of the firm. They are primarily accounting manipulations. To be sure, many of the banks that have engaged in these transactions have subsequently failed or been forced to merge with financially stronger firms. Direct Lease A direct lease is initiated when a firm acquires the use of an asset that it previously did not own. The lessor may be the manufacturer of the asset or a financial institution. In the latter instance, the user –lessee first determines the following: • What equipment will be leased • Which manufacturer will supply the equipment • What options, warranties, terms of delivery, installment agreements, and service agreements will have to be made • What price will be paid for the asset The lessee then contacts a financial institution and works out the terms of the lease, after which the institution (which then becomes the lessor) acquires the asset for the lessee and the lessee starts making the lease payments. Under this arrangement, the lessee is usually responsible for taxes, insurance, and maintenance. Leveraged Leases A large proportion of all financial leases currently written in the United States are leveraged leases. Also known as third -party equity leases and tax leases, leveraged leases are designed to provide financing for assets that require large capital outlays (generally greater than$300,000) and have economic lives of five years or more. Leveraged leases are usually tax motivated because the asset user (lessee) is not in a tax position where it can make use of the accelerated depreciation tax shields if the asset is owned instead of leased.

A leveraged lease is a three-sided agreement among the lessee, the lessor, and the lenders. The lessee selects the leased asset, receives all the income generated from its use, and makes the periodic lease payments. The lessor (normally a financial institution, such as a leasing company or a commercial bank) acts either for itself or as a trustee for an individual or a group of individuals to provide the equity funds needed to purchase the asset. The lenders (usually banks, insurance companies, trusts, pension funds, or foundations) lend the funds needed to make up the asset’s full purchase price.

Specifically, the lessor normally supplies 20 to 40 percent of the purchase price, and the lenders provide the remaining 60 to 80 percent. For example, in the Public Service Company of New Mexico sale and leaseback of the Palo Verde Nuclear Plant discussed earlier, the lessors (Chrysler Capital, Drexel Burnham Leasing, and Mellon Financial Services) borrowed approximately 80 percent of the purchase price of the facilities.

Figure is an announcement of a leveraged lease that was arranged by Salomon Brothers for Kansas City Southern Lines. In this case, the Ford Motor Credit Company acted as the lessor and provided equity funds of $4,728,974 to acquire 450 boxcars, which were leased to Kansas City Southern Lines. Debt funds of$10,072,198 were provided by a number of institutional lenders.

In a leveraged lease, the long-term money is supplied to the lessor by the lenders on a nonrecourse basis; that is, the lenders cannot turn to the lessor for repayment of the debt in the event of default.Normally, the lender receives mortgage bonds secured by the following:

• A first lien on the asset
• An assignment of the lease
• An assignment of the lease rental payments
• Occasionally, a direct guarantee from the lessee or a third party (such as the government, in the case of merchant vessel financing)

Referring again to the Public Service Company of New Mexico nuclear plant sale and leaseback example, the public debt used to finance the transaction was indirectly secured by the facilities and was payable from rental payments due by the utility under the leases. The debt was structured to have principal and interest payments that correspond to the receipt of rental payments. Because the lenders do not have recourse to the lessor in the event of default, the lessor’s risk is limited to the 20 to 40 percent equity contribution. As the owner of the asset, the lessor reports the lease payments as gross income. The lessor receives benefits from the tax -deductible interest and accelerated depreciation. As a result, the lessor incurs large tax losses and receives large cash inflows during the early years of the lease.

Because the lessor receives the entire accelerated depreciation tax shield although making a relatively small equity investment, the lessor can provide an attractive lease rate to the lessee. Lease rates of 4 to 6 percent are not uncommon when AAA-rated bonds are yielding from 9 to 10 percent. Figure is a diagram of a typical leveraged lease arrangement. Lessees who anticipate that their taxable income will not be sufficient to allow them to take advantage of the tax benefits of ownership are most likely to use leveraged leases for large transactions. These include firms with low profit levels, large tax-loss carryforwards, or large amounts of tax-exempt income. The lessee effectively gives up the tax benefits of ownership in exchange for more favorable lease rates.