Basic questions to ask for a lease
TERRY J. WINDERS
Traditional balance-sheet lending works well for commercial loans, but it is not adequate for equipment leasing, where characteristics of the equipment affect the creditworthiness of the transaction. Too many bank leasing departments decide to make a lease without considering important facts about the equipment itself. Asking the proper questions about the equipment may help you strengthen the credit or make you question it.
Here are 13 questions you should ask about the equipment underlying every lease.
Can You Describe the Equipment Completely?
A complete equipment description sounds simple; however, an adequate description rarely makes it to the lease agreement. Vendors have idiosyncratic identification systems that may be unclear to you. Even after you have the invoice in hand, you usually must telephone the vendor to understand the equipment, how it is identified, and what is or is not an attachment or special part. Many lessors have tried to retrieve their equipment from bankruptcy trustees, landlords, or other creditors, only to find that a poor description makes it difficult or impossible to identify and claim the leased equipment.
It is important to include a plain English description of the eqiupment-as well as the more technical information-on a Uniform Commercial Code (UCC) filing. Otherwise, inexperienced purchasers may think your equipment is lien free and buy it from the lessee. The UCC filings would give you the right to retrieve your equipment, but once it has been sold out of trust, it is almost impossible to discover who purchased it and where it is. Even if you can learn who purchased the equipment, you probably will face a legal fight to establish your right to the equipment.
Proper description also allow you to use guidebooks to distinguish the particular equipment being leased form similar equipment and to verify the proper purchase price. Many times vendors give sloppy descriptions to conceal price increases to handle payoffs on poor trade-ins, unpaid repair bills, or even kickbacks to your customer. Lack of proper or complete equipment descriptions indicates that something is amiss in your lease request.
Who is the Manufacturer and How Strong Is the Distributor or Vendor?
Manufacturers and distributors of new technology sell equipment with lots of sizzle, but they themselves tend to be low on experience. Leasing equipment based on a new technology is a major risk if the manufacturer or distributor does not have the staying power to remain in business over the life of the lease. The manufacturer must be financially secure to supply spare parts and to live up to warranties and guarantees. A strong lessee is little comfort when equipment fails to perform and the distributor is out of business. Lessees hate to pay for equipment that doesn’t work and will use every legal method available to stop paying rent.
Even for proven equipment, a distributor or vendor in weak financial condition could cause hardship and expense for your customer. This could have a material effect on the creditworthiness of the transaction.
In general, distributors that are in poor financial condition make promises that are difficult to keep. Discuss with your lessee all warranties and guarantees, both verbal and written, offered by the vendor. View unusual promises with skepticism; avoid distributors who make such promises.
How Do Total Costs Break Down?
Vendors usually are very reluctant to break down the total cost of the equipment. By investigating the proper description and identifying each individual piece of equipment or attachment, you can learn what proportion of the total cost is hard costs, or costs for the equipment itself. The remaining soft costs are generally irretrievable. They include installation, transportation, site preparation, permits, taxes, training, after-the-sale support, technical assistance, extended service, extended warranty, insurance, operating software, licensed software, and so on. The mere existence of soft costs should not cause alarm about a potential lease. However, it is important to identify soft costs in order to assess the value of the leased equipment.
Occasionally, improper sales tax is assessed because soft costs such as transportation, site preparation, and technical assistance are included in the equipment cost. If these items are separated out, the extra sales tax may be avoided. Also, proper identification of all costs is necessary to evaluate the term and structure of your lease.
What is the Useful Life of the Equipment?
Unfortunately, many bankers and lessees are accustomed to arranging leasing terms that match loan terms. Just because the customer may have used five-year financing before does not necessarily mean that five years is the correct term for the lease. The term should match the period that the lessee plans to use the equipment.
In many cases, the useful life of the asset depends on use. For example, a forklift may be used either in a foundry to handle forms of molten metal or in a candy facotry to load boxes of marshmallows on the back of a delivery van. The useful life of this equipment varies substantially because of these two uses. The collateral value of equipment under lease is therefore very dependent upon its use. It is necessary to determine how your lessee is going to use the equipment and then match the term of the lease to the useful economic life of the equipment.
Leases with terms that do not match the use of the equipment generally incur larger losses in default because customers had sought longer terms to improve cash flow. The lessee who seeks a term of lease that is longer than the useful life of the equipment ultimately presents a risk to the lessor.
Where Will the Equipment Be Located?
Will It Be Moved?
The location of equipment is important for many reasons, especially for tax considerations. Your lessee is responsible for paying all taxes assessed on the equipment (except your income tax). Nevertheless, if the lessee fails to pay, you will be responsible for the unpaid tax because you are the registered owner of the equipment. Lessees often move equipment from one tax authority to another (usually from one state to another). If the equipment is on site when the local tax is assessed, taxes may be due and neither you nor the customer may know about them.
A change in location sometimes signals a change in use. Many companies start out with an assumption about how the equipment will be used, but changes in business may cause them to make a change. This is common with companies that have multiple subsidiaries engaged in different types of business. It also is not uncommon for your equipment to be subleased for idle periods. Explain to your lessee that any change in location or use must be reported and that this change may result in an adjustment in rent or term. It may be wise to require in the lease documents that any change in location must be reported or be held in default.
