(Don't) Look Deep into My Lease

The promise of low monthly payments had enticed Rojacks Food Stores into leasing restaurant equipment rather than buying its own. But when the end of the lease loomed in 2000, the Mansfield, Massachusetts, chain still needed the shelving, refrigeration, and other items for which it was being charged. The leasing company, GE Capital, set a buyout price of $500,000. Suddenly, the lease arrangement seemed like a very bad deal.

Andrew Almquist, who had joined Rojacks as vice president and controller that year, sought help from consultants. An appraiser was hired, and the leasing company was persuaded to reduce the proposed buyout price by half. For the now-defunct Rojacks, it was a narrow escape from a plight that companies often encounter when they become entangled in unfavorable lease arrangements.

"Leasing is like buying a used car," says Almquist, now finance vice president and controller of Dedham, Massachusetts, restaurant chain Papa Gino's. Lessees that take just a quick glance under the hood won't learn much about how the lease operates. And unless a careful study is made, as Almquist puts it, "The leasing companies hold all the cards."

It is unquestionably a big game. With the total value of equipment being leased by companies rising — from $213 billion in 2005 to an estimated $229 billion this year, according to the Equipment Leasing Association of America (ELA) — leasing represents more than a quarter of all investment in equipment.

Further, the rules are about to come under review. The Securities and Exchange Commission has put leasing standards high on the list of items in a reconsideration of off-balance-sheet accounting. The Financial Accounting Standards Board is preparing to take a position as well. About half of American companies now cite off-balance-sheet accounting as among the reasons they choose to lease, rather than buy, equipment (see "On Borrowed Time" at the end of this article).

A Review of the Pitfalls
But whatever accounting changes are made in the future, it is worth reviewing the pitfalls that lead to lessee complaints — mainly when they discover some costly contract term that was overlooked originally.

In choosing whether to buy or lease, of course, companies weigh the cost of borrowing for purchased equipment against monthly lease payments, figuring in any tax advantages from leasing. Lessors, whether they are banks, commercial finance companies, or other entities, often present leasing as the more attractive option because of its low monthly costs and its convenience, among other reasons.

A 2004 survey by Global Insight gave the number-one reason for leasing — listed by 65 percent of the 150 companies in the Waltham, Massachusetts, economic forecaster's survey — as the discipline it imposes on the maintenance and replacement of equipment. Protection against obsolescence was cited by 54 percent, and off-balance-sheet accounting by 53 percent. Convenience scored with 51 percent. The efficient use of tax incentives was cited by 36 percent.

But for companies like Rojacks, which failed to anticipate the high residual value of the equipment, the concentration on low monthly and up-front payments disguises the true costs of leasing.

Large corporations aren't immune from making basic cost miscalculations, either. When Cleveland-based industrial-equipment maker Eaton Corp. entered a contract to lease computer servers some years ago, the deciding factor should have been residual-value predictions, according to vice president and treasurer Bob Parmenter, who was not involved in the decision at the time. Those who did call the shots, however, were seduced by the convenience factor.

"They looked at month-to-month instead of total costs, so the bias was toward leasing," Parmenter says. "When leases came to their normal end, rather than deciding to dispose of the equipment or find a new lease, they continued to lease. It was a very bad economic decision."

Among their mistakes, Almquist and Parmenter's predecessors failed to recognize that some lessors expect the high back-end returns to offset the low payments they dangle up-front. According to industry statistics, lessors on average realize 15 percent yields on the equipment they lease, says Susan Franklin, CEO of American River Partners, a Cohasset, Massachusetts-based consulting firm.

"Most lessors make money through some obfuscation in the lease," maintains Michael Keeler, CEO of Ecologic Leasing Solutions, a lease management outsourcing company in Great Falls, Virginia. "If the rates are pushed down at the beginning of the lease, the rates at the back end go up."

There are more-standard reasons that front-end costs are low, maintains ELA president Michael Fleming. Smaller monthly payments reflect higher residual values of the equipment, and also come with longer lease terms. Back-end terms are simply meant to protect the leasing company, which assumes the risks associated with the value of the equipment. "It isn't that the lessors obfuscate," says Fleming. "The main problem is that lessees just don't think about the lease as an ongoing thing that has a beginning and an end."

Still, a lessee that pays too little attention to that end can incur significant costs. Lessors often set deadlines for lease-renewal notification as much as six months before the end of the lease, for example, and being late can subject the lessee to steep penalties or commit it to another lease term at the same rates. Such costly results are common, leasing experts say, because lessees often don't recognize the importance of leased equipment until they have to replace it.

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