The Advantages of Open-End Leasing

This article is a counterpoint to the preceding article (appearing on page 36) which argues the advantages of a closed-end lease. In the following presentation, Don Kreft, president of Lease Plan USA argues the advantages of an open-end lease. Specifically, he argues that open-end leasing provides for the purchase of the vehicle and delivery through a local dealer, vehicle hilling and the sale of the used vehicle - all done by the lessor - relieving the lessee of this responsibility.

After having marketed fleet leasing to major corporations with various sized fleets for the past 25 years, it has become obvious to me why the open-end finance lease is the product most often chosen by CFOs and fleet administrators.

The open-end finance lease, which, in most cases, has either an addendum or a modification to the contract (changing it to an operating lease for accounting purposes), provides the lessee with the maximum flexibility available. It has almost all the advantages of company ownership and fleet leasing combined into one package.

Let's start out with the obvious; all costs are spelled out in the lease agreement at the front end. A lessee knows how a vehicle will be capitalized in relation to the factory invoice. A fleet administrator or CEO has the ability to choose the depreciation rate (if leasing with one of the major financially-independent lessors) and vehicles can be kept as long as required. The interest rate is clearly defined and the lessor's monthly administrative fee is displayed. As a result, open-end leasing eliminates the smoke and mirrors concept used by many closed-end lessors.

From the fleet administrator's point of view, when a vehicle leasing package is presented to the company's CFO for a decision, it is important to have all costs identifiable. Only the open-end finance lease provides this. Even though service should be the primary decision factor for any fleet administrator or CFO, understanding how rates are formulated is essential for any comparative financial analysis.

Analyzing the Advantages

Only in open-end finance leasing is the lessor willing to display costs in relation to factory invoice; thus, there isn't any chance for a misunderstanding as to the base amount used to determine the monthly rentals by application of the multiplier. In some instances, an open-end lessor may allow vehicles to be purchased through a lessee's own sources. Although this is usually not as economical as allowing the lessor to purchase them, this option can be quite attractive in certain geographic areas for local political reasons.

Most major lessors will automatically reduce the capitalized cost by the amount of the factory fleet incentives. Sometimes these fleet incentives are not passed to small-to medium-size fleets by dealers and sometimes they are not used to calculate closed-end lease rates.

Financially-independent lessors will usually allow a lessee to vary the depreciation on a vehicle-by-vehicle basis. The standard of two percent per month is usually valid only if a vehicle is kept beyond 30 months. If a fleet has vehicles that turn anywhere from 18 to 36 months, as most do, they need the flexibility of not being tied into a fixed term. They need the flexibility to choose their own depreciation rate based on the historical information of a particular driver. The open-end finance lease allows this flexibility, while the closed-end lease does not.

In this age of financial sophistication, numerous indices are available to set interest rates. In the closed-end lease, you usually never know what the rate is charged to the lessor or what method of funding is used by the lessor's funding source. The open-end finance lease will allow the lessee to choose either fixed interest rates or floating rates. Clearly, the most popular and economical are floating rates indexed to one-month LIBOR (London Inter Bank Offered Rate) or 30-day commercial paper. One-month LIBOR and commercial paper are usually 1.5 percent to two percent below the current Prime rate.

As far as fixed rates go, the popular index is three-year LIBOR or two-to three-year Treasuries. These are also money market rates that have proven to be quite competitive over the past 12 to 18 months. Fixed rates indexed to Prime - and Prime in general - are becoming less and less popular as leasing companies move away from the motor companies for funding. Prime is a rate determined by the major U.S. banks and is set only after analyzing interbank rates, commercial paper, and other financial arenas.

But the cutting edge of this business is now the money markets such as LIBOR or commercial paper. The flexibility they offer is not available in closed-end leasing, and therefore cannot be analyzed by the CFO.

Last, but not least, is the lessor's monthly administrative fee. This is usually stated as a percentage of the capitalized cost per month and it should be noted that this is the only part of the equation the lessee should look at. This fee is used to defray overhead expenses for the services of purchasing and disposing of the fleet and providing consulting services, newsletters, and timely and accurate billing to the client. In a closed-end lease, the lessee never sees what this fee is.

These areas have been defined to emphasize that in an open-end lease, all of these factors are displayed to the lessee while in a closed-end situation, they are not broken out and the lessee never knows the true costs of these items.

One of the many advantages to the lessee in an open-end lease is the opportunity to analyze a lessor's ability to fund the lease at a competitive rate. For example, a lessee knows immediately that if the lessor is indexed only to Prime, there usually is minimum flexibility and financial stability behind that company. If a lessor is not willing to index to money market instruments, something is lacking in its treasury department.

Many limes, lessors purposely market this closed-end leasing so that they don't have to display their inability to obtain funds at competitive rates. They use the sales pitch that they are taking any risk of resale away from the lessee, but only by under-depreciating the vehicles can they have competitive monthly rental rates.

You can rest assured that at the end of the 24- or 36-month rental term, someone is going to have to pay for this under-depreciation. Most likely, as has been proven historically, the lessor will bill back excess mileage and wear-and-tear charges. These may or may not be warranted, but are needed to satisfy the under-depreciation of the vehicle.

In open-end finance leasing, the lessee settles his account on each unit based on the unamortized book value at the time of sale. If there is a profit; as compared to this amount, the lessee receives the profit; if there is a loss, the lessee must make up the loss. This is no different than ownership and obtaining a bank loan that still has a balance at the time of the vehicle sale. This can occur regardless of the mileage or condition of the vehicle.

OPEN-END VS. CLOSED END LEASE COST COMPARISON

Vehicle:

Ford Taurus with standard fleet equipment

Interest:

Open End = One-month LIBOR + .50 percent

Closed End = Prime +1.0 percent

Term

Vehicle used 36 months/60,000 miles

Open End = 36 months

Closed End = 36 months/55,000 miles/$.07 per mile beyond 55,000 miles

Depreciation:

Open End = 2.0 percent per month

Closed End = 1.8 percent per month

* These items are usually never revealed by a closed-end lessor.