Lease education and consulting by Vinod Kothari

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Elements in lease structure: 

This is an explanation of the elements in a lease - the parties, asset, rentals, residual value, etc. This section would also elaborate the unique features of a lease as different from a regular financing transaction.

The transaction of lease of lease is generically an asset-renting transaction. What distinguishes a lease from a loan is that in the latter, what is lent out is money; in a lease, what is lent out is the asset.

Therefore, a lease could be generally defined as a contract where a party being the owner (lessor) of an asset (leased asset) provides the asset for use by the lessee at a consideration (rentals), either fixed or dependent on any variables, for a certain period (lease period), either fixed or flexible, with an understanding that at the end of such period, the asset, subject to the embedded options of the lease, will be either returned to the lessor or disposed off as per the lessor's instructions.

There are two parties to a lease: the owner and the user, called the lessor and the lessee. The lessor is the person who owns the asset and gives it on lease. The lessee takes the asset on lease and uses it for the period of the lease.

Any one can be a lessor, and any one can be a lessee, subject to usual conditions as to competence to contract, or holding of properties.

Technically, in order to be a lessor, one does not have to own the asset: one has to have the right to use the asset. Thus, a lessee can be a lessor for a sub-lessee, unless the parent lessor has restricted the right to sub-lease.

The subject of a lease is the asset, article or property to be leased. The asset may be anything - an automobile, or aircraft, or machine, or consumer durable, or land, or building, or a factory. Only tangible assets can be leased - one cannot contemplate the leasing of the intangible assets, since one of the essential elements of a lease is handing over of possession, along with the right to use. Hence, intangible assets are assigned, whereas tangible assets may be leased.

The concept of leasing will have the following limitations:

1. What cannot be owned cannot be leased. Thus, human resources cannot be "leased".

Leasing of immovable properties may have complications

2. While lease of movable properties can be effected by mere delivery, immovable property is incapable of deliveries in physical sense. Most countries have specific laws relating to transactions in immovable properties: if such law provides a particular procedure for a lease of immovable or real estate, such procedure should be complied with. For example, in Anglo-Saxon legal systems (UK, Australia, India, Pakistan, etc.), transactions in real estate are not valid unless they are effected by registered conveyance. This would apply to lease of land and buildings, and permanent attachments to land.
3. A lease is structurally a rental for the lease period: with the understanding that the asset will be returned to the lessor after the period. Thus, the asset must be capable of re-delivery: it must be durable (at least during the lease period), identifiable and severable.

The existence of the leased asset is an essential element of a lease transaction - the asset must exist at the beginning of the lease, during the lease and at the end of the lease term. Non-existence of the asset, for whatever reason, will be fatal to the lease.

The term of lease, or lease period, is the period for which the agreement of lease shall be in operation. As an essential element in a lease is redelivery of the asset by the lessee at the end of the lease period, it is necessary to have a certain period of lease. During this certain period, the lessee may be given a right of cancellation, and beyond this period, the lessee may be given a right of renewal, but essentially, a lease should not amount to a sale: that is, the asset being given permanently to the lessee.

In financial leases, is common to differentiate between the primary lease period and the secondary lease period. The former would be the period over which the lessor intends recovering his investment; the latter intended to allow the lessee to exhaust a substantial part of the remaining asset value.

The primary period is normally non-cancellable, and the secondary period is normally cancellable.

The lease rentals represent the consideration for the lease transaction. This is what the Lessee pays to the Lessor.

If it is a financial lease transaction, the rentals will simply be the recovery of the lessor's principal, and a certain rate of return on outstanding principal. In other words, the rentals can be seen as bundled principal repayment and interest.

If it is an operating lease transaction, the rentals might include several elements depending upon the costs and risks borne by the Lessor, such as:

• Interest on the lessor's investment.
• If the lessor is bearing any repairs, insurance, maintenance or operation costs, them charges for such cost.
• Depreciation in the asset.
• Servicing charges, or packaging charges for providing a package of the above service.

Put simply, "residual value" means the value of the leased equipment at the end of the lease term.

If the lease contains a buy out option with the lessee, residual value would mostly mean the value at which a lessee will be allowed to buy the equipment.

If there is no embedded purchase option, residual value might mean the value that the lessee or some one else assures will be the minimum value of the equipment at the end of the lease term. This is typical in case of financial leases where the lessor cannot grant a buyout option to the lessee; for the lessor to protect himself against asset-based risks, he would take an assured residual value commitment either from the lessee himself or from a third party, typically an insurance company.

The residual value might also the value that the lessor assures to pay-back to the lessee in case the lessee returns the asset to the lessor: that is, it might be the value the lessor assures as the minimum value of the equipment. Such a lease, obviously an operating lease because the lessor is taking a risk on asset values, is a full payout lease, but the lessor agrees to refund the guaranteed value on the lessee returning the equipment at the end of the lease term.

The options allowed to the lessee at the end of the primary lease period are called end-of-term options.

Essentially, one, or more, of the following options will be given to the lessee at the end of the lease term:

• Option to buy (buyout option) at a bargain price or nominal value (typical in a hire-purchase transaction), called bargain buyout option
• Option to buy at a fair market value or fixed, but substantial value
• Option to renew the lease at nominal rentals, called bargain renewal option
• Option to renew the lease at fair market rentals or substantial rentals
• Option to return the equipment

In any lease, which option will be suitable depends on the nature of the lease transaction, as also the applicable regulations. For example, in a full payout financial lease, the lessor would have recovered the whole or substantially the whole of his investment during the primary lease period. Therefore, it is quite natural that the lessee should be allowed to exhaust the whole of the remaining value of the equipment. Regulation permitting, the lessor provide the lessee a bargain purchase option to allow the lessee to complete the purchase of the equipment.

However, in many jurisdictions, it is the existence of such buyout option that demarcates between lease and hire-purchase transaction. If the lessor is interested to structure the lease as a lease and not hire-purchase, he would be advised not to provide any buyout option, but instead, to allow the lessee to renew the lease to continue the use of the asset. In essence, a renewal option achieves the same purpose as a purchase, but the lessor retains his ownership as also his reversionary interest in the equipment.

Fair market value options, either for purchase of equipment, or for renewal, are typical of operating leases, but are really speaking no more than assuring to the lessee a continued use of the equipment. If an equipment has to be bought at its prevailing market value, it can be bought from the market rather than from the lessor - therefore, the fair market value option carries no value for the lessee.

Lessors may require one or more of the following upfront, that is, instant payments from a lessee:

• Initial lease rental or initial hire or down payment
• Advance lease rental
• Security deposit
• Initial fees

The initial lease rent or initial hire (the word hire is more common in case of hire-purchase transactions) is a surrogate for a margin or borrower contribution in case of loan transactions. Note that given the nature of a lease or hire-purchase as asset-renting transaction, it is not possible to expect a lessee's contribution to asset cost as such. Hence, the down payment or first lease rent serves the purpose of a margin.

Between advance lease rent and initial lease rent - the difference is only technical. The whole of the initial lease rental is supposed to be appropriated to income on the date of its receipt, whereas advance rental is still an advance - normally an advance against the last few rentals. Therefore, the advance rental will remain as a deposit with the lessor to be adjusted against the last few rentals.

The security deposit is a proper deposit to secure against the lessee's commitments under the contract - it is generally intended to be refunded at the end of the lease contract.