Both real estate and movable assets (movables) can be considered as objects for financing through leasing. In the management of real estate there is always the acquisition of equipment, machinery, vehicles, for which the question of financing arises. This article gives an overview in its three parts and thus helps the house owner and manager to subject possible offers in all areas to a critical appraisal.
1. problem definition
Leasing is one of several alternative forms of financing. In addition to the quantitative comparison of leasing, in this case with credit purchase, the qualitative assessment leads to a critical examination of actual and supposed advantages of leasing. This aspect is particularly important because not all leasing effects can be quantified – even in monetary terms – but are nevertheless significant for the decision “lease or credit purchase”. The study sheds light on various aspects that can also be found in the advertising of major providers.
2.1. Useful life risk From the investor’s point of view, the useful life of the capital good is decisive:
2.1.1. Time limit
First of all, there is the risk that the investment object is definitely no longer available after the expiry of the basic leasing period, which depends on the form of the leasing contract. This is regularly associated with an expense for the procurement of replacements. If the need for replacement still falls within the basic lease term, problems may arise, among other things, from the question of the valuation of the old leased asset if the parties are unable to reach agreement. In the practice of the courts, too, the points of contention entwine around the terms “residual value, acquisition, realisation”. With regard to the further use of the leasing object after expiry of the basic leasing period, leasing does not offer any greater flexibility than a credit purchase: on the contrary, constellations are conceivable in which, e.g. due to a right of tender or an extension option in favour of the lessor, a commitment can also exist beyond the basic leasing period.
2.1.2. Basic rental period
If the basic lease period is less than the useful life possible at the time of purchase, the investor must examine the costs and burdens in detail. As a rule, the leasing instalments of the basic leasing period cover the lessor’s expenses or costs for acquisition, financing, administration, distribution, taxes, risks plus a profit margin. In particular, the proceeds from the sale – in the event of the sale of the purchase or leased asset – or, on the other hand, the net benefit from the continued use of the purchase or leased asset beyond the duration of the basic lease term must be compared by the investor with certainty of judgement. This is based on a forecast based in particular on foreseen price developments and technical progress. If the capital good were to be replaced by a new one at the end of the leasing period, the further financing costs involved or the savings for the purchase alternative together with additional costs for maintenance and care would have to be estimated.
2.1.3. Technical progress
It is not uncommon to hear references to greater flexibility of leasing, especially in the renewal of fixed assets. In this context, it is overlooked that the credit purchase usually allows to part with the capital good at any time, whereas in the case of leasing, the contractual basic leasing period usually has to be “kept through” in order to avoid compensation payments to the lessor. When deciding on a modernisation or replacement investment, leasing does not offer any advantages, because at the end of the basic leasing period the alternative “purchase or leasing ?” arises again. In addition, leasing has the disadvantage that until the expiry of the respective and possibly extended basic or fixed lease term, a replacement investment must be coordinated with the lessor for contractual reasons, at least in terms of time.
2.2. Financing effect Leasing companies often tout leasing as having a positive effect on corporate financing.
Since leasing is also an instrument of sales policy and leasing companies have in the past – at least apparently – been more risk-averse than banks, it has sometimes even been possible to achieve 100% financing of the capital goods. However, depending on the creditworthiness of the customer, this is also conceivable with banks. Moreover, in the case of bank financing, the repayment of the loan in a short period of time compared with the useful life corresponds to the discrepancy in time between the basic leasing period and the normal useful life of the leased asset, so that leasing does not offer any decisive advantage in this respect either. An accurate picture can only be obtained by examining the payment flows. Both banks and leasing companies may require additional collateral to be provided, so that the financing often only appears to be full financing. This also applies if no one-off payment is to be made when the contract is concluded. It should also be noted that, under the Bankruptcy Code, leasing companies with their right to separate satisfaction are in a better position than banks with their right to separate satisfaction in the case of assignment as security for a loan; this may result in a slightly increased appetite for risk on the part of leasing companies.
