Serves the Commercial Small Fleet Market of 10 – 50 Vehicles

Open-End Versus Closed-End Leasing

March 2016, by Paul Clinton - Also by this author

Photo via iStockPhoto.com/Abscent84
Photo via iStockPhoto.com/Abscent84

For larger commercial fleets, leasing is the dominant acquisition method. On the other hand, small commercial fleets still have a tendency to buy, though many realize the benefits of leasing.

Large fleet or small, companies choose to lease their vehicles as a way to reduce the amount of capital tied up in non-core assets, as well as reduce sales tax by paying tax on the lease payments instead of paying tax on the vehicle purchase amount.

Larger fleets that opt for leasing — over financing or outright cash purchases — still mostly prefer an open-ended TRAC lease, also known as an operating lease. TRAC, which stands for Terminal Rental Adjustment Clause, is a certification that tells the Internal Revenue Service that the lease conforms to its tax codes and is a true lease. Open-ended leases typically offer a fleet manager more flexibility in dealing with variable mileage and greater input into remarketing decisions.

“We have found that the TRAC lease meets the objectives of the widest audience,” says Bruce Wright, strategic consulting manager with Element Fleet Management. “The TRAC lease traditionally offers the lowest total cost of ownership over the long run of the portfolio due to the customer experiencing the actual depreciation based on their asset utilization patterns.”

Other fleets — often smaller fleets or executive fleets that tie vehicles to compensation — prefer closed-end operating leases. They tend to provide a fixed level of service and attention that result in greater cost certainty when budget adherence is a higher priority than seeking the inherent uncertainties associated with obtaining the lowest cost.

“Companies turn to closed-end leases when they’re looking to get a fixed-cost solution for the provision of vehicles rather than taking the risk themselves and waiting until the vehicle is disposed to know what their ultimate cost was,” says Joe Pelehach, vice president of Motorlease Corp.

Choosing a lease should always be undertaken with a clear idea of how the vehicle will be used in the field. Other factors that must be considered include the company’s financial needs, operational requirements, asset type, and utilization. Executives with fleet management companies suggest that fleet managers should calculate the total cost of ownership (TCO) of a vehicle before choosing a leasing instrument.

Let’s take a closer look at the two most common options available to commercial fleets: open- and closed-end leases.

Open-Ended Leasing: Flexibility and Control

Open-end leases are pervasive in fleet leasing because they offer fleet managers greater control of asset utilization and disposal. In an open-end lease, the lessee agrees to a minimum term that’s usually at least 12 months and can terminate the agreement at any point after the end of the term. The lessor then sells the vehicle.

If the proceeds of the sale are greater than what was calculated in the agreement, the lessee receives a reimbursement. If the vehicle is sold for less, the lessee must reimburse the lessor for the difference.

Open-end leases carry no mileage restrictions and as a result appeal to companies with unpredictable mileage.

However, high-mileage vehicles will depreciate faster, which will force the open-end lessee to bear the brunt of higher use in the used-vehicle market. The lessee also assumes responsibility for remarketing decisions, including the risk or reward involving resale value.

Open-end leases also appeal to fleet managers with remarketing expertise who monitor the used-vehicle market and can sell vehicles during peaks in the value cycle.

“In North America, most fleets exist to serve as work and business tools and are not provided in lieu of compensation,” says Norman Din, vice president of strategic sales with Wheels Inc. “Because they are work tools, mileage is typically both high and varied.”

Fleet management companies usually offer different kinds of open-end leases depending on the accounting guidance from the corporation’s finance department. A lease would be considered a capital lease versus an operating lease if one of four factors is met, says Bryan Wilson, ARI’s controller.

“The difference between a capital and operating lease comes down to the accounting guidance that governs leases,” Wilson says. “If at least one of the four criteria is true then the lease would be classified as a capital lease on the lessee’s account books.”

A lease would be considered a capital lease if the ownership of the asset is shifted to the lessee, the lessee purchases the asset at below market price by exercising a “bargain purchase option,” the lease term encompasses at least 75% of the useful life of the asset, or the present value of the minimum lease payments — plus any lessee guarantee — is at least 90% of the fair value of the asset at lease inception.

In the present leasing environment, a capital lease would be added to a company’s balance sheet while an operating lease could be kept off the balance sheet, a situation that will likely change under the new accounting standards (see sidebar).

Fleet management companies specializing in open-end leases include ARI, Donlen, Element, EMKAY, LeasePlan, and Wheels Inc.

Photo via iStockPhoto.com/Norlito
Photo via iStockPhoto.com/Norlito

Closed-Ended Leasing: Predictable Outcomes

Closed-end leases appeal to fleets seeking a fixed monthly payment. “Companies often view commercial closed-end leases with the same broad brush as they do retail (dealer) leases,” says Pelehach. “However, fleet management companies (FMCs) specializing in closed-end leases typically have more flexible offerings.”

With a closed-end lease, the term is typically set, and monthly payments are based on the estimated residual value of the vehicle at the end of the term. The leasing company estimates this value and sets expectations on mileage and wear. The lessee can walk away from the deal at the end of the term with no additional costs if the vehicle didn’t exceed the maximum mileage or wear-and-tear parameters. The lessor sells the vehicle and assumes responsibility for any profits or losses caused by fluctuations in market value.

