Sudhir Amembal,
Chairman and CEO,
Amembal & Associates

Having recently garnered increased consideration from CFOs, fair market value leases are on the rise in most markets. Under the umbrella of operating leases, FMVs are presenting new opportunities for equipment financiers and offering dozens of benefits to their customers.

In the ever-evolving landscape of equipment financing, the fate of fair market value (FMV) leases has been a topic of speculation. Would these leases, known for their manifold benefits, fade into obscurity with the rise of loan-like products? Such concerns were assuaged based on a recent survey published in Monitor Suite, which noted that operating leases (the accounting expression for FMV leases, which qualify as operating leases) are on the upswing.

The article, “The Rise in Consideration of Operating Leases,” was based on a survey of 1,300 mid-sized company’s CFOs. The survey unveiled a growing openness among respondents towards engaging in more operating leases than in 2018. The increase permeated most sectors — in particular, the manufacturing, food and beverage and healthcare sectors. The numbers spoke volumes. In 2018, 15% of CFOs in the manufacturing sector were willing to consider operating leases. In 2023, that percentage soared to 40%.

The survey respondents were mid-sized companies. One could extrapolate and conclude that larger companies — which, by definition, have bigger capex budgets — would be arriving at the same conclusion to engage in more operating leases.

WHAT EXACTLY IS AN FMV LEASE?
Is it appropriate to refer to such a lease as an operating lease? Terminology in our industry is unfortunately not standardized. In brief, one must look at the world of leasing within four frameworks — marketplace, accounting, tax and legal. For the purpose of this article, it is sufficient to address the first two frameworks.

The marketplace framework has to do with product characteristics, while the accounting framework has to do with the financial reporting treatment of leases. An FMV lease in the marketplace is one in which the lessor takes a reasonably significant residual position in pricing the lease and gives the lessee a fair market value purchase option to potentially purchase the equipment at the end of the lease. Defining “significant residual” remains elusive; generally, it surpasses 10%. Given this, many — if not most — FMV leases will fail all five accounting criteria. This leads to a lease being classified as a finance lease, essentially a loan-like instrument. This, in turn, leads to the conclusion that most marketplace FMV leases are likely to be classified as accounting operating leases. Based on this, it is fair to surmise that the aforementioned survey was referring to FMV leases.

There is an obvious difference between “willingness to consider,” which represents a thought or even a plan that CFOs have, and the actual increase in the FMV product. Industry data, albeit not imminently clear, reveal a stark reality as these leases constitute less than 10% of the total equipment financing volume in the U.S. — a figure that has remained stagnant over the past half-decade. The discrepancy between intention and execution prompts introspection. More importantly, it leads to opportunities for equipment finance companies willing to seek it.

WHAT MAKES FMV LEASES SO COMPELLING?
The answer lies in the plethora of benefits they offer to the customer — 34, to be exact. These benefits range from flexibility of not being locked into potential tax advantages. While 15 of these benefits overlap with those offered by capital leases (akin to full-payout loans), FMV leases boast an additional 19 benefits, making them a tantalizing option for lessees seeking optimal value.

The shift towards loan-like products, such as the equipment finance agreement and the full-payout capital lease, was gradual. Tax law changes, such as the repeal of the investment tax credit, certainly played their part. Section 179 and bonus depreciation accruing to customers who finance via EFAs and capital leases further accelerated the exodus. The “repeal” of off-balance sheet financing was a big deal. Tax and accounting do play an important role in shaping the choice of products from a customer’s point of view. However, even within these two frameworks, financiers can seize on many opportunities to rejuvenate a product that seems to be in demand.

TAX AND ACCOUNTING PERSPECTIVES
All customers are not tax and accounting motivated. Even those who are will find that FMV leases, from a tax point of view, mitigate the limitation placed on the deductibility of interest expense. Also, FMV leases allow the lessor to claim the bonus depreciation. This allows lessors to defer taxes. The present value of the tax deferral, particularly on large-ticket transactions, can be passed onto lessees in the form of reduced lease payments.

From an accounting point of view, off-balance sheet financing was not fully repealed. Unguaranteed residual does not constitute “lease payments” in the context of the present value test. This results in a lower amount being capitalized by the lessee. Hence, partial off-balance sheet financing still exists.

Assets and liabilities being lower than a cash purchase, an EFA or a full-payout finance lease enhances three key financial ratios: the current ratio, return on assets and the gearing ratio. To boot, a lower asset and liability base leads to higher earnings as depreciation, and interest expense are lower compared to the previously-mentioned options. Higher earnings! Who would not covet this?

SIX PRIMARY LEASING MOTIVATORS
There are six major motivators for why lessees lease. Alongside tax and accounting, they are:

• Cash management: FMV leases lead to lower payments owing to the residual.
• Hedge Against Obsolescence: FMV leases, with bells and whistles, can offer technology refresh, early termination options and upgrades.
• Flexibility: FMV leases, with varied end-of-term options, preclude a lessee from being locked in.
• Financial: FMV leases can offer a non-tax motivated lessee with the lowest present value cost.

It would behoove lessors to fully grasp the overwhelming benefits offered by FMV leases and selectively sell those benefits based on which of the six motivators varied customers have. Existing FMV lease players should have no difficulty expanding their volumes to meet the increased demand. In fact, they can create additional demand by singing all the praises of this product.

Although there are some hurdles for new players to enter this market, the hope is that they will surmount them and join the fray. •

Sudhir Amembal created the first-ever commercial equipment leasing seminar for the industry. Since then, he has spearheaded the training of more than 80,000 leasing professionals worldwide. He was inducted into ELFA’s Hall of Fame; nominated at Monitor’s Converge 2023 and 2024 conferences for MVP Behind the Scenes; and awarded the first-ever honorary CLFP designation. He continues to be active in offering training to the industry, in particular his flagship seminar “Winning With Leasing!” He may be contacted at [email protected].