Vinod Kothari's leasing site

Operating leases:

Any lease other than a financial lease is an operating lease.

Operating lease does not mean the lessor operates the asset - any lease other than a financial lease is operating lease.

In a financial lease, the lessor does not operate the asset he leases, he merely finances it. Does the name "operating" lease mean the it is the lessor who operates the leased asset? Well, that might have been the meaning years ago, but today, the word "operating lease" is applied with no indication to the lessor operating the asset, but only a contra-distinction to financial leases.

Therefore, any lease where lessor takes a risk other than a plain financial risk is an operating lease.

This would include a variety of lease plans with differing add-ons or leave-outs by different lessors but broadly falling into two categories:

Short term rentals
Long term cancellable leases

The first category includes hiring of utility assets for short periods - say, hiring of a car for a day, or furniture for a function at home, etc. These hirings are done by agencies specialized in this respective hiring, and since these assets are hired for a very short-term need, these are not included in the caption "lease" at all. Understandably, such rentals are highly commodity-specific, and including these all as a part of the "operating lease" category would bring into fold an extremely variegated, mutually unrelated asset-rental activity.

So what is included in the "operating leasing" industry is such asset renting where the user needs the asset for long term, but he does not commit himself to any permanent usage or a very long term. In other words, the lease is long term, but is cancellable.

Within this long-term but cancellable lease variety, it is possible to have:

Full service leases
Net, but cancellable leases

A full service lease will imply the lessor will run and maintain the asset. Such leases are common in case of cars, earth-moving equipments, etc. It makes good sense for the lessor to run and maintain the asset, because thereby the lessor can control his asset-based risks.

Hybrid operating lease are virtually financial leases, but with an element of asset risk with the lessor - the lease period is partly cancellable, and the lease is not full payout.

In some cases, a lessor would take the risk of obsolescence by providing the cancellation option, but would not operational or maintenance responsibilities. This is almost a financial lease by structure, and might be non-cancellable for a substantial part of the asset life to allow the lessor to recover a major part of his investment; thereafter, the lease is cancellable at the lessee's option. This is more common in case of plant and machinery. Such leases are not operating leases in the strict sense as they are non-cancellable in part; they are also not financial leases as the lessor does carry a risk, albeit limited risk, on the asset value. Such leases can be called hybrid operating leases or hybrid financial leases.

A prototype operating lease:

Whereas financial leases are more or less similar, operating leases take innumerable forms - based on the risks the lessor takes or avoids, and the involvement of the lessor in operation of the asset. Besides, operating leases are still in emerging form, and there are no standard operating lease plans.

The following is, however, one possible operating lease example. This is a re-statement of prototype financial lease example taken earlier.

Company A wants to acquire a boiler of a particular specification. It would cost $ 100,000.

Company B is prepared to give it on operating lease on lease rentals of $ 22.50 per month payable monthly in advance, for a non-cancellable period of 4 years, and thereafter, cancellable at the lessee's option.

Let us suppose the deal is to be put through.

A will be allowed to negotiate all commercial terms with the supplier including the technical specifications. B would walk in after everything is finalised: B would place its orders in the terms A instructs, and acquire the asset.

The asset would be put on lease for 48 months non-cancellable period; thereafter, the lessee has the option to renew the lease at the same rental or to return the asset and close the lease.

All operation and maintenance will be the responsibility of the lessee.

Returns in operating leases are residual-dependent

This model has been drawn on the basis of the financial lease example above, but there are significant differences. Most significantly, the non-cancellable lease period is only 4 years, during which the rental charge does not fully payout the lessor. In other words, the lease is non-full payout : after paying off the lessor over 4 years, the lessee may decide to go for an alternative equipment. As the lessor would not have recovered the whole of his investment over the fixed period, he depends on the value of the asset at the end of the lease period, viz., residual value for recovery of the balance. He might make a profit or a loss in the deal depending upon the actual residual value of the asset - therefore, the lessor's returns in an operating lease carry a residual dependence. As a matter of fact, an operating lease is an investment in the value of an asset, and therefore, it is never possible to pre-estimate the returns from the operating lease.

Note one striking feature: though hypothetically, but we presumed that the rentals in the above example are the same as in case of financial lease. Is that possible? Is it possible that the lessor charges the same as in the financial lease example, and yet significant risk on the value of the asset?

Yes, it is quite possible that the operating lease rentals may be the same, or in fact, lower than those of a financial lease. This is based on the lessor's estimation of the residual value of the asset - in a financial lease, this value has no significance since all the lessor would get is the pre-fixed rental. In the example above, the lessor may continue to get the same rental for the 5^th, the 6^th and the 7^th year, if the asset has substantial value. Or, he may make a profit by sale of the asset at the end of 4^th year.

Features of an operating lease:

Once again, as an operating lease itself fails a standard definition, there are no standard features of operating leases. However, the basic features that differentiate it from a financial lease are as follows. Once again, the following is a re-statement of the features of financial leases noted earlier:

Operating leases may not allow the asset to be virtually exhausted by the same lessee: a rental transaction, for example, allows an asset to be used by a series of users.

Operating leases do not put the lessee in the position of a virtual owner: in full service rentals, the lessee is merely using the asset. Even in case of hybrid leases, the lessee does not have the same commitment to the asset he has in case of owned assets.

The lessor does take asset-based risks and asset-based rewards: the extent of such risks and rewards differs based on the nature of the lease. In a full-service operating lease, the lessor is directly affected by the state and efficiency of the asset. In a hybrid lease, the lessor carries a residuary asset-based risk. Hence, the lessor takes both financial risks and asset-based risks.

The lease is either fully cancellable or partly non-cancellable and partly cancellable, meaning the lessee can return the asset and not pay the whole of the lessor's investment.

In this sense, operating leases are non-full-payout, meaning the full repayment of the lessor's investment is not assured by the lessee.

In an operating lease, the lessor may provide any services relating to the asset, such as maintenance, or operations. In such case, the lease is wet lease.

The risk the lessor takes is asset-based risk; of course, there is always a dependence on the lessee's commitment to pay, and hence a lessee-based risk. The value of the asset is important not only from the viewpoint of security of the lessor's investment, but the value itself determines the lessor's returns.

In operating leases, the lessor's rate of return is dependant upon the asset-value, performance, or costs relating to the asset. The fixed lease rentals cannot give rise to an ascertainable rate of return on investment. Therefore, the implicit rate of return in an operating lease is always a matter of probabilities and is uncertain.

Financial leases are technically as well as substantively different from secured loans.

The move towards operating leases:

It was noted earlier that there has been a growing awareness among regulators, taxmen, and accountants that a plain financial lease is no different from a secured lending. Hence, there has been a strong tendency towards equating the two.

Move towards operating leases is partly for tax and accounting motivations

Operating lease, a developing part of the leasing industry, has been propelled both by market forces (basically the need to distinguish the lease product from other financial products) as also by such regulatory tendency. Accounting standards in many countries have long recognized the substance of financial leases and put leased assets and liabilities on the lessee's balance sheets. Tax laws also over years have moved from granting asset-based tax allowances to every lease to only such leases which qualify as true leases and that term would exclude a strict financial lease. The move towards operating leases, particular the hybrid leases, has been helped largely by such regulatory developments, and the trend would understandably continue.

Carry on (recommended)

Contents

Go to Start Page of Primer

Go to Financial Leases

Send comments to the author

Leasing primer by Vinod Kothari - operating leases