There are a number of tough decisions that fleet managers will be faced with during their careers. But, perhaps the biggest is helping to determine whether their companies’ fleets would be better served being leased than owned.
Most likely this isn’t a decision left solely to a fleet manager, but to the extent it is, he or she can help senior management reach an informed decision. And, if the answer is leasing, it will undoubtedly be up to the fleet manager who will lead the negotiations to getting the company the right deal for the fleet.
Leasing can involve more complex negotiations to get the most for the fleet dollar. For those new to leasing, pursuing this method of fleet acquisition can be overwhelming, particularly while negotiating lease terms. But, it doesn’t have to be.
To Lease or Not
There are a number of considerations to evaluate when making the decision to move from an ownership to a leasing model for a company’s fleet.
“Every decision in fleet, from what type of vehicles to select, to the services and the type of lease structure, should be evaluated based on your company’s overall goals and culture,” said Laura Jozwiak, vice president of client relations for Wheels. “If your company currently owns, and you would like more flexibility on when to replace and how many to replace, leasing provides that flexibility.”
In these times of tight budgets, leasing could provide another big advantage, according to Jozwiak. “Instead of seeking approval for a capital budget expense, which is typically required under an ownership model — and may or not be approved for the full level you requested — you could move to leasing which offers mitigation of up-front sales tax in most states, flexibility on when to replace vehicles, freeing up capital, and many other valuable advantages.”
Time is another consideration to make when evaluating the pros and cons of leasing. “If you cycle your vehicles four years or less, you’d probably want to lease the vehicles,” according to Tom Coffey, VP sales and marketing for Merchants Fleet Management. “There are also the identifiable accounting and tax benefits that you should consider.”
Echoing Coffey, Bryan Steele, senior vice president, client relations for LeasePlan USA, said that there are five primary reasons to consider leasing over owning:
- Pay only for the usage of the vehicle.
- Avoid diverting capital away from business objectives.
- Possible off-balance sheet reporting.
- Predictable budget; one lower monthly payment.
- Tax benefits.
For Paul Azores, controller for ARI, how leasing feeds the bottom line is paramount. “With leasing you’re trying to maximize cash flow. There are no up-front fees and you can use the excess cash you save to reinvest in the core business,” he said.
On the Day-to-Day Business Side
Jim Kachidurian, SVP client services for Donlen, noted that leasing makes sense because it requires less administration on acquisition, titling, and remarketing. “Tying up capital to acquire vehicles may not be a good business decision,” he said. “It’s better to concentrate on your core business.”
For Tim Mundahl, senior strategic consult, GE Capital Fleet Services, leasing is a win-win for fleets.
“Leasing often provides all of the benefits of owning fleet vehicles plus the cashflow benefit of paying rental tax over time versus up-front sales tax in rental tax states — approximately two-thirds of the states are rental tax states. Leasing often has a positive net present value (NPV) versus up-front purchases when discounting at a company’s true opportunity cost of capital,” he explained. “Leasing also takes the acquisition of fleet vehicles out of the arduous fight for capital allocation budgeting process, is easier to administer, normalizes cash-flow while purchasing, creates ebbs and flows, and through a fleet management company leasing provides complete reporting, ease of ordering, discounts on acquisition costs and many more benefits.”
While Mundahl is an advocate for leasing, he does concede that there are times when owning makes better sense.
“For example, infrequently used vehicles and specialty-use vehicles with a limited resale market might be better candidates for purchase,” he said. “Finally, companies in danger of violating restrictive covenants on their debt instruments need to evaluate the impact of leasing as part of their consideration.”
Establishing the Goal
Once the fleet has determined leasing instead of owning is the best option, then it will need to issue a request for proposal (RFP), but there is a step that fleets need to take prior to asking for bids. They should establish the goal of the leasing program, according to the experts.
“The most fundamental question to ask when requesting a bid is what type of lease is being offered,” explained Mundahl of GE Capital Fleet Services. “Companies need to know if the lease has mileage limitations, if the lease is closed-end or has a set end date, who is taking the residual risk on the vehicle, what amortization term is assumed, what the interest rate index is and if it is publicly available, what burdening or rounding will impact the rate, what is the interest adder, what is the management or administrative fee for the lease, are there any document or commitment fees, who will be getting the tax benefits of the lease, and, finally, if the lease can be considered an operating or capital lease. On some occasions, a lease will be presented simply as a monthly payment and it behooves a company to understand what parameters make up that payment.”
Jozwiak advised the focus should be on answering fundamental questions.
