Type of Leases Exist in Financial Markets

Type of Lease  

How many types of lease are you aware?

Did you know that how many types of leases are exist in financial world, you will say that Operating and finance lease. Here I will discuss few of them. But first of all we have to understand what is Lease

What is Lease

Lease is a legal document outlining the terms under which one party agrees to rent property from another party. A lease guarantees the lessee (the renter) use of an asset and guarantees the lessor (the property owner) regular payments from the lessee for a specified number of months or years. Both the lessee and the lessor must uphold the terms of the contract for the lease to remain valid. Or in other words Leases are the contracts that lay out the details of rental agreements b/w the lessor and lessee for the use of specified asset for the specified time.

For example, if you want to rent an apartment, the lease will describe how much the monthly rent is, when it is due, what will happen if you don't pay, how much of a security deposit is required, the duration of the lease, whether you are allowed to have pets, how many occupants may live in the unit and any other essential information. The landlord will require you to sign the lease before you can occupy the property as a tenant.

Accounting standard recognizes two types of lease which are as under :-

Majorly Lease are defined in two Variants

1.      Operating

2.      Finance

Operating Lease

An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership, but also want to return equipment at lease-end and avoid technological obsolescence.

a)      An operating lease usually results in the lowest payment of any financing alternative and is an excellent strategy for bypassing capital budgeting restraints.

b)      It typically qualifies for off-balance sheet treatment and can result in improved Return on Asset (ROA) due to a lower asset base.

c)      It can also result in higher reported earnings in the early years of the lease.

Finance Lease

A finance lease is a full-payout, non cancellable agreement, in which the lessee is responsible for maintenance, taxes and insurance.

a)      Finance leases are most attractive in cases where the lessee wants the tax benefits of ownership or expects the equipment's residual value to be high.

b)      These leases are structured as equipment financing agreements with residuals up to 10 percent.

c)      The lessee purchases the equipment upon lease termination at a pre-agreed amount.

d)      The term of a finance lease tends to be longer, nearly covering the useful life of the equipment.

 

Other Type of leases also exists in financial world which are as follows:

Walk-Away Lease or Closed-End Lease

A rental agreement that puts no obligation on the lessee (the person making periodic lease payments) to purchase the leased asset at the end of the agreement. Also called a "walk-away lease", "true lease"  or "net lease" “Closed-End Lease”.

Since the lessee has no obligation to purchase the leased asset upon lease expiration, that person does not have to worry about whether the asset will depreciate more than expected throughout the course of the lease. Thus, it is argued that the closed-end leases are better for the average person.
On a walk-away lease, the lender assumes the risk of predicting what the residual value of the asset will be at the end of the lease period. The predicted residual value is not only an important consideration in establishing an appropriate amount to charge for lease payments, it ultimately determines how much profit the lender earns on the lease of a asset. Ideally, the total value of all lease payments in conjunction with the asset's residual value should be greater than the cost paid for the asset.

For example, suppose your lease payments are based on the assumption that the new car that you are leasing cost Rs 12,00,000  will be worth only Rs.3,00,000 at the end of your lease agreement. If the car turns out to be worth only Rs.2,40,000, you must compensate the lessor (the company who leased the car to you) for the lost Rs.60,000 since your lease payment was calculated on the basis of the car having a salvage value of Rs.3,00,000. Basically, since you are buying the car, you must bear the loss of that extra depreciation. But, if you have a closed-end lease, you don't buy the car so you don't bear the risk of depreciation.

Open-end Lease

A conditional sale lease in which the lessee guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the lease.

Capital Lease

Type of lease classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, if it meets any one of the following criteria:

a)       the lessor transfers ownership to the lessee at the end of the lease term;

b)      the lease contains an option to purchase the asset at a bargain price;

c)      the lease term is equal to 75 percent or more of the estimated economic life of the property (exceptions for used property leased toward the end of its useful life); or

d)      the present value of minimum lease rental payments is equal to 90 percent or more of the fair market value of the leased asset less related investment tax credits retained by the lessor.

 

Direct Financing Lease (Direct Lease)

A non-leveraged lease by a lessor (not a manufacturer or dealer) in which the lease meets any of the definitional criteria of a capital lease, plus certain additional criteria.

Lease to Own

An arrangement where an individual enters into a lease agreement with an owner with the inclusion of a clause that typically gives the individual the right, but not the obligation, to purchase the item leased at a predefined price and time. More often than not, a portion of the total rental payment goes toward paying down the value of the item leased in the event that the renter wishes to exercise the option.

For housing properties, the cost involved in lease-to-own agreements tend to be more expensive compared to standard rental agreements. In addition to paying rent, lease-to-own contract users need to pay an option fee, similar to an amount paid to buy a traditional stock option, and usually, a rent premium as well, which is not returned to the renter in the event that he or she does not exercise the option to buy the leased item.

First Amendment Lease

The first amendment lease gives the lessee a purchase option at one or more defined points with a requirement that the lessee renew or continue the lease if the purchase option is not exercised. The option price is usually either a fixed price intended to approximate fair market value or is defined as fair market value determined by lessee appraisal and subject to a floor to insure that the lessor's residual position will be covered if the purchase option is exercised.

If the purchase option is not exercised, then the lease is automatically renewed for a fixed term (typically 12 or 24 months) at a fixed rental intended to approximate fair rental value, which will further reduce the lessor's end-of-term residual position. The lessee is not permitted to return the equipment on the option exercise date. If the lease is automatically renewed, then at the expiration of that initial renewal term, the lessee typically has the right either to return the equipment without penalty or to renew or purchase at fair market value.

Full Payout Lease

A lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance upon the leased equipment's future residual value.

Guideline Lease

A lease written under criteria established by the IRS to determine the availability of tax benefits to the lessor.

Leveraged Lease

In this type of lease, the lessor provides an equity portion (usually 20 to 40 percent) of the equipment cost and lenders provide the balance on a nonrecourse debt basis. The lessor receives the tax benefits of ownership.

Net Lease

A lease wherein payments to the lessor do not include insurance and maintenance, which are paid separately by the lessee.

Sales-type Lease

A lease by a lessor who is the manufacturer or dealer, in which the lease meets the definitional criteria of a capital lease or direct financing lease.

Synthetic Lease

A synthetic lease is basically a financing structured to be treated as a lease for accounting purposes, but as a loan for tax purposes. The structure is used by corporations that are seeking off-balance sheet reporting of their asset based financing, and that can efficiently use the tax benefits of owning the financed asset.

 

Tax Lease

A lease wherein the lessor recognizes the tax incentives provided by the tax laws for investment and ownership of equipment. Generally, the lease rate factor on tax leases is reduced to reflect the lessor's recognition of this tax incentive.

Trac Lease

A tax-oriented lease of motor vehicles or trailers that contains a terminal rental adjustment clause and otherwise complies with the requirements of the tax laws.

True Lease

A type of transaction that qualifies as a lease under the Internal Revenue Code. It allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions.