Equipment

What Contractors Don't Know About Equipment Leases Could Cost Them a Fortune

It is never too late to negotiate, or renegotiate, lease agreements—especially when market conditions have changed. In the shadow of COVID-19, businesses are evaluating every aspect of their operations and restructuring lease agreements for assets and property to conserve cash and gain better control over their portfolios.
By Marc Betesh
August 15, 2020
Topics
Equipment

In the age of the coronavirus, every business owner has learned how important it is to have the financial means to withstand a prolonged period of disruption. One of the ways companies tend to preserve cash is to lease equipment rather than buy it. In the construction industry, it’s often more prudent to lease when the need for specialized equipment may be required for only a short period of time on a single job or the cost of ownership is out of reach. However, businesses need to be extremely diligent with the management of those leases or they can inadvertently cost themselves a fortune.

There are two common, and costly, mistakes that businesses make with equipment leases: poor oversight of lease expirations and lack of management of lease financing costs.

Lease Expirations

When and how a lease ends is just as important as when it commences. Too many companies don’t pay attention to the fine print in these documents and penalties and charges can continue to add up—obliterating any of the cost savings the company had initially hoped to realize by leasing in the first place. There are a number of common mistakes companies make at lease end, including the following.

  • They don’t have quick visibility to the expiration dates. With surprising frequency, many companies continue to pay past the expiration of their lease agreements, racking up months—or sometimes even years—of additional payments without realizing it.
  • They aren’t aware of penalties. Companies don’t return equipment on time, or in the agreed upon condition, and incur significant penalties.
  • They pay premium fees on devalued equipment. Lease payments are based on the value of the equipment being leased, and at the end of a lease the residual value of the equipment is only a fraction of its original value. Many companies make the mistake of extending their leases without adjusting the payments to account for this reduced value.
  • They don’t track costs over time. If businesses aren’t evaluating the costs of a lease long-term, they may end up paying three or four times the value of the actual equipment.

Lease Financing Costs

Leasing is designed to allow businesses to rent equipment instead of buying it. However, that convenience comes at a price and each business must fully understand what that price is before entering into a lease agreement. There are a few pitfalls companies need to watch out for, including the following.

  • Paying high interest rates: When a person pays to lease equipment over time, there is interest built into the payment structure. It is critical to have a clear understanding of that interest component and not just evaluate a lease based on the monthly payments.
  • Failing to negotiate the interest rate: Companies may be able to refinance an existing lease at a lower rate if there are changes in market conditions and interest rates or a change in the value of the equipment. In the same way that you can refinance the mortgage on a home, businesses can refinance the interest and principal payment on a lease with the existing lease holder or a new provider. Be aware that if you are able to negotiate a reduction in your payments, this would cause a “remeasurement” under the new lease accounting rules. Your lease liability and the Right of Use for the asset will change.
  • Missing the economies-of-scale advantage: Organizations with multiple leases may have the opportunity to aggregate lease agreements to secure more favorable terms with the existing lease holder or a third-party bank.

Looking for a simple demonstration of these concepts? Consider a standard car lease. The dealer calculates the value of the car based on the anticipated usage (in this case, miles) and devaluation of the car at the end of the term. The anticipated valuation at the end of the term, together with an interest component, determines lease payments.
In the construction industry, leasing heavy equipment such as excavators, haulers and loaders functions much like leasing a car. The dealer estimates the loss of value of the equipment over the life of the lease, adds an interest rate and calculates the lease payments.

When the lease expires, the dealer expects the asset to be returned on the agreed date and in the anticipated condition. Noncompliance with those terms can lead to penalties and additional fees. If an individual decides to extend the lease, the monthly payments should be recalculated based on the new (lower) value of the asset at the time of the extension. Alternatively, the lessee may opt to purchase the asset at the new, lower value or finance that purchase through a bank that offers a lower interest rate.

Best Practices in Equipment Lease Management

Through proper lease management, many of the issues described above can be avoided. Best practices for equipment lease management or management of any leased asset include the following.

1. Read the fine print. Look for hidden fees, costs, penalties and potential risks in these clauses, specifically the following.

  • Default provisions: A default provision should provide a clear indication of potential penalties for failing to meet any condition of the lease.
  • Termination clauses: Similar to default clauses, the termination section may also include potential negative actions for failure to meet the terms of the contract.
  • Force majeure and service-level clauses: Both of these typically focus on the ability of an asset to perform its duties. For example, if a contractor leases a crane and it is inoperable, the clause outlines the responsibilities of the lessor in this scenario. However, it does not necessarily absolve the business from the need to make lease payments on the equipment.

2. Evaluate lease versus buy options. Thoroughly evaluate the lease versus buy implications and financial impact, including the following.

  • Innovation over time: If a business is leasing equipment over three years or more, there may be advances in technology or regulatory requirements that make it necessary or more desirable for a company to have new equipment every few years.
  • Cost of ownership: In certain circumstances, purchasing equipment may be less expensive than leasing equipment over a long period of time. Total cost of renting and ownership should be evaluated side by side.
  • Control of assets: Some organizations may prefer purchasing over leasing assets if they have a need to control certain aspects of the equipment usage that may be restricted in a lease agreement.
  • Cash flow management: Companies may not want to tie up capital through a purchase even if it is more cost-effective. Organizations may prefer to minimize a financial commitment in the short-term.

3. Keep tight controls. Proper management of lease agreements can mitigate risks and reduce costs.

  • Audit all leased assets: Conduct annual or biannual audits on all lease agreements to ensure compliance with terms and conditions and to avoid defaulting and other penalties.
  • Implement lease management software: Use lease management and accounting software to manage multiple, complex leases and track trigger dates and events closely. Best-in-class lease management solutions will provide a return on investment in hard and soft-dollar savings in less than two months.

It is never too late to negotiate, or renegotiate, lease agreements—especially when market conditions have changed. In the shadow of COVID-19, businesses are evaluating every aspect of their operations and restructuring lease agreements for assets and property to conserve cash and gain better control over their portfolios. Although the sanctity of the lease contract is paramount, current economic conditions and fear of mass bankruptcies may make lessors more amenable to renegotiating terms with lease holders. Finally, do not allow poor lease management to cause your company to pay more than necessary or incur penalties due to missed deadlines and inaction.

by Marc Betesh

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