“What is your definition of success for the bid? What is the business issue that we need to solve? Knowing what is important to you, those ‘must haves,’ will help you properly score in an objective manner and create the best outcome for your company,” she said.
Azores of ARI added that fleets need to understand how their vehicles are being used, what the replacement schedules are, where they’re being used, and the fleets’ funding sources. “And, you need to know if you can fund the rest of the business and set the payment to reflect exactly how you’re managing the fleet,” he said. “You also need to know how the fleet management company is managing the total cost of ownership, such as fuel and maintenance.”
Coffey of Merchants Fleet Management echoed Azores. “I think it’s incumbent on the fleet manager to know the strengths and weaknesses of the FMC. And, you have to determine which existing FMC has the tool kit you need to manage the fleet without having to make drastic changes.”
Steele of LeasePlan USA expanded on the FMC theme. “What is the liquidity position of the fleet management company that you are considering? You need to make sure that the fleet management company that is selected has the ability to fund the vehicles,” he advised. “What are the various types of lease offerings that are available — open-end, closed-end, or, if the company is considering ownership, is there a purchase and disposal program available?”
When requesting lessor bids, specificity is a “must.” Lessors must have specific data on the company, vehicle, and service needs to prepare a suitable response to a bid. Remember, a lease quote is a function of the vehicle’s capitalized cost as well as the lease payment rate factor, so it’s important to provide prospective lessors with vehicle types, models, equipment, anticipated mileage, and vehicle usage.
This allows the proposal quotes to be based on the fleet’s specific vehicles as opposed to generic dollar-value quotes, which assume all capitalized costs will be the same.
“The key ingredients required to give a realistic picture on pricing is: what type of vehicle do you purchase, what are your replacement miles and months, how many vehicles do you have in the fleet, and what services are required,” Jozwiak said. “The best bids we see give a very specific vehicle to quote on, along with MSRP, manufacturer incentive, options, date in service, date out of service — all the key events for your one main vehicle so it helps you gain insight into all the potential pricing terms. The more information you can provide, the more accurate pricing picture you will receive.”
Mundahl of GE Capital Fleet Services noted that providing the information needed by FMCs to develop an RFP is straightforward.
“The easiest way to provide a fleet management company with pricing information is to provide it a fleet inventory list showing year, make, and model plus months in service and current odometer readings,” he said. “A fleet manager should also indicate his or her preference for floating rates, fixed rates, or both and their preferred amortization term by asset. Other information includes desired payment terms, preference for operating or capital lease structure, and lessor or lessee retention of IRS tax benefits.”
Kachidurian of Donlen also added that the FMC needs to know are how the fleet is administered. “Among the things an FMC bidder needs to know how vehicles are sold, maintenance is handled, and what administrative services would be needed,” he said.
The reason for this specificity is simple. Without it, the fleet will not receive an accurate bid, according to Steele of LeasePlan USA.
“By not providing the appropriate information, it can impact the pricing components,” observed Steele. “It is also important, under an open-end lease, to understand the appropriate depreciation to be utilized based on the useful service life of the vehicles. This potentially could impact the book value of the vehicle at time of resale, which, in turn, will determine the lessee risk on resale. From an operational perspective, it is important to understand the usage of the vehicle so that the proper replacement cycle is utilized to minimize maintenance expenses and downtime.”
Coffey of Merchants Fleet Management also noted that the RFP should clearly state its goals. “We want to know how you operate and how you’d like to operate. For instance, if you’re looking for full outsourcing, but don’t make it clear in the RFP, then you won’t get an appropriate response.”
Giving a full picture of the fleet as it is and as the fleet manager hopes it will be is crucial in developing the appropriate plan for the fleet, according to Craig Neuber, director of strategic consulting for ARI.
“The overarching answer is that the more information a company provides regarding usage and application, the better both parties will be,” he said. “It’s very rare that there is a one-size fits all solution for a fleet. Typically, the best solution is tailored to suit the specific needs of a certain fleet. And, depending on the vehicle usage, there might be instances when a company may be looking for a closed-end lease and usage may steer it toward an open-end lease; this is a case where the information provided to the FMC will allow it to hand tailor a solution.”
Understanding Leasing Fundamentals
There are two basic types of vehicle leases, each with many variations: closed-end and open-end.
The closed-end lease will cover a fixed term with level payments, mileage limits, and, most important, the depreciation risk lies with the lessor (subject to “normal wear-and-tear”).
An open-end lease can have either a fixed or open-ended term with a terminal rental adjustment clause (TRAC) where the lessee assumes the depreciation risk or benefit when the vehicle is resold. The lease terms for each of these lease types will impact the ultimate net cost of the lease.
