Allan Levine, COO
In this article, we will theorize about depreciation and pricing. There will be no mention about maintenance or other variable costs.
The components of a lease finance structure are, in many ways, simple. In short, most companies (customers) have their favorite or preferred type of lease structure and the client and salesperson (s) work together on specific terms for the fleet. Depreciation, interest, and a service fee (profit) are the pricing components. Or, many leasing companies have a cost of funds and want a number of basis points over this cost. An example would be borrowing at 4% and charging the lessee 8%, thus making a 400 basis point gross profit monthly on the lease structure.
So, let’s look at a few examples of vehicle lease financing formats. The largest lease financing companies primarily offer open ended, finance lease, or TRAC type leases and work closely with their clients to determine a desired term. For example, depending on mileage, a fleet manager may want a 50-month structure. Therefore, the vehicle depreciates 2% per month. To the monthly depreciation is added an interest component, and then a service fee (profit), and we then have the monthly payment.
It looks like this:Vehicle cost: $20,000
Depreciation (2% per month): $400
Interest cost at 4% avg. per month: $34.92 (avg. over term-in arrears)
Service fee: $28 per month
Total payment, plus taxes, tag, etc: $462.92 total per month
If one has a large fleet, the manager and leasing company’s sales professional decide on one or more depreciation schedules (50, 40, 45 months, etc.) and the pricing is very straightforward. In this structure and if the unit is kept the full term of months, there will always be a gain on sale (works for many). Or, if terminated by a mileage limit (company vehicle policy), sales losses and gains can be controlled and fixed costs are predictable. That was a few sentences full. Also, many large lessors and their clients may do declining payments where after each 12 months, the payment reduces as interest costs are absorbed as incurred.
Ex: Year one with above pricing scenario: $487 for months 1-12 Year two with with above scenario:$471 for months 12-24 And so on for the third and months 37-50
In this scenario, an amortization schedule virtually mirrors income earned to the leasing company on a cash basis and at anytime the lessee knows the balance owed. Also, many leasing companies provide amortization schedules with each lease even in a fixed price open-ended lease type scenario.
No, I did not forget TRAC leases. In short, a terminal rental adjustment clause lease, if documented properly, is really an open-ended or finance lease type. At lease end, the client participates in the gain, if any, and makes up any loss from the sale of the unit in relation to the prestated contractual residual. In short, it has the same result as most finance leases. If certain TRAC terms and provisions are met, there are tax implications, not discussed in this article, that inure to both lessor and lessee.
Next , many smaller leasing companies use straight pricing for their finance- open-ended, or TRAC leases. The contract has a monthly price and a term. Normally, there is a termination provision with a formula in the event of early termination. For example, a lease will have:
A type-open ended or finance lease, etc. State a payment and term. A termination provision with a formula. A residual value. Plus all the legalese of any normal lease contract.
When a vehicle is sold in an early termination scenario, there will be a gain or loss. Without an amortization schedule for the lessee, there is more uncertainty for the lessee, there is more uncertainty for the lessee in the final accounting.
Smaller leasing companies tend not to use interest fluctuating leases or even service fee structured leases. There is normally a payment and a residual. Also, smaller companies can be a bit more hands on and work with their clients to do whatever is needed for maintaining a relationship. The fun begins with manufacturers’ leases that are virtually all closed end, or called a net lease or walk away lease. When the economy is booming, the manufacturers use high residuals to get lower payments and move units. It is a strategy that appears to be outside the profitability model (in many cases), but it does move units. Generally, manufacturer leases are for lower mileage drivers and are great deals for consumers wanting to lease a vehicle. With a 60 to 65% residual used to calculate depreciation for a three-year-old car, truck, or SUV (and that is based on list price, and not cost), payments become very appealing to the consumer who wants a high-end or lower priced vehicle. The lease provisions are based generally on mileage to 10k, 12k, or 15k, with options to buy excess mileage in advance or pay for overage in the end (that can get costly). For the individual needing a family car or biz car, there are usually some great choices out there. For a company needing numerous cars, this platform would not be smart (my opinion). Having 100 cars come back and having a manufacturer nickel and dime repairs for a closed end lease, for business units, could be sticky… and costly.Manufacturers move product through consumer leasing and wind up having fine used cars to sell at auction or to their dealer network. Manufacturers’ pricing can be erratic as inventories build or decline as sales are either up or down.On the commercial side, whether a large or small leasing company, one can structure all types of scenarios. There can be seasonal billings, declining payments, annual payments (have some of those), or any of the above mentioned structures and more.The mid-size and smaller leasing companies tend to write both open and closed type leases. For example, a company could have 15 salesmen’s cars and two closed end leases for the execs. Flexibility keeps the smaller and medium companies competitive. A few dollars per month per unit saving is less significant to a small company’s owner or CFO who may be handling the company’s fleet of less than 100 units.It is probably time to interject some thoughts on depreciation. After 39 years of tracking vehicle sales prices as a percent recouped on the purchase price (not on the list price), I have some thoughts.Below are guides that I use for tweaking closed and open end leases. It is just a guide and has to be adjusted for those and makes and models that have higher resale values. Also, there is an adjustment for the time of year, whether beginning of model year, holidays, and spring.
Residual values- American Autos
· Multiply vehicle costs times % · Use as a guide MPY is miles per year
Many smaller lessor companies work with their lessees and use logic based on historic resale values of specific units, mileage driven, used car environment (although can be fleeting), and the customer’s desired goals. To interject, I have had large clients who want me to push the residual envelope on lease end values. They operate under the drive now, pay later. And work off my money. Many customers love to get a check at lease end of their leases, and many like to get as close to even as possible. This is more in the medium to smaller lessor/lessee environment.
We are not in an easy business. Whether picking monthly depreciation percents for full payout leases, making customers happy with open-end future resale values, or calculating closed end values for units four years down the road, we need a crystal ball. Well, since we do not have that, we have to rely on experience, industry tools, and a wealth of information to make us doctors of used cars. And, we need to be economists as well and predict what vehicles will be hot in three, four or five years.
Many have said goodbye to the industry, as their residual choices were wrong. I have seen 5,000 SUV’s come back in a high-priced gas environment and the manufacturer lost $20,000,000. In the old days, that was OK, but not now. And, until a customer pays you from an open-ended lease loss, it is just a receivable. Coming to get the money is harder than giving money back. Plan wisely.