Avoid these equipment leasing mistakes

As we move into the latter stages of 2021, the market has continued to be very busy.

It is in times like this, particularly when I am talking to new clients, that I often think of the few mistakes that a typical applicant makes when trying to arrange their first equipment lease. Most people without experience arranging a lease for machinery rely on experiences from other industries. Others who understand the nuances of equipment leasing have trouble securing an approval because of a credit profile that is incompatible with the machine they are looking to lease.

Mistake No. 1: Comparing the rate and structure for automobile leases with equipment leases

All lending in Canada is based on the prime rate, also known as the prime lending rate, which is the annual interest rate Canada's major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable-rate mortgages.

Any business that borrows money from its bank, whether it is a term loan, operating line, or line of credit, has its borrowing rate based on the prime rate (these days it’s roughly 2.5 per cent.) Depending on the amount borrowed and the financial strength of the borrower, the cost is anywhere between 1 and 3 per cent above the prime rate.

Banks also want to be secured by at least three times over, meaning they want assets and guarantees from borrowers that will ensure they are covered by a minimum of $3.00 for every $1.00 they provide. When an alternative lender is arranging financing for equipment, it typically only has the equipment itself as collateral for the transaction, so it charges something higher because it is not nearly as secured as a bank. If a borrower’s credit is strong, the premium could lower by a percentage point or so.

Most people experience leasing in one way: getting a car. What happens next is that they equate how that transaction was handled, and the rate charged, with a lease for machinery or equipment. These, however, are two totally different types of transactions.

First, the structure for a car lease is much different because the lender normally will have a large residual at the end of the transaction, in many cases as much as 40 to 50 per cent, which is guaranteed by the dealer/manufacturer. This means the customer literally has the option to either purchase the car or toss the keys back. The dealer is more than happy to take the car back, charging for whatever needs to be repaired, and then resell it since the dealer makes a better profit margin from the sale of the used car than when it was new.

The structure of a typical equipment lease is either 10 per cent at the end or a nominal amount (like $1), and the borrower is responsible for the purchase option, so they eventually own the equipment. Second, the car lender can offer very cheap lease rates, often under 2 per cent, because it is subsidized by the manufacturer.

Because all lending is based in some way on the prime rate, the only way to offer cheap rates is to take the profit from the sale of the car when the lease was booked to buy down the interest rate. This becomes obvious when the cash purchase price for the same car includes discounts that are not offered when the car is priced for the lease.

The irony is that this is a common strategy for equipment leases as well, because some manufacturers offer cheap rates by using the same method.

I always tell my customers that they are much better off negotiating the lowest price possible for the equipment and keep the financing as a separate entity. When you do the math, you always find more money is saved in the long run by taking a substantial upfront discount for a cash purchase. All equipment funders pay the seller in full upon delivery and arrange the lease with the buyer at true market rates.

Mistake No. 2: Having a weak credit profile and buying low-cost equipment

When evaluating the application for an equipment lease, the first thing lenders look at is what’s being financed. When it comes to machine tools, anyone with industry knowledge knows a good brand-name machine tool has excellent resale value.

Because a lender’s first concern is exit strategy in the event a deal goes badly, it wants the comfort of knowing the asset can be resold with relative ease, recovering a significant portion of the outstanding balance.

Next, the size of the transaction and whether it fits the equity box of the applicant is reviewed.

Specifically, lenders will look at the company’s total net worth, which is its retained earnings (net profit not paid out as dividends). From a security standpoint, the asset itself is the collateral for the transaction, along with either the guarantee of the incorporated entity or the corporate guarantee along with one from a shareholder.

It is important to keep in mind that a new piece of machinery will depreciate the moment it is installed, no different than a car depreciating the moment it is driven off the lot.

This normally is at odds with a typical buyer’s thinking. When they are aware that their credit is less than stellar, they will try and find a less expensive machine that will do the job but costs less, figuring this is the path of least resistance to getting a lender’s approval.

However, the reality is that a lender would prefer to finance a better asset because of the resale value and ease of reselling upon repossession. So, the question then becomes how to get a good asset financed when the credit isn’t completely supportive.

Mistake No. 3: Inability to provide a deposit

When the transaction does not fit the borrower’s credit profile (or it did but the most recent year was a tough one), the best way to put a lender at ease and facilitate an approval is by offering a deposit. This means that instead of going after 100 per cent financing, it’s only 80 to 90 per cent.

Offering a substantial deposit mitigates the risk and allows lenders to approve a transaction that would normally be declined. It is the first year when any transaction is at its highest risk, the asset depreciates by its largest percentage, and few payments have been collected. So, from a lender’s perspective, it is very meaningful, and in certain cases necessary, to get a deposit. Essentially, the deposit counteracts the first year of depreciation.

Many lenders will want a deposit even if the borrower’s credit is strong if it’s the first deal when starting a new relationship. A deposit provides a level of comfort that cannot be duplicated.

Ken Hurwitz is vice-president, Equilease Corp., 416-499-2449, ken@equilease.com, www.equilease.com.