Choosing the Best Lease
In addition to finding a lessor, probably the biggest decision a fleet will have to make is whether to go with a closed-end lease or an open-end lease.
“There are advantages to both open-end and closed-end leases,” observed Steele of LeasePlan USA. “It is simply a decision that makes the most financial sense to the organization.”
Closed-End Lease. Available lease terms range from 12 to 60 months, although most cover 24 to 36 months. They require fixed monthly payments, limit mileage (with penalties for excess mileage), and hold the lessee responsible for excess wear-and-tear.
“With a closed-end lease, the payment is based on a fixed interest index for the term of the lease,” observed Tom Casey, national vice president, client relations, LeasePlan USA. “Residual value risk is assumed by the lessor, not the lessee, resulting in a fixed, budgetable payment for the term of the lease. The lessee does remain responsible for excess mileage and abnormal wear and tear charges. This is typically a better choice for risk-averse companies.”
Jozwiak noted that the advantage of a closed-end lease is predictability. “Closed-end makes sense for a company that is looking for a predictable, flat payment each month and has the time to be mindful of excess mileage and turn-in parameters, to keep the costs down,” she said.
GE Capital Fleet Services’ Mundahl noted that there are a number of restrictions fleets should consider when examining a closed-end lease. “A closed-end lease is often more restrictive from a usage perspective,” he said. “If a fleet is certain of the mileage and months it intends to use an asset, it should consider a closed-end lease. Because the lessor holds the residual risk on a closed-end lease, that instrument contains substantial penalties for excessive wear-and-tear, over-mileage and under-maintained vehicles. Lessees do not get to share in the resale upside on vehicles that are sold at a higher value than the residual which was set in the contract.”
Coffey of Merchants noted that fleets with global operations typically find closed-end leases as the ideal.
Open-End Lease. This is a fixed-term lease that offers payment levels that typically run from 24 to 36 months, although lease terms from 12 to 60 months are also available. A residual value is agreed on at the lease inception, and, when the vehicle is sold, the sale proceeds are applied to this unamortized value with the lesee receiving the excess or the lessee will be held responsible for the difference.
“Open-end leases are very well accepted in the fleet management space,” said Kachidurian of Donlen. “It’s a transparent and flexible product.”
A flexible term lease will establish an amortization (depreciation) rate for the vehicle and provide declining monthly payments for each 12-month period since the rate factor is applied to the average unamortized. After a minimum term (usually 12 months), the vehicle may be terminated, at the lessee’s option, at any time. The vehicle will then be sold with the lessee’s gain or loss determined by applying the sale proceeds to the unamortized or “book” value of the vehicle.
An open-end lease is generally better suited to larger, high-mileage fleets. It typically provides a greater flexibility and economy (dependent on a good used-car market and maximized sales results) than a closed-end lease, but requires close attention by some level of in-house fleet management.
As with closed-end leases, Jozwiak sees both advantages and disadvantages of open-end leases. “Open-end leasing provides transparency, flexibility, and typically lower overall costs,” she said. “However, you do take on the residual risk of the vehicle at time of sale, which right now, our open-end clients are giddy about. Again, both are valid options — a fleet just need to discover what is important to it and the best lease can be matched up to its goals.”
The No. 1 factor that fleets have to determine when deciding on a lease type is their tolerance for risk. “With an open-end lease, there is risk that the market value of the vehicle may be less than the remaining book value of the asset resulting in a loss to the lessee at the time of sale,” observed Casey of LeasePlan USA. “This risk is mitigated, but not eliminated by setting the proper amortization schedule at lease inception. Open-end leases are usually funded with floating rate interest indexes (LIBOR), which can go up over the life of the lease, resulting in increased interest expense.”
Mundahl sees the open-ended lease as the better solution. “An open-ended lease is often the better solution because the lessee is truly only paying for how much they have used a vehicle,” he said.
No matter which type of lease that a fleet chooses Donlen’s Kachidurian said there is one pitfall that should be avoided.
“The big pitfall that many fleets fall into is focusing on price, but the focus needs to be on total costs vs. simply upfront transaction costs,” he said.
That being said, Mundahl noted that fleets have to be on the lookout for hidden fees. “Be aware of invoice charges, interest escalators or floors, excess mileage penalties, excessive wear and tear penalties, rounding or burdening of interest indices, documentation or origination fees, additional fees for the processing of upfitting invoices, etc.,” he said. “However, the biggest pitfall to avoid is getting caught up in focusing on the interest and fee portion of a lease and losing sight of the total cost of leasing and operating the vehicle over its lifecycle.”