Managing the Financial Side of Commercial Fleets

Strategies to Fund Fleets in Today's & Tomorrow's Economy

Interest rates have been at historic lows; gas prices, historic highs. Funding is tight, the economy is flat. What kinds of funding strategies can help fleet managers deal with this kind of uncertainty?

May 2012, by Staff

For decades, fleet managers have had to deal with the ups, downs, and difficulties of the economy. The economic booms of the ’50s and ’60s, the recessions of the ’70s, early ’80s and ’90s, to be followed by the boom and bust, right on up to the international banking and real estate meltdown of 2008, has always made finding the right kind of funding a challenge for fleets.

Lease or own? Fixed rates or floating? Open- or closed-end? The choices are out there to be had, but choose the wrong one and the costs can be substantial. No one has a perfect crystal ball, but funding techniques are available to help weather economic storms, as well as ride the crests of economic waves.

Covering the Basics: Leasing
The most common fleet lease is the open-end, terminal rental adjustment clause (TRAC) lease. Its basics are well known; an amortization rate is agreed upon, when vehicles are taken out of service and sold, the proceeds are either greater than or less than the unamortized balance, and the lessee either pays or receives credit for these differences.

These leases contain two other factors: an administrative fee and a funding cost component. That funding cost component is applied to the declining balance of the asset (as the monthly amortization is deducted from the capitalized cost).

Funding for fleet leases can be fixed (at the inception of the lease) or floating (changes as the rate basis for the funding changes). Funding for fleet leases can be obtained from a number of sources:
■ Banks.
■ U.S. Treasury issues.
■ Commercial paper (funds issued by companies).
■ Securitization of leases (vehicle leases, bundled and sold as
■ Internal funds.

Fleet TRAC leases are billed monthly, and the lease rate factor (including the funding cost component) is applied to the average annual outstanding (unamortized) vehicle asset balance. Because the annual average balance is used, for the first six months of any year, the lessee underpays what the actual funding cost is, and for the last six, overpays. When any particular lease is terminated, the lessor sometimes bills the lessee for the cumulative difference between the average and actual balance. This is often referred to as the “deficit interest” adjustment.

Going Over Funding Goals
What factors do companies look for when choosing funding alternatives? How does a company determine the most cost-efficient way to fund assets? Several factors come into play:
● Rate: Obviously, this is the most important funding factor considered. Companies seek the lowest rate available at the inception of the lease transaction.
● Consistency: Some funding rates are more volatile than others. Consistent, predictable rates are preferable.
● Availability: Not all funding is available all the time.
● Matching: Funding should match the life of the asset as closely as possible.

Much of the decision on how to fund a fleet is in the timing. Borrowing rates on many of the options available have, historically, been volatile, and if timing is wrong, it can be costly.

Dealing with Volatility
Volatility is the enemy of good funding. For a long time, interest rates were fairly stable; a move of three or four percent over several years was a big one. But beginning around 1977, rates took off. Fed fund rates nearly tripled between 1977 and 1981 — dropped, rose, then began a fairly steady decline through the 1990s, with minor spikes in the mid-2000s.

Then came the financial meltdown in 2008. Rates plummeted, and now sit at historical lows; Fed funds, as high as 16.39 percent in 1981, dropped as low as 0.1 percent in 2011. The point of all this is to stress how critically important timing is in choosing funding for fleet vehicles. For example, when rates dropped to 8 or 9 percent in 1989 and 1990, a company coming off the incredibly high borrowing rates of the early 1980s might rush to lock in those “low” rates — only to see rates fall to 3 percent by 1992. Another company, in 1992, might have decided to wait just another year or two to lock in funding, only to see them back up near 6 percent by 1995.

What is different today? A lot is different, and smart fleet managers can take full advantage of today’s funding opportunities.

Considering Fixed or Floating
For a long time, the rate basis for fleet leases was the prime lending rate, usually plus some percentage or fraction thereof. Lease rates were fixed, for example, at “prime plus one,” or thereabout. There weren’t any of the myriad options available to fleet managers, and setting rates meant simply trying to negotiate a lower rate vs. the prime rate.

Next, lessors began to offer the same rate basis, but with the lease rate floating as the prime rate changed. If a fleet manager or the company treasurer believed that the prime rate would fall, they’d choose a floating rate to fund their leases. Soon after, other funding alternatives began to appear: commercial paper and U.S. Treasury issues — and, with them, lower rate bases compared to the old prime rate-based funding, particularly when the client chose a floating rate for their leases.

Lessors eventually offered the final piece in the funding puzzle: a floating rate option that allows the lessee to fix the rate, one time, during the life of the lease. There have been other, more exotic funding alternatives; however, this progression from a single, fixed-rate option to a suite of rate options with the choice of fixed or floating rates, and the further ability to change the rates chosen (if desired) gives fleet managers flexibility today that they didn’t have in the past.