2.2.2. Risk premium
The possibility of greater financing impact results not only from the different position of lessor and collateral owner in bankruptcy, and consequent valuation differences in creditworthiness. When granting a loan – in whatever form – the lender calculates so-called risk premiums and risk surcharges into his interest rate in the broadest sense. In the case of leasing, the lower risk aversion, which is probably also motivated by sales policy, will therefore generally be bought. In calculating the leasing rates, the lessor is likely to apply a higher risk premium than is customary in the traditional credit business, which is often more stringent in terms of creditworthiness checks.
2.2.3. Golden rule of balance
The assertion that leasing complies with the golden balance sheet rule because there is no pre-, post- and interim financing does not stand up to scrutiny. The decisive factor is that the leasing contracts can take a course in which incalculable costs – in particular damages – are to be expected. The argument of conserving own or borrowed funds is not valid because payments to be made are a use of money or an entry in the accounts which is reflected on the assets side of the balance sheet.
It is not appropriate to make a fundamental assumption that liquidity is conserved in the case of leasing in comparison with the purchase of credit. Consequently, in the case of leasing, as in the case of credit, a large number of arrangements are conceivable, and tax issues also have an effect on liquidity.
2.3. Exploitation know-how
It is also occasionally argued that the leasing companies are able to calculate differently because they have a higher level of exploitation know-how – in particular through trading organisations operating on the property and used machinery market – and are also less bureaucratic. However, because prices on the goods market – unlike those for services – are “orderly” in the Schumpeterian sense, i.e. they come about over greater spatial distance through supply and demand, this argument is also unlikely to be very convincing. The investor also has access to the market of the asset he is leasing because he has also regularly chosen it. It is doubtful whether it is justified to conclude that the lessor has a better possibility of realisation, and even more so whether this does justice to the usual division of the proceeds of realisation between lessor and lessee.
2.4. Closing effectiveness
If you believe the advertising of the leasing companies, leasing should always have positive effects on the balance sheet and income statement.
2.4.1. Balance sheet effectiveness
18.104.22.168. Balance sheet protection
The leasing companies point out that leasing protects the balance sheet because no balance sheet is drawn up, i.e. an extension of the balance sheet is avoided. Leased assets and liabilities are not presented as assets or liabilities in the company’s statement of financial position at the end of the financial year. This should result, among other things, in a better balance sheet picture and a better credit rating.
Especially for reasons of competition, companies try to keep their investments secret from suppliers, competitors, and customers, which is supposed to be possible with leasing. It should be noted, however, that medium-sized and large corporations within the meaning of § 267 HGB pursuant to § 285 No.3 HGB, are required to disclose their other financial obligations in the notes to the balance sheet. A disclosure obligation may also arise from the Disclosure Act if two of the three variables “turnover, balance sheet total, number of employees” exceed certain threshold values. For this reason, balance sheet protection can only have a practically significant effect in a few cases, namely in particular when leasing can still avoid “advancement” to another company category or class within the meaning of the PublG or HGB. Therefore, a case-by-case assessment is necessary on this point. It is therefore not possible to make any general statements.
22.214.171.124. Balance sheet analysis
In the context of balance sheet analysis, a simple evaluation with ratios can produce an apparently more favourable picture of the debt-equity ratio, which signals a higher creditworthiness. However, it is crucial that professional lenders attach great importance to more detailed information, i.e. also on the scope of the lease financing. For example, banks regularly ask for business analyses, lists of totals and balances, or certificates from tax advisors and auditors in preparation for a decision on granting a loan. This makes it possible to calculate the cash or present value of the liabilities by way of capitalization, and subsequently to form a leasing external financing item. In lending practice, this is then additionally entered in the balance sheet by way of calculation; by forming the ratio with the equity capital, this leads to the disclosure of the actual degree of indebtedness. In addition, a serious analyst will of course also include in the balance sheet the assets that are not included in the balance sheet, in this case the leasing objects. In any case, from a business point of view, liabilities from continuing obligations, in particular from leasing, must be taken into account in determining the debt-equity ratio, irrespective of their weighting and valuation.
