Basic Leasing Terminology
Leases and rentals are contractual arrangements by which the owner of
property (the "lessor") allows another person (the "lessee")
to use the property for a stated period of time in exchange for cash payments or
other compensation. There is no real legal distinction between a
"lease" and a "rental." In practice, however, rentals
generally are considered short-term arrangements (a day, a week, a month), while
leases are arrangements for longer terms (a year or more).
The two main types of equipment leases you'll encounter are "true"
leases and "financial" leases. You also may hear about "sales and
leaseback" leases, which in reality are sophisticated financing
True leases. If the lessee acquires no rights to the property other
than its use, then the lease is commonly referred to as a "true" (or
"straight") lease. Under a true lease, the lessor is treated as the
owner of the leased property for both tax and non-tax purposes, and the lessee's
rental payments do not establish any equity in the property. A true lease
usually gives the lessee the option to prematurely end the lease, subject to
conditions that are spelled out in the agreement.
Financial leases. A lease that is used to effectively finance the
purchase of assets is commonly referred to as a "financial" (or "financing"
or "finance") lease. The distinguishing characteristics of financial
leases are that (1) the duration of the lease generally coincides with the
functional or economic life of the property, (2) the lease may not be canceled,
and (3) the lessee is responsible for maintaining the property. Frequently, a
financial lease will be structured so that the lessee's only practical choice at
the end of the lease is to purchase the asset. For example, the parties may
agree at the inception of the lease that the lessee will purchase the asset for
a specified price (this type of lease is effectively a conditional sales
agreement). Or perhaps the lease gives the lessor the right to compel the lessee
to purchase the asset or provides the lessee the option to purchase the property
for a nominal price.
If the lessor remains responsible for maintaining the property, then a true
lease also may be referred to as an "operating"
(or "maintenance") lease.
For accounting and tax
purposes, financial leases are generally treated as a sale.
Sale and leaseback leases. Under a "sale and leaseback"
arrangement, the owner of an asset sells the asset to a third party and then
immediately leases it back. The benefit of this transaction is that the owner
frees up the cash that was tied up in the asset (through the sale) while still
retaining its use (through the leaseback).
To a large extent, your expected need for the leased equipment will determine
whether you end up with a true lease or a financial lease. If you expect to need
the equipment for most, if not all, of its useful life, then you'll probably end
up with a financial lease. In contrast, if you expect that you'll need only the
equipment for a specified period and that the equipment will be of use to
someone else at the end of that period, you probably can find a lessor who's
willing to set you up with a true lease arrangement.
Key lease terms. Here are some of the major terms commonly found in
equipment leases of which you should be aware:
- Lease term — identifies how long the lease will be in effect. If
you suspect that your need for the equipment may exceed the initial term,
try negotiating the inclusion in the agreement of a renewal option
that entitles you to renew the lease for a specified period or periods and
for a specified rent.
- Rental rate — identifies how much the rent is and when it must be
paid. Most leases also include late payment provisions that impose an
additional charge if you fail to pay the rent when it's due or within a
specified grace period. If your business experiences seasonal or irregular
sales activity, try negotiating a flexible rental rate that corresponds to
the changes in your cash flow.
Although not always explicit in nature, the rental rate for
equipment leases frequently has an interest component.
Accordingly, when interest rates drop, lease payments may also
drop on new equipment leases. Following an interest rate drop,
check to see if your lease can be modified. If the lease cannot
be modified due to an expensive cancellation provision,
investigate buying out the lease with less costly bank
- Maintenance — identifies who is required to maintain the
equipment. Be wary about accepting a requirement that you provide a higher
degree of maintenance than would be required if you owned the equipment.
- Improvements and modifications — identifies whether you have the
right to make improvements or modifications to the equipment so that it
better suits your needs. Depending on the equipment involved, you may want
to specify who's responsible for modifications required by federal or state
- Insurance — identifies who is required to insure the equipment,
as well as who is entitled to what part of any settlement if the equipment
is lost, stolen, or damaged.
- Stipulated losses — specifies amounts you'll owe if the equipment
is lost, stolen, or destroyed by casualty. Such amounts may be in addition
to or in lieu of the value of the equipment.
- Purchase option — identifies whether you'll have the right or
obligation to purchase the equipment. The provision should specify an option
price or range and how and when the option may be exercised.
- Transfers — identifies whether you or the lessor has the right to
transfer your respective interests in the lease. You want to be sure that a
transfer by the lessor will in no way infringe upon your expectations under
the lease. You'll also want to check under what conditions, if any, you'll
be able to sublease the equipment to others.
- Claims — identifies whether you can sue and take other actions in
the lessor's name to assert claims against suppliers and others with respect
to the equipment and whether you're entitled to retain any settlements from
- Early termination and amendment — identifies under what
conditions the lease may be amended or canceled. These provisions become
more important as the term of the lease increases. Try to forecast the
circumstances under which the equipment may become uneconomical or useless
to you (for example, the adoption of a law that makes your use of the
equipment illegal, a technological advancement that makes the equipment
obsolete, etc.), then try to negotiate a provision that addresses those
- Modern equipment substitution — provides for updating the
equipment or replacing it with a newer model during the lease term. This is
an especially useful provision to have included in a lease for computer
equipment, communications devices, and other items that are subject to rapid
- Termination costs — identifies who is responsible for the costs
(dismantling, packing, shipping, insurance, etc.) related to returning
equipment to the lessor at the end of the lease term.
- Master lease — identifies that additional equipment can be leased
by an addendum to the agreement that describes the new equipment, the rental
rate, and lease term. This type of provision can yield substantial savings
in negotiation costs if you expect an ongoing relationship with the lessor.