Lease or buy? What rural builders should know when weighing the options

This entry was posted in Business and Management, Construction Industry News, Featured Magazine, In the Industry, Industry Experts, RB December 2012, Rural Builder Magazine and tagged Equipment Leasing and Finance Association, leasing construction equipment, mark battersby. Bookmark the permalink.

By Mark Ward –
“Today’s variety of leasing options couldn’t come at a better time for construction businesses, which have experienced the worst market conditions we’ve seen in years,” reports William Sutton, president and CEO of the Washington-based Equipment Leasing and Finance Association.

On the other hand, “This is a bad time for most businesses to get into leasing,” suggests Mark Battersby, “Money Talk” columnist for Rural Builder and an independent specialist in tax and finance issues based in Ardmore, Pa.

Strangely enough, both are right.

There are solid reasons for rural builders to consider leasing rather than purchasing new or used construction equipment—everything from backhoes and light trucks to telecom systems and photocopiers. Tight economic times demand nimbleness and flexibility, and leasing affords opportunities to free up working capital. Then, too, even a single wrong decision on a major purchase—a piece of capital equipment that becomes obsolete, or proves too little for the need, or can’t be justified if increases in volume doesn’t materialize—can impact your bottom line for years to come.

“When you consider that companies in virtually every industry and of every size,” says Sutton, “from Fortune 500 corporations to one-person micro-businesses, lease items from office and IT equipment to trucks to aircraft, I can’t think of an instance where someone wouldn’t find benefits from leasing.”

Battersby agrees that “leasing offers real advantages, including reduced cash outflows and greater control.” Industry surveys show, he states, that “a startling eight out of ten businesses lease some equipment.” But his reason for advising caution has less to do with the immediate benefits of leasing, and more with the long-term uncertainties introduced by forthcoming changes in the nation’s Generally Accepted Accounting Principles.

“Some businesses have used leases as a way to get their equipment financing off the balance sheet,” Battersby explains. “But as the economy is becoming globalized, there’s a push to get U.S. accounting standards in line with European standards. So in the future you may be required to put leases on your balance sheet as liabilities. If that happens, you’ll have to include those liabilities whenever you apply for a loan, which could make getting the loan harder.”

Battersby recommends a wait-and-see approach. “It’s an issue to keep an eye on over the coming years,” he believes.

Sutton and the ELFA are also on the alert. An October 2012 report in the association’s Equipment Leasing and Finance magazine notes that the draft of a new GAAP lease-accounting standard is expected by the end of 2012 and could be adopted as soon as a year from now.

Amidst all the changes—in construction equipment technology, in leasing options, in accounting standards—another trend to watch is the changing nature of equipment dealers. According to the Associated Equipment Distributors, a Chicago-based trade group, the network of dealers around the country is becoming increasingly consolidated. Larger companies are expanding as many smaller independent dealers are either acquired or exit the business.

Dealers in small towns and rural areas may be the first to feel the pinch. Rural builders may need to consider the staying power of their local equipment dealers as they decide whether to lease or buy.

The case for leasing
Though the issues that impact the leasing market are complex, the basic pros and cons of leasing itself are easy to grasp. Leasing equipment “is a source of funding that lets you hold onto your cash or working capital, so it can be used for other areas of your business,” explains Sutton. Taking out a traditional loan requires a down payment, while leases can be arranged for little or even no money down. One hundred percent financing is common, so builders can avoid big cash outlays while using new equipment right away to generate revenue.

Construction equipment and office systems are often leased in the anticipation that they will be justified later as a business grows or realizes increased efficiencies and savings. Those benefits take time, however, so that leasing “can mitigate the uncertainty of investing in a capital asset,” continues Sutton. If anticipated growth or savings do not materialize, the equipment can be returned at the end of the lease.

In addition to managing risk, leasing is a way to manage money and enjoy “greater certainty in budgeting,” advises Sutton. Payment schedules can be “customized to match your cash flows, even your seasonal cash flows,” he adds. Upfront shipping, installation and training charges can be bundled into some leases. At the same time, he explains, leasing “hedges your inflation risk because, instead of paying for the total cost of the equipment upfront or with a large down payment in today’s dollars, the stream of lease payments delays your outlay of funds. The lessor absorbs the devaluation of your payments over time due to inflation.”

Along with managing risk and managing money, Sutton maintains, leasing is an effective means to manage equipment. Compared to pay-as-you-go, financing new equipment with a lease or loan allows rural builders, he says, “to acquire more and technologically better equipment. Certain leasing finance programs can also allow for technology upgrades and/or replacements within the term of your lease contract. Also, the lessor bears the risk of the equipment becoming obsolete so that you don’t get stuck with out-of-date technology.”

From the start, rural builders can tap into the expertise of the leasing company for advice on managing the equipment through its lifecycle. With many leasing companies, Sutton adds, “You can even outsource your asset management by having the lessor track the status of the equipment, schedule and perform maintenance, and alert you when it needs to be upgraded or updated.” Finally, the lessor handles disposal of the equipment. “Equipment management services enhance your ability to focus on your core operations,” he says.

Differences between leasing and buying equipment are easy to understand. But how do leases compare to traditional loans? First, when you borrow money to purchase equipment, you become the asset’s legal owner and then repay (with interest) the funds advanced to you by the lender. When equipment is leased, however, the lessor generally holds title to the equipment, although you may have a purchase option at the end of the lease term.

This helps explain, says Mark Battersby, why “most banks require a down payment of around 20 percent if you plan to borrow the money to buy equipment and make payments,” while lease arrangements typically offer 100-percent financing. In contrast to a loan where the builder is advanced money to gain legal ownership of an asset, adds Sutton, “Leases involve the payment of rent. In a true lease, the lessor retains significant residual value and tax advantages that come from retaining ownership of the equipment” and this fact “reduces the rent payment considerably below the cash requirement of a conditional sales contract.”

Although an ELFA report describes nearly 20 types of lease arrangements, Sutton believes three basic structures are most relevant for rural builders: a master lease, a buy-out lease, and an operating lease.

“A master lease is a lease contract in which you lease assets that you currently need and can acquire other equipment under the same basic terms and conditions without negotiating a new lease contract,” explains Sutton. Buy-out leases can be helpful for builders “who are fairly certain they will want to purchase the equipment at the end of the agreement,” he relates. Often this is accomplished by paying one dollar at the end of the lease term. By contrast, operating leases cover short-term use of an asset, typically a period of three to 10 years, after which the equipment is returned.

Another difference between buy-out and operating leases is ownership. “The owner of the equipment at the beginning of a one-dollar buy-out lease is considered to be the lessee/user,” observes Sutton, while with operating leases “the lessor retains ownership of the equipment and expects it to be returned at the end of the term.”

The question of ownership carries important tax consequences. “With lease-to-buy arrangements,” reports Battersby, “the IRS is famous for asking, ‘Is this a lease or a purchase agreement?’ An operating lease isn’t considered long-term debt or liability, which makes you more appealing to traditional lenders when needed. And operating leases are generally treated as fully deductible business expenses. Your tax professional should be consulted to determine what percentages of other types of leases can be deducted.” 

A productive relationship
Rural builders who decide to lease equipment should evaluate—and cultivate productive relations with—their leasing companies as they would any other vendors or suppliers. From building materials suppliers you expect good products and services, plus good advice from knowledgeable reps that are familiar with your business and the type of construction you perform. You expect the same from a bank or other lender.

“That’s what you should be looking for in an equipment dealer and leasing company,” advises Battersby. “You’re shopping both on price and on knowledgeability. Do they know the rural building business? Do they know the kinds of lifts you need to erect a pole barn? Don’t be afraid to shop around. And look for dealers who source equipment from multiple manufacturers. That will introduce more competition and more options in getting a favorable lease.”

Moreover, builders can avoid the dangers of dependence on a single equipment manufacturer. That manufacturer’s equipment may, over time, struggle to keep up with new technology or lose ground versus competitors. Especially in small towns and rural areas, a given manufacturer may be slow in servicing equipment or may even decide to pull out if the territory is deemed insufficiently profitable.

“But when you do find equipment dealers who can meet your leasing needs,” continues Battersby, “communicate with them. Give them your business plans. Show them the contracts you’re bidding on. Above all, be honest. If it’s true, then tell them you’re strapped for cash and ask if they’ll work with you. Your relations with an equipment leasing company are a lot like your relations with a bank or lender. Honesty and open communication, on both sides, leads to productive relations that help both parties.”  

Nevertheless, Sutton notes that rural builders can benefit by being prepared to ask questions specific to leasing. “The first question,” he says, “is a question to ask of yourself: ‘How will we be using the equipment, and for how long?’ That allows you to perform a simple cost/benefit analysis that compares the periodic leasing payment to the revenue you expect to generate from using the equipment. Then you can decide if leasing makes sense.”

Next, Sutton advises builders to work with equipment finance company representatives who understand your business and particular market. “This is even more crucial with regard to leasing,” he reports. To structure a desirable lease contract, the company must be knowledgeable about market fluctuations and other factors that affect local construction activity. “For example, if your business is seasonal then you probably want the flexibility to miss one or more payments without a penalty during your low season,” he points out.

In addition to industry and market knowledge, an equipment leasing company “needs to understand your particular business, such as your tax and cash flow requirements,” continues Sutton. If the lease is properly structured, builders can reap immediate benefits as payments are treated as tax-deductible overhead expenses. But if the IRS deems that the lease is, in fact, a purchase agreement then the builder may be compelled to depreciate the equipment over five to seven years, in accordance with IRS schedules.

“Residual rates, or the value of the leased equipment at the end of the lease term, are another key reason to work with an equipment finance company that’s knowledgeable about your market,” states Sutton. “Having the knowledge and experience to set the residual accurately allows the company to provide you the best possible lease payment schedule.”

Before signing a lease, rural builders should ask about its total cost—insurance, taxes, late fees, other surcharges—and not just the amount of the monthly payment. Also ask whether the terms of the lease can later be changed or if the lease can be ended early. To avoid additional payments or charges, provisions for changing the lease terms or its length are best addressed up front. “Or you could consider a master lease,” advises Sutton, “which controls the terms of subsequent leases and is designed to facilitate changes in leasing needs.”

Except in the case of master lease, agreements to upgrade or add equipment usually require a new lease. “When structuring a lease program,” suggests Sutton, “builders who anticipate growth should negotiate an option to add equipment under original terms and conditions.”

Another question to discuss in advance is responsibility for damaged or destroyed equipment, as well as who pays for any insurance, taxes, and maintenance.

A final set of questions to ask up front concerns the end of the lease. Are you expected to return the equipment, purchase it a nominal fixed price, purchase it at fair market value, or renew the lease? If the equipment must be returned, says Sutton, “Find out whether you must return the asset to the equipment finance company, what documentation and packaging materials are required, who pays for shipping or delivery, and when the equipment must arrive. Also ask about any additional costs based on your account activity, such as late payments. Know when all payments, fees, and costs are due.”

Changes on the horizon
The last consideration are the larger issues—changes in accounting practices, consolidation among equipment dealers—that rural builders cannot control but which, as Mark Battersby explains, “may have a trickle-down effect that can eventually impact everyone.”

According to ELFA, American businesses, nonprofits and government agencies annually invest more than $1.2 trillion in capital goods and software (excluding real estate). Just over half of this investment, or $628 billion, is financed by loans, leases, and other financial instruments. The equipment finance industry divides its market into three tiers: “small ticket” financing of less than $250,000; “middle ticket” financing of $250,000 to $5 million; and “big ticket” financing in excess of $5 million.

Any way it is divided, equipment financing is a major economic activity. Little surprise, then, that attempts to “hide” liabilities by calling them “leases” and then stashing this off of a company’s balance sheets has drawn the attention of regulators. Since 1973 the Securities and Exchange Commission has made the Financial Accounting Standards Board, a private nonprofit organization, responsible for developing the Generally Accepted Accounting Principles that all U.S. public traded companies must follow.

In turn, the FASB is the nation’s counterpart to the International Accounting Standards Board. The two bodies began discussing a new lease-accounting standard six years ago,  soon after the SEC reported in 2005 that public traded U.S. companies had shifted an estimated $1.2 trillion in future cash obligations off their balance sheets through leasing. By the end of 2012, the FASB and IASB expect to circulate the draft of a new global standard for public comment.

Predictably, different parties—from businesses and investors to leasing companies and tax agencies—have their own reactions. ELFA’s Ron Hurd, a San Francisco-based capital advisor and chair of the association’s Financial Accounting Committee, worries that compliance with the proposed changes could raise the cost of equipment leases, would “impact the vitality of true leasing,” and prompt lessees to either demand price concessions in offsetting the new costs “or decide that leasing is no longer worth it.”

Bill Bosco, who serves on Hurd’s committee and on the IASB Lease Project Working Group, cautions, “If lessees are required to report front-loaded lease expenses … rather than straight-line rent expense as under today’s GAAP,” they might choose a straight loan over a lease. For rural builders, the trickle-down effect may be felt when they apply for loans and the bank asks, under the new accounting standard, to be shown the future interest expense and capitalized asset amortization implied by any leases.

Meanwhile, equipment dealers are feeling their own pinch. A March 2012 report in Construction Equipment Distribution, the journal of the Associated Equipment Distributors, documents that the typical AED member is surviving on a profit margin of 1.8 percent. Since the recession, the journal also reports increasing consolidation among equipment dealers.

For example, a March 2010 report noted that construction equipment manufacturers’ product offerings continue to advance in quality. But training and support may be faltering at the dealer level due to consolidation as dealers are bought out or exit the business. The fear that a local dealer may go away is forcing customers to think twice about depending too heavily on a particular manufacturer or piece of equipment.

All these trends eventually come back to the basic question: Is the time right to lease equipment? Or is it better to wait and see? The advantages of leasing are quite real, but so are the trends that may impact this equipment financing option in the future. Yet decisions about how and when to allocate resources—whether hiring crews, purchasing supplies, taking out advertising, or acquiring equipment—are a daily fact of life in the building business.

 

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