The argument “pay-as-you-earn” is often used, which is supposed to mean that the financing is made from the current income: Thus, a parallelism of the payment flows from income due to the use of the leasing object and the payments of leasing rates is assumed here. This is misleading, since even in the case of leasing there is no guarantee that the investment, which is mentally project-related, will turn out to be profitable or have an effect on sales or earnings. The payment obligation with regard to the leasing instalments is not performance-related, and appears as an immediate burden on liquidity in that the first instalment must be paid regularly before there is any entrepreneurial income at all. Moreover, the question of whether the asset was financed by leasing or credit purchase is irrelevant to the profitability of the investment. A detailed examination of the effect of bank interest and depreciation compared to leasing rates is the subject of qualitative analysis.
2.5. Investor Risk
From the investor’s point of view, the following distinctive risk aspects still arise:
2.5.1. Ownership risk
Leasing and credit purchase do not show any relevant differences here, because the lessor is indemnified by the lessee – for example against the risks of loss and damage. In the case of leasing, the investor can withdraw the leasing object from the entrepreneur or terminate the contract more quickly in the event of a financial crisis due to the leasing companies’ more effective access options in practice. The claim for damages arising in the event of premature termination would have to be compared quantitatively with the bank’s default damages; in this respect, leasing is likely to prove less favourable to the investor.
2.5.2. Warranty risk
There do not seem to be any significant differences here, because the lessor generally assigns the manufacturer’s or supplier’s warranty to the lessee, and is therefore not involved in the handling of such matters. For the lessee, however, there is a twofold advantage compared to the credit purchase: Firstly, in this case he does not bear the bankruptcy risk with regard to the supplier or manufacturer. If the supplier goes bankrupt or the manufacturing company is liquidated, the lessee remains entitled vis-à-vis the lessor to terminate his leasing instalment payment and to reclaim any leasing instalments made. In addition, the lessee – in contrast to the purchase of a loan – does not have to pay the leasing instalments if the leased object is not fit for use in the legal sense from the outset.
2.5.3. Risk of misinvestment
Leasing does not show any noticeable differences to purchase with regard to the risk of bad investment. In both cases, the investor bears the disadvantages arising from misconceptions about the possibility of use, from new technical developments and the associated fall in prices, from internal changes – in particular the need for rationalisation and replacement investment, from the emergence of competing products and changes in market demand. Leasing appears to be less flexible here because it usually involves contracts with a fixed basic rental period: During this period, even if it no longer makes economic sense, the investor is usually contractually prevented from discontinuing care and maintenance or from using the object for a purpose other than that for which it was originally intended. Insofar as it is argued that leasing reduces the investment risk due to the shorter period of formation compared to credit purchase, this is a fallacy: The shorter useful life in the case of leasing can also be achieved in the case of purchase; in both cases, this results in higher costs due to replacement investment brought forward in time or shorter useful life than originally once planned.
2.5.4. Liquidity risk
The argument that leasing puts the company in a better position to take advantage of business opportunities that arise at short notice because the capital base is not so tight is beside the point. In practice, the decisive factor is which credit line the company has with which lenders: In this context, it is not only conceivable that the leasing financing remains hidden from the house bank, but also that the house bank does not become aware of the extent to which further liabilities exist with which other credit institutions. In view of this, leasing advertising occasionally appears to be an invitation to the customer’s bank not to inform the customer of the true extent of financial obligations, despite the customer’s obligation to inform the bank as a rule, or to reckon with an erroneous failure to take into account the leasing object and related liabilities. The starting point for the question of liquidity is the credit rating, which in turn is based on the total debt: It is therefore doubtful whether leasing actually conserves the investor’s credit line or reduces dependence on financing sources – for example supplier credit. If complete and correct information is available to all lenders, the lessee’s future credit margin is likely to be reduced as a result, even in the case of leasing. It is probably true that leasing can be less bureaucratic than bank loans because of the more effective organisation in terms of sales policy. In the long run, the reference to budget flexibility is also irrelevant, because the assessment of the financial situation must also include all those commitments that less dependent employees in the company organisation were allowed to enter into within the scope of their assigned competence. Decision-making authority of employees within the scope of delegation does not lead to an expansion of the budget elasticity of the respective lessee. Incidentally, it would also be a mistake in this context to compare only the first leasing instalment, rather than the accumulated liabilities to the lessor, with a credit obligation in the case of leasing.
2.5.5. Cost risk
Just as credit institutions can generally adjust their prices, in the case of leasing constellations are conceivable in which the basis for planning and costs may cease to exist. The greatest imponderables arise from the question of the residual value of the leasing object at the end of the contract. In any event, fixed leasing rates alone are not a clear or sufficiently transparent basis for calculating costs. With regard to the development of interest rates, leasing does not offer any better protection against surcharges, because credit institutions are also prepared to enter into fixed interest rate agreements. In addition, it should be pointed out that no hidden reserves can be formed with leasing. It also cannot be pointed out clearly enough that an assessment of the comparative calculation and leasing conditions can only be made on a case-by-case basis.
2.5.6. Service risk
Leasing offers no advantages over buying when it comes to administrative overhead or additional service. The service fringe benefits can also be obtained by a buyer on the open market from special companies: This can even be cheaper, because the competition is not limited by a leasing commitment as a so-called “full service” or the like. Non-in-house management brings with it the disadvantage of increased control effort, so that the obvious advantages of accounting, depreciation, asset accounting, disposal, etc. can be more than compensated for by the lessor.
2.5.7. Information risk
It is not infrequently pointed out that the lessor has better information about the market and the leased asset, and that this makes the lessee’s decision – with the lessor on his side – more secure or well-founded. This is to be countered by the fact that the lessee must always refer to the supplier or manufacturer with regard to possible breaches of obligations to provide information and advice, even if the leasing object was purchased by the lessor directly from the supplier. It is true that it is increasingly difficult for a lessee without basic knowledge of financial mathematics to compare leasing offers because of the great diversity in the design of leasing offers; this applies all the more to the comparison with credit purchase. Moreover, it is an open secret that manufacturers like to sell low-selling products through subsidiaries, namely leasing companies. Finally, it is not only true within the leasing sector, but also in relation to the traditional lenders for a purchase acquisition, that price comparisons and negotiations are often worthwhile because of the competition. It should also be borne in mind that manufacturer-independent leasing companies may be more interesting to potential lessees because of their greater distance in terms of advice and choice.
2.5.8. Bankruptcy risk
A particular handicap is the fact that leasing companies – unlike banks and insurance companies – are not subject to state supervision. Moreover, there are no legal conditions of access to the opening of a leasing company. Therefore, the investor is well advised to inform himself about the creditworthiness of the lessor before concluding the contract or, in the case of large projects, to insist on a letter of comfort from the parent company of his lessor. Otherwise it is conceivable that the lessee will find himself in a situation in which his better position as lessee – cf. point 2.5.2. – is now economically worthless.
2.6. Non-leased goods
It should be noted that the state investment and economic development programmes of the Federal Government, the Länder and the European Communities do not take leasing into account. Only the purchase on a credit basis is subsidised by the state or supranationally, but not the leasing alternative. Finally, it should be pointed out that the above aspects must be assessed in each individual case, depending on the sector and company structure, and that the quantitative analysis should also be used for a decision.
The order of presentation does not represent any weighting in this respect. Bibliography for Part III: Feinen, Klaus: Das Leasinggeschäft, Frankfurt 1990 Giovanoli, M.: Le Cr�dit-Bail (Leasing) en Europe – Developpement et nature juridique, Paris – Librairies Techniques 1990 Perridon L., Steiner M.: Finanzwirtschaft der Unternehmung, 6th edition, Munich 1991 Spittler, Hans-Joachim: Leasing für die Praxis, Cologne 1990
by RA Dr. Johannes Fiala
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Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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