by Brian Bjella on Tuesday, July 09, 2013
This article first appeared in the June 2013 issue of Construction Business Owner magazine.
A common trait of successful construction companies is the ability to manage risk and minimize the effects of uncontrollable conditions. However, not all adverse jobsite conditions can be mitigated. So, many businesses, construction and otherwise, develop financing relationships beyond banks to add stability to their operations.
Following the recession, there is pent-up demand for equipment replacement, and leasing has replaced cash and loans as the most frequently used method of acquisition. As noted in the Equipment Leasing and Finance Foundation’s “U.S. Equipment Market Study 2012-2013,” construction equipment leasing increased from 8 percent to 31 percent between 2006 and 2011 while loan financing shrank from 40 percent to 17 percent.
For many, leasing can seem like a confusing landscape of options. There are two reasons that leasing may seem complicated. First, the financing industry has thrown too many lease types at customers. Second, many business owners have had bad experiences with less-than-reputable leasing companies.
In its simplest terms, a lease is an agreement for someone to use something that someone else owns. The lessee pays the leasing company periodically for the use of a manufacturer’s equipment, and the leasing company pays the manufacturer a lump sum. Leasing companies make money on the payment stream, and lessees make money on the products and services they are able to sell based on the use of the leased equipment. The idea is that the monthly payment is a fraction of the monthly revenue the equipment creates.
Choosing One of Many
If you research “lease types,” you will find websites that list 15 to 20 types of leases, some using different names for the same lease function. It is nice to have options, but options in such convoluted abundance make it harder for potential lessees to make decisions. This is how the leasing industry has failed the customer.
Most businesses are familiar with the $1 buyout lease. In construction, the $1 buyout lease is used for most of the leased equipment that falls in the $3,000 to $200,000 range. This is the go-to lease for this equipment because the payment terms are straightforward and there is no ambiguity about who owns what at the end of the term. The $1 buyout lease is also eligible for favorable tax treatment under the Section 179 tax benefit.
A fair market value (FMV) lease has lower monthly payments than the $1 buyout option, but the leasing company makes up for these lower payments by maintaining ownership of the equipment at the end of the term and negotiating the potential buyout. At the end of the leasing term, the buyer can either walk away from the equipment or purchase it at fair market value. Also known as residual value, this fair market value is the remaining value of the machine at the end of the lease period, based on its remaining lifespan. Some leasing companies, however, will inflate the residual value to make greater profits. Contractors going the “FMV route” should ask leasing companies to establish the residual value in writing before signing the lease agreement.
The Hot Stove Effect
Leasing is a fairly unregulated industry, and some businesses have been taken advantage of by leasing companies. It is important to know what kind of lease you’re being offered. Rates that seem too low might be FMV leases, require an end-of-lease payment or contain other terms that lead to the “hot stove” effect. Mark Twain said that if a cat sits on a hot stove, it probably will never sit on a stove again. That’s smart, but the cat will also refuse to sit on a cold stove, even when doing so may be beneficial. Business owners who have had bad leasing experiences should understand that not all leasing companies are the same.
To protect yourself, make sure you are working with a financing company with good references and experience in your industry. Avoid leasing companies that charge a low price but lack reputation. These companies often provide poor service and have questionable business practices. The inability to get through red tape and voicemail will leave you frustrated. Your three- to five-year agreement with a leasing company should be a partnership that helps you with current and future purchases. There’s also potential that an otherwise low price is being recouped with hidden charges or high end-of-lease purchase rates.
It is important to look for hidden charges. If the representative selling you the equipment isn’t sure whether there are charges of which you may be unaware, ask the leasing company what to expect at the beginning and end of the lease, and get their answers in writing. Always make sure you know how much the “documentation fee” is before you sign the agreement. This fee can vary widely from one company to the next.
Also, check to see if you will be charged “interim rent” according to the terms of the agreement. When interim rent is in place, the leasing company starts the billing cycle on the date you sign the financing agreement, before your equipment is in place. With interim rent, you will probably pay more than the term on the lease. Insist on a leasing company that waits until the equipment is installed and calls you to set the first billing date. This is favorable for the lessee, and it demonstrates that the leasing company understands how your business works.
Finally, remember that the finance company’s willingness to put its promises in writing is indicative of its general business practices. Finding a company that will commit to its claims in writing will go a long way toward establishing a beneficial relationship.
- See original article here on the Construction Business Owner website.