History is useful only when applied to the current economic and financial climate. Where does all this leave fleet managers today?

As Good As It Gets
When looking back, the issues fleet managers dealt with involved movement in funding rates — sometimes movements of several percentage points in short periods of time. The record of funding rates, however, over the last four years (since the 2008 financial crisis) has been unprecedented. Rates have plummeted to levels not seen in our lifetime.

In 2007, Fed fund rates hovered at roughly 5 percent, a very attractive number. In the fourth quarter of 2008, however, the housing bubble burst, and years of bad loans hit every financial institution even tangentially involved in the mortgage market like a freight train. As losses mounted, business funding dried up. The Fed, seeking to loosen restrictions on business lending, began to lower interest rates aggressively, and that’s where we are today.

Fleet managers today have an unprecedented opportunity to fund at rates that they’ll likely never see again: The prime rate is 3.25 percent (the lowest it’s been since the 1950s), three-year Treasury issues are below 1 percent (at 0.75 percent), and 90-day commercial paper is as low as 0.25 percent. Just about every funding basis is at historic lows.
For those looking to save on fleet funding, 2012 is akin to Christmas morning; there are funds sitting under the “fleet funding tree” at rates few have ever seen. But, there are still challenges to overcome.

First, accessing those rates isn’t as easy as unwrapping a Christmas present. Not all fleets have an option to fix floating rate leases they have now. Many have leases that are in their second and third years of declining annual payments; refinancing even at these lower rates could end up costing more. And, replacing existing units with lower rates may not save money; remember, your cap cost to which the lease rate factor is applied may be higher today than it was two years ago.

Aside from the mechanics of the lease payment, credit is still tight, and some lenders have far more stringent credit approval requirements today than they did before the financial crisis.

So as good as current funding rates are, there are challenges to overcome. Still, these rates are so low that every fleet manager should take a close look at making a move.

What Can Be Done Today

First, take a close look at the existing lease agreement. If it contains the option to fix floating rates, do it as soon as possible. The leases are likely based on a relatively short-term funding indicator, such as commercial paper or Treasury issues, which change daily and are regularly traded in the financial markets. But, how low can they possibly go over the coming months and years? Locking in your rates now, when these remarkable rates are the norm, will save money in the long run. Indeed, there isn’t much room for them to fall any lower than they are today, and there is substantial room to rise.

If your agreement doesn’t have such an option, ask your lessor if you can renegotiate one into it. Most of them allow for fixed rates to be converted to floating, and vice versa, one time. Few fleet vehicles likely predate the financial meltdown of 2008, so you’ve likely had the advantage of plummeting rates already. But, the uncertainty that hovers over the economy could bring renewed volatility to funding rates, so it is important to take advantage while you can.

If you don’t have such capability, and for whatever reason your lessor won’t work with you to negotiate one into your existing agreement (or accept a new one), consider going out for bid. Most lessors offer such an option, and with a market that is brutally competitive, would be very happy to take on a new customer. One way or another, fix those rates now, and do so under an agreement that allows you to convert to a floating rate, if at some point in the future it is advantageous. Of course, any move should be preceded by a careful analysis of existing inventory, and will depend in large part on the age of the fleet and the funding rates for its leases.

The Game Has Changed
Funding fleet vehicles for a long time was a gamble. Rates were volatile, sometimes over a very short period of time. There was little flexibility in lease agreements, and limited choice in funding sources. For the forseeable future, however, the game has definitely changed. Remember the basics of asset funding:

■ Choose sources that are as consistent as possible. Keep in mind that some are more volatile than others; the shorter the term, the more volatile the rate.

■ Try to match your funding to the life of the asset. Longer-term funding may cost a bit more, but funding a three-year asset with 30-day financing can cause problems.

■ Talk with the fleet lessor and try to gain as much flexibility in the lease agreement as possible. First and foremost, get a lease with the ability to fix floating or float-fixed leases at some point in the asset life when it may be to the fleet’s advantage.

■ Learn about and track the various funding mechanisms. You can track funding rates online very easily. Find out how the lessor funds its portfolio: Commercial paper? Securitization? Long- or short-term? It’s all part of a good financial grounding that will help make sound decisions.

Above all, make certain to get as much help from within the company as possible. Stay apprised of the company’s fleet funding strategy by consulting with the treasury manager or CFO.

For a long time, funding a fleet for today was a different matter than funding for tomorrow, simply because rates were higher. Doing so in 2012, with rates in the low single digits and even lower, is a plan for tomorrow as well. You have an opportunity to lock into rates that you may not ever see again, so the time is right to take full advantage. FF

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