Who Will Operate the Equipment?
Asking who will operate the equipment gives you the opportunity to inform your customer about unauthorized use. The equipment should be used only by company personnel on company business. As the owner of the equipment, you must be sure that no one outside the company can operate the equipment and that no employee can use if for personal use. Unauthorized use generally invalidates insurance and sometimes invalidates the manufacturer’s warranties and guarantees.
On occasion, some types of equipment may require special technicians or operators. You should investigate how this affects the value of your equipment. Often, equipment values can suffer as much from a shortage of experienced personnel as from the lack of a secondary market.
When Will the Equipment Be Delivered?
The delivery date determines when your equipment lease begins; often this can be up to 90 days in the future. Therefore, you may quote a lease rate as a function of prime or some other benchmark to maintain your spread if interest rates change.
This covers your rate risk, but delivery dates also raise other issues to discuss with the customer. For example, an immediate delivery generally means that the equipment being replaced has failed and the need for a replacement is critical. This should make you ask whether the replaced equipment was used beyond its useful life and question whether or not the lease term is appropriate. The equipment may have failed during a period of heavy use; therefore, a new lease in full years would end at the wrong time of year in the middle of the heaviest use. Try to decide the best time for a lease to end, so your customer does not have to make important end-of-the-lease decisions at inopportune times.
Is This Replacement or Additional Equipment?
The question of whether the equipment is replacement or additional leads to the cash flow to pay rent. If the equipment is additional, it may depend on revenues form increased production to pay your rent. These revenues may be in the future after the product has gone to market. Therefore, rent may need to be smaller at the beginning of the lease to compensate for lack of funds.
If the equipment is being replaced, information about the useful life of the old equipment would be valuable for structuring the lease.
What Will Be the Costs of Removing the Equipment?
The value of equipment that requires special wiring, major site preparation, or unusual installation procedures can be eroded seriously by the cost of removing it. High removal costs usually eliminate residual value of the equipment and give rise to serious tax questions. If removal costs cancel out the value of the equipment, it can be said that the equipment has a single use-good only to the user. Therefore, the IRS would consider it to be purchase or financed-not leased for tax purposes. To qualify for a lease, the equipment must have multiple purposes, and it must be possible to remove and reassemble it at moderate expense.
Will the Equipment Need Major Maintenance during the Term of the Lease?
If the equipment will require major expenditures for overhaul or repair, the customer may not be able to meet rental payments and pay for the overhaul simultaneously. Compare the number of hours the manufacturer suggests the equipment be used before an overhaul to the number of hours your customer plans to use the equipment. Then plan your rent to compensate for major repairs or overhauls.
If a major overhaul is necessary when your lease ends, keep this in mind when evaluating your residual risk. Also, knowledge of the timing of major repairs should affect your collection effort if your customer begins paying slowly. Lease terms that do not take repairs into consideration generally increase risk and guarantee losses in default.
What Are the Vendor’s Payment Terms?
Interest begins accruing on loans when the bank disburses the funds to the customer. In an equipment lease, there is no connection between when the customer begins paying rent and when the bank pays for the equipment. You should review each vendor’s invoice to ensure that you comply with the vendor’s payment terms. Many vendors do not require payment until 30 days after the customer accepts the equipment. You can enhance the yield on an equipment lease by 35 basis points or more for each month that you can delay payment to the vendor. Many vendors are on manufacturer programs that allow them to pay for equipment up to six months after the sale. If your vendor is a customer of the bank or you know the vendor, find out exactly when the equipment must be paid for. If possible, take advantage of delaying payment to the vendor to enhance your yield.
Is Insurance Protection Adequate?
Is the Insurer Reliable?
In today’s volatile insurance market, rates and coverage can vary substantially. Carefully evaluate both the insurance coverage and the insurance carrier. Large deductibles and exceptions combined with weak insurers have left many leasing companies with damaged equipment and no recourse to the insurance company. Do not place insurance policies in the customer’s file until the proper personnel read and qualify them. Explain insurance requirements before the customer takes delivery of the equipment.
Will the Customer Modify the Equipment to
Perform a Special Task?
Many customers take good, solid equipment and alter it for a special purpose. On the surface, the equipment appears valuable. However, when the equipment is altered its purchase price is inflated to make it handle a special task. In default, altered equipment must be returned to its base state. The cost of reconfiguring the equipment to make it marketable and the increased purchase price may eliminate any equity or even create a serious loss. Exercise special care when leasing equipment that will be used for a limited or unusual task.
For an equipment lease, evaluating the equipment is as important as evaluating the customer’s creditworthiness. By knowing as much as you can about the equipment, you can structure the lease to take into consideration facts that will identify the true risk of this particular credit.
In this column, I have addressed questions that apply to all types of equipment. Naturally, there will be other questions that apply only to special kinds of equipment within specific industries. For a computer lease, for example, you might want to ask whether it has been around for a while and is therefore subject to change. Or you might want to know whether or not the computer could be upgraded or expanded.
Knowing the right questions not only will protect your bank from risk but also will help you to structure the lease to best serve the customer’s needs. Taking care of the customer’s true needs always makes a better customer than reacting to the customer’s assumptions.