Tim Sattler, the Vice President of Commercial Leasing at Choice Financial in Grand Forks, has spent 20 years coordinating leases in the construction equipment industry, having managed deals ranging from $25,000 to $4 million.
In the world of banking, few can negotiate the enigma that is leasing. Even we bankers struggle to comprehend its scope. And yet, commercial leasing can often be a great option for your company — not to mention, potentially save you thousands of dollars.
I would describe leasing as a valuable lending tool, but also a misunderstood tool. At its most basic definition, it’s not unlike a loan, where an entity borrows money to acquire a piece of equipment or property. The terminology from a loan to a lease differs as well, in that every lease has a lessor, someone who leases their equipment or property to the user or the lessee.
There are many types of leases, but the three that I find to be the most popular are the tax lease, capital lease, and municipal lease. Let’s break them down.
“At Choice, we’re here to make your financial journey easier.”
Tax or Operating Lease
For simplicity sake, we will tie these two lease types together since they work similarly.
A tax lease is when the lessor is the owner of the equipment and receives the tax benefits of ownership, including depreciation and certain other tax credits. The lessee or the user of the equipment does not receive these benefits and credits, but may instead; claim the lease payment as an operating expense deduction.
“A tax/operating lease gives you more financial legroom.”
A tax/operating lease may give you more financial legroom compared to a traditional loan since most times there is no down payment required, the monthly payments are lower, and it does not tie your credit up.
Here is an example of how an tax/operating lease could work. The dealership has an established a price of $190,000 for a wheel loader. With a tax lease, the lease company, or lessor, may set up a lease that will run for five years. Times and terms can vary but we will use five years for this example. The lease company can set up a residual value, commonly called a balloon payment at the end of the lease. This number can be based off historical values, market trends, and or current fair market values — in this case, let’s say about $57,000.
The payment stream is based on the financed amount of $133,000.00 or the sell price paid down to the balloon payment ($190,000.00 – $57,000.00). At the end of the five-year term you will have paid $133,000.00 plus interest for the use of this loader. The next question is what happens at the end of the lease? You now have four potential options in dealing with the balloon payment of $57,000.00.
- You can elect to turn the equipment back to the leasing company and walk away from the lease.
- You can trade it in to a dealership and lease another new loader.
- You can take that $57,000 balloon payment and write the lease company a check, or the bank will finance that remaining balance and the loader is yours.
- It is also possible to release the machine again based off the $57,000.00 balloon payment.
The major benefit of a tax lease is that the product you are leasing does not show up as an asset on your balance sheet. It is treated as though you were renting. The lessee would write these payments off as an expense.
Why is this important? Well, if you’re a contractor, you need to be aware of the strength of your bonding status and the fact your credit is not tied up for other items you may need. The better your balance sheet looks, the stronger your bonding position becomes. Your balance sheet will look a lot better without a lot of miscellaneous loans tied to it.
Now it important to note that the FASB is currently reforming the tax lease laws, so these rules are subject to change in the next two years. Eventually, all leased equipment will show up on your balance sheet.
A capital lease is essentially the same thing as a traditional loan. In fact, one of the most common questions is, “Why wouldn’t I just get a traditional loan?” It is a good question but there are a couple key differences that can make a capital lease a better option.
The most prominent one being: no down payment.
Here’s an illustration. Farmer John is looking at purchasing a combine. Farmer John would like to depreciate that asset for tax purposes but wants to keep as much cash on hand as he possibly can.
With a capital lease, the combine stays on his balance sheet so he now has depreciation benefits for taxes and instead of having a large down payment of 20-25%, a lease can start with 1-2 monthly payments up front allowing Farmer John to keep a lot more of his cash.
A new combine can cost up to $780,000, a 25% down payment can mean a capital outlay of $185,000. With a capital lease, Farmer John only needs to come up with $25,000. Now he’s got $160,000 worth of liquidity, which can go toward purchasing fertilizer or other operating expenses instead of tying it up in a down payment.
“A capital lease allows you to have more liquidity for operating.”
Why do it then?
In the end, it all has to do with the mindset of the customer. Sometimes the customer wants as little as debt as possible. These customers are fairly liquid want to put down the 25% which is fine. But a capital lease allows you to have more liquidity for operating.
Many clients here ask — what about interest?
Typically, the payment amount is tied to a payment factor that is related to an interest rate. These payment factors will vary on credit score and types of equipment. If the interest on your loan is 4%, your lease interest rate can be as much as 4.3 – 5%.
A municipal lease is geared towards governmental entities. For instance, if you have a tax-exempt ID number, you are qualified to use a municipal lease. This includes cities, states, or county entities, school districts, or any other government organizations.
“A construction general contractor may have a 5.25% interest rate, but as a governmental agency, the school district can get a municipal lease from Choice for a 2.9% interest rate.”
The municipal lease is similar to a capital lease, with the added benefit of having a municipal or a tax-free rate.
For example, say the Grand Forks school district needs to lease a wheel loader for snow removal equipment. A construction general contractor may have a 5.25% interest rate, but as a governmental agency, the school district can get a municipal lease from Choice for a 2.9% interest rate.
Municipal leases are becoming more popular because of the rising cost of equipment. These kinds of leases can be used to finance anything from laptops to playground equipment. It is a very effective tool in controlling payments, cash flow, and interest expenditures.
How do I know which lease is for me?
In the end, it is always best to consult with your tax accountant and your Choice Financial advisor to go over the advantages and disadvantages. Be sure to ask about the leases discussed here, and how they could provide you with flexibility and potentially save you money. At Choice, we’re here to make your financial journey easier. Hopefully this list will give you a head start on deciding which type of lease can work for you.
Tim “T Sat” Sattler is the Senior Vice President of Commercial Leasing and Equipment Finance at Choice Financial, and that long title basically means he is the Master of Leasing. But what you might not know is he used to race Super Dirt Late Model race cars and is a “fairly decent drummer.” He also has the hidden talent of being a pretty good skid steer operator and loves operating a bulldozer. At Choice, he enjoys being part of the Choice culture, saying, “It truly is about people first and making a positive difference for our customers, communities, and teammates.” That, he says, makes all the difference.