“Closed-end leases have the benefit of a predictable monthly payment with no residual risk to the lessee at term end,” says Craig Lehmann, Donlen’s director of equipment leasing operations. “With the lessor assuming the residual risk, the potential drawback is there are usage provisions incorporated into the lease, which could lead to end-of-term charges for customers that did not accurately project usage at lease inception.”

FMCs specializing in closed-end leases contend that those end-of-term charges — for mileage overages or increased wear and tear — would end up costing a customer in an open-end lease, as well, with a lower value upon resale. Moreover, FMCs offering closed-end leases often make adjustments for unexpected circumstances to gain customer loyalty.

“The mere prospect of having an excess mileage charge or early termination fee causes some fleets to remove closed-end leases from consideration,” says Pelehach. “The reality is that whether a lessee is in a closed-end lease or an open-end lease, they are going to have to deal with the economic realities of the use of that vehicle, whether it is terminating a lease earlier than anticipated or driving higher miles.”

As one way to ease the impact of unpredictable mileage, some lessors allow fleets to pool mileage to help even out driving patterns.

Similarly, Motorlease offers a mile-per-mile credit that allows a fleet to apply the unused miles from one vehicle to the mileage overage of another vehicle. Mileage overages that result in penalties can be viewed as a way to account for unplanned depreciation, Pelehach added.

“Assuming that the leasing company is fair in their excess mileage charge, the additional cost that is incurred by an excess mileage charge is nothing more than capturing the additional depreciation that occurs as a result of the higher mileage,” says Pelehach.

Closed-end leases can also make more sense in an environment of rising interest rates, because the rate is fixed with other costs at the beginning of the term, says Pelehach. However, fleet management companies that offer open-end leases say rates can be fixed on those products, as well.

Closed-end leases provide more certainty to fleet managers who worry about the future of the used-car market, which has been strong in recent years. These leases fix the cost of depreciation, which typically makes up the highest cost in the TCO equation.

“The used market is beginning to move off of those historic all-time highs, and looking at historical data can be dangerous if trying to calculate future expectations,” Pelehach says. “That’s a huge problem with open-end leases and TCO. You don’t know what your TCO is until the vehicle is sold.”

Fleet management companies specializing in closed-end leases include LeasePlan, Merchants Fleet Management, and Motorlease.

How Will New Lease Accounting Rules Affect Small Fleets?

In February, the Financial Accounting Standards Board (FASB) published new lease accounting rules that require lessees to include leases on their balance sheets, though they are not required to count the leases toward debt. 

The new guidance, known as the Accounting Standards Update (ASU), is designed to improve financial reporting of lease transactions and will require both open-end and closed-end leases to be added to balance sheets. They will be counted as assets and liabilities but not debt obligations.

While changes in lease accounting have been discussed since the ’80s — and the present rules-making project began 10 years ago — questions had surfaced as to how this change would affect a company’s ability to borrow money, how it would affect financial statements, and whether the changes would even affect the decision to lease or purchase.

Photo via iStockPhoto.com/Dem10
Photo via iStockPhoto.com/Dem10

The lessors Business Fleet spoke to agreed the changes would have little effect on a company’s decision to lease. “None of that is changing,” says Shlomo Crandus, chief financial officer of Wheels Inc.

“I don’t see a seismic change on how (we) go to market because I think most customers are using our services as a fleet management provider as opposed to as a pure lessor,” says Tom Coffey, vice president sales and marketing for Merchants Fleet Management.

For most midsize to large companies, these lessors say the change shouldn’t have a major effect on corporate financial statements or how taxes are reported.

But how would it affect a company’s ability to borrow? Lease obligations are already taken into account by lenders as disclosures in the footnotes of financial statements. Regarding the new rules’ effect on covenant and leverage ratios, “Our reading is that it won’t affect the covenants that are driven by debt measures or leverage because it won’t be counted there,” Crandus says.

Though private companies have until annual periods starting after Dec. 15, 2019 to comply with the new rules, Coffey says many small and midsize companies have already made changes to their lease accounting. “We’ve also seen customers go to outright capitalizing of these leases more commonly than if they treated them as pure operating expenses,” Coffey says.

However, the rules change will likely have an effect on the accounting of both closed- and open-end leases.

Under the new rules, all types of leases will go on the lessee’s balance sheet, and the amount that goes on the balance sheet will be based on the contractual term of the lease. An open-end lease containing a 12-month term that then goes month-to-month would require 12 months of payments on the balance sheet.

A closed-end lease that is typically written for a contractual term of two to three years would require a larger amount on the balance sheet, assuming the fleet does not believe there is an obligation to take on any residual risk on an open-end lease, Coffey says.

But whether that will tip the scales to companies switching lease types, “It is one of many factors that the lessee evaluates and won’t make that big of an impact,” Crandus says.

Crandus and others concur that the rules will make very noticeable changes on the balance sheets of companies that have substantial equipment or real estate lease obligations, such as airlines or drugstores. “Those are the companies that the regulators and accountants are focused on,” he says.

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  1. 1. Courtney - commercial [ May 06, 2016 @ 05:45PM ]

    Curious why would a company not consider a balloon note ? Or is that just for smaller companies.

 

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A specialized version of an open end lease used in the United States primarily for automobiles and light-duty trucks. TRAC is an acronym for "Terminal Rent Adjustment Clause," an arrangement featuring a final rental adjustment on the lease which occurs after the vehicle is removed from service and sold.

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