Equipment Leasing: An Introduction

The history and progress of equipment leasing with some observations as to why this segment of the leasing industry is becoming increasingly popular with corporations faced with tight-money problems and the problems of reducing long-term debt.

There is nothing new under the sun - including adages like that one, which expresses a lot of contemporary truth in a few words. That old saying is still with us because it applies to many things in our Atomic Age, among them the practice of leasing.

We tend to think of leasing as a relatively recent development, yet the sale and leaseback of land was known in Egypt in the time of the Pharaohs, and the medieval kings of England granted rights to land and conveyed them under contract of lease.

Those early contracts involved real estate rather than personal property, but by the start of the 19th century such chattels as barges, wagons and ships were being leased, and the term "bare boat charter" goes back at least a century. The lease became a common way for a business to acquire the use of industrial real estate, and the concept was extended to personal property used for the production of goods.

The equipment lease as we know it today developed from the practices of two companies - practices later held to be illegal. United Shoe Machinery Company, wishing to protect its dominant position, retained title to the machines it placed in its customers' plants, thus fully controlling the use of each machine, its patents and its disposal. In similar fashion, IBM declined to sell its business machines. It would only rent them to customer-users.

The U.S. Department of Justice ultimately held such practices to be unduly restrictive and both companies were forced to make their machines available for outright sale. But the concept of equipment leasing had become established, and businessmen had come to realize the benefits it offered.

It became apparent that corporate management had to consider leasing if it was to properly evaluate asset acquisition of effective product marketing. The subject of leasing - including everything from salesmen's automobiles to a new computer or a production machine - had to be included in any discussion of corporate management policy.

The first major use of equipment leasing in its present form was in the railroad field, with rolling stock handled on a complicated Equipment Trust Certificate type of lease.

Passenger car leasing gained its first popularity after World War II. The years 1946-53 saw the introduction and growth of the full-service automobile lease. The excess-profits tax added to the attractiveness of car leasing, and the one-year, full-maintenance service lease became widely used. Finance leasing - on a net-lease basis, with no maintenance or insurance - began in 1949 and has grown along with the full-service lease to tremendous proportions.

It is estimated that nearly 20 percent of all passenger cars sold in 1968 went to leasing companies for leasing or daily rental uses.

Truck leasing has grown more slowly, and leased trucks comprise less than 5 percent of the total production, but a growth in this field similar to that in car leasing should take place in the next five to ten years.

The real growth in equipment leasing has taken place only in the past 15 years or so, and it might be valuable to examine the reasons why this financial device has become so popular and widely accepted.

Basically, there are two distinct types of equipment leasing: service or operating leases cancellable on notice, bearing no relationship to the cost of goods and carrying no fixed com­mitments; and finance or net leases - noncancellable, full-payout leases requiring payment of interest and principal, containing a series of payments equal to the cost plus interest and loading charge, spread over the expected useful life of the equipment.

Service lease differ from finance leases in that they contain an additional charge for such items as maintenance, insurance and acts of purchase and sale in the lessee's interest.

Both service and finance leases are written on passenger cars and trucks; finance leases, in addition, are used for production equipment of all kinds.

What advantages will a corporation find in leasing? Leasing makes it possible to finance 100 percent of the cost of the assets involved, where as only a fraction (67 to 80 percent) usually is borrowed to acquire them. Thus, full financing conserves funds for working capital requirements.

When assets are leased instead of being bought with the proceeds of a bond issue, the "boiler plate" restrictions usually imposed in bond indentures are avoided and borrowing capacity is conserved for other needs that may arise in the future. Also, to the extent that leasing lessens the need for stock financing, it helps avoid dilution of the stockholders' equity.

Some of its advocates maintain that leasing reduces both the investment in fixed assets and long-terms borrowing, thus "cleaning up" the corporate balance sheet. However, if prospective creditors take lease charges fully into account, such an "advantage" is minimized.

It is true, however, that modernization and expansion are facilitated when assets can be acquired merely by entering into a lease agreement, eliminating the need for a cash down payment. Then, too, leasing may give a tax advantage, although this has become less significant as depreciation allowances have been liberalized. Leases may result in larger rental deductions from taxable income during the early years of the lease. Rentals can include the value of land that is not subject to depreciation, and the sale of a building for lease back may result in a capital loss to the selling corporation.

Also on the plus side is the fact that leasing can help simplify labor-management problems. When a building is leased, the lessee has one less union to bargain with. The same holds true when drivers are included in truck leases. It should also be borne in mind that the maximum claims of lessors against a corporation under Chapter X is for three years' future rent.

Leasing is a junior financing medium for many businesses. It resembles subordinated debentures in that it permits a business to acquire a number of assets without expanding its senior debt. For example, when large petroleum companies obtain tankers and service station sites through leases - even at relatively high rentals - rather than borrowing, they safeguard their ability to resort to bond financing should the need arise.

So long as administrators find that leasing helps assure their ability to borrow readily in the future on favorable terms in needed amounts, they are likely to favor the use of leases for many of their asset requirements. Finally, a non-full-payout lease with cancellation privileges offers a hedge against early obsolescence.

Are there disadvantages to leasing? Certainly. First is higher cost. A middleman owns the asset, usually cannot buy it cheaper than you can, and must borrow money to acquire it. The cost of borrowing, plus his profit, is passed on to you. In the case of a lease involving land, the lessee must consider the loss of appreciation and the fact that there is no residual value. There is also the factor of early obsolescence - you are under contract for rental payments so you tend to continue to use old equipment or outdated facilities.

Finally, any tax benefit will be challenged if the lease is not bona fide, with no cheap options to buy given the leassee. The IRS is beginning to insist that the lessor have some cash investment in the leased asset. Some rulings call for as much as 20 percent equity.

In general, leasing as an alternate method of financing asset acquisition should continue to be popular with prospective lessees. Whether it can continue to be a way for a lessee to get around the often unrealistic guideline life-depreciation regulations set by the IRS is questionable. The IRS seems determined to plug some of the loopholes that leasing has exploited, thus minimizing the depreciation deduction and maximizing today's income tax bill.

On the lessor's side, strict attention is necessary to assure that his lease agreement is in fact a bona fide lease contract within the rulings, regulations, and case law evolved with the IRS. The lessor can be badly burned, while the practical effect on the lessee is small. Thus in this case it is a matter of caveat venditor - let the lessor beware!

It would appear that as time goes on the prime-lessee leases will be written by banks, pension funds and tax-shelter investment groups rather than by professional leasing companies. The latter, with their heavy debt structures and high borrowing costs, will just not be able to compete with the low-cost leases written directly by banks. Most of the professional leasing companies are in the process of emphasizing either service leases or diversification.

We forecast continued growth in equipment leasing, with the lessee looking at leasing as another way to borrow money. "Leverage," or heavy borrowing, is the name of the game in today's corporate financial world; the company with no long-term debt is considered an inefficiently managed company.

It is easily possible to foresee the day when a material portion - at least 15 to 20 percent - of a corporate's total assets will be under soma type of leasing arrangement.

Mr. W. I. Newsletter, Jr. is vice president of Havenfield Corporation in New York. He has served as a leasing consultant to such companies as St. Regis Paper, Ingersoll-Rand, and Broadway Maintenance Co. From 1953 to 1964 he served as an executive and then president of Lease Motor Vehicle Co. of Pittsburgh, Pennsylvania and in a management capacity with Leaseway Transportation Corp. of Cleveland, Ohio. The article appearing here for the first time was presented to the American Management Association's Seminar on Equipment Leasing at their Chicago headquarters in December, 1969.