COMMON QUESTIONS REGARDING
LEASE-PURCHASE FINANCING
Lease-purchase financing is becoming an increasingly important element in the financial management strategies of local governments. Nationwide, the annual dollar volume of lease-purchase obligations has grown from $700 million in 1980 to an estimated $8 billion in 2000. As it has grown, the lease-purchase market has also evolved to address a variety of funding needs and institutional constraints. To assist public officials and staff to understand the state of lease-purchase financing, these are some fundamental questions that are most frequently raised on this subject.
What is Lease-Purchase
Financing?
How does
Lease-Purchase Financing Differ from True Leasing?
How does
Lease-Purchase Financing Differ from Bond Financing?
What
Types of Assets Can be Acquired Through Lease-Purchase Financing?
What
Factors Should be Considered in Deciding When to Lease-Purchase?
How are Lease-Purchase
Obligations Structured?
How are Lease Obligations Funded?
How do Transaction Costs
Affect the Cost of Borrowing?
What
are the Essential Components of a Successful Lease-Purchase Financing Program?
What are
the Basic Elements for Concluding a Lease-Purchase Financing?
1. What is Lease-Purchase Financing?
Lease-purchase financing is one means by which a municipality or a public agency can
acquire real or personal property. It involves the purchase of an asset through periodic
lease payments, which have principal and interest components. Lease-purchase financing is
an alternative to purchasing an asset with cash, acquiring its use for a period of time
through a true lease or issuing bonds.
-TOP-
2. How does Lease-Purchase Financing Differ from True Leasing?
To a governmental lessee, the difference between lease-purchase financing and true
leasing is who owns or will own the asset. In a lease-purchase, the lessee acquires an
ownership interest in the asset, obtaining title to the asset at the end of the lease
term. In a true lease, the lessee acquires only the right to use the asset for a period of
time, but no ownership of the asset. The term of a true lease is usually much shorter than
the useful life of the asset, while a term of a lease-purchase generally approximates its
useful life. The term length differs because of what happens at the end of the term. With
a true lease, the municipality typically relinquishes the asset but may purchase it at a
price that reflects its residual or market value. With a lease-purchase, the municipality
retains the asset.
-TOP-
3. How does Lease-Purchase Financing Differ from Bond Financing?
A bond financing is an exercise of a governmental entity's authority to incur debt.
Unlike a bond issuance, in most states a lease-purchase financing is not considered to be
debt for state law purposes and voter approvals are not necessary to authorize the
transaction. The underlying security for the two types of obligations is also different.
With bond financing, the borrower pledges a designated revenue source, such as property
taxes or user charges, and obligates itself to raise revenues to the extent necessary to
pay debt service. Usually there is no such obligation supporting a lease-purchase
agreement. The governmental entity agrees only to budget and appropriate payments from
available revenues each year.
-TOP-
4. What Types of Assets Can be Acquired Through Lease-Purchase Financing?
Lease-purchase financing can be used to finance almost any real type of personal property that the public agency has the authority to acquire. Among the most-often leased property:
| Computers | Office equipment |
| Buses | Permanent buildings |
| Fire fighting equipment and vehicles | Portable buildings |
| Heavy equipment and machinery | Road maintenance vehicles |
| Light aircraft and helicopters | Solid waste disposal equipment |
| Medical equipment | Telecommunication systems |
5. What Factors Should be Considered in Deciding When to Lease-Purchase?
The primary financial objective of any asset acquisition decision is to obtain the use of the asset for the lowest possible total cost, as measured over the period the asset is to be used. Of course, other considerations are important, and may determine which options are available or appropriate in a particular jurisdiction or situation. Factors that should be considered include:
- Availability of cash at time of procurement
- Competing demands on capital resources
- Essentiality of the asset to the basic functions of the agency
- Useful life of the asset
- Desirability of matching costs and benefits over time
- Ability to improve bargaining positions with vendors
- Political attitudes toward debt financing
There are relatively few instances where all four options - paying cash, true leasing, lease-purchase financing and the issuance of bonds - are available and appropriate. Each is particularly suited for different types of assets. Cash is appropriate for low-cost items, those with short useful lives or assets which do not serve essential governmental functions. True leasing is useful for assets that tend to become technologically obsolete in a short time (one to three years), those that serve a function of limited duration, or that require regular service or maintenance. Historically, lease-purchase financing works best for assets with a useful life of three to seven years, that serve an essential governmental function and carry an initial cost that would consume a disproportionate amount of available cash. The issuance of bonds usually is reserved for the most costly capital expenditures, typically assets with a useful life of at least ten years, and a source of revenues that can be pledged to pay debt service.
When the costs of two or more available options differ, they should be compared in
terms of all of their associated costs. In addition to payments for the asset itself,
these include down payments, transaction costs, legal fees, operating and maintenance
expenses, ongoing administrative costs and service fees. There are various methods for
comparing the costs of different asset acquisition strategies, such as present value
analysis and equivalent annual worth analysis. Present value analysis is most useful for
comparing alternatives with the same term length or comparing lease-purchasing to paying
cash. Equivalent annual worth analysis is most useful for comparing alternatives with
different term length, such as true leasing and lease-purchasing. These are not the only
methods for evaluating asset acquisition strategies, but any analytical approach must
incorporate the time value of money to yield a meaningful result.
-TOP-
6. How are Lease-Purchase Obligations Structured?
The obligation of the municipality to make periodic lease payments is the cornerstone
of the lease-purchase transaction. In California, this obligation may be cast in two
different ways. The resultant structures are known as "covenant" leases and
"annual appropriation" leases. A related instrument is the installment sale
obligation.
-TOP-
7. How are Lease Obligations Funded?
Once it has been decided that lease-purchase financing is the least expensive or the
most appropriate means to acquire one or more capital assets, a funding strategy must be
implemented to use this financing tool most effectively. There are essentially four
funding sources from which municipalities can obtain lease-purchase financing.
-TOP-
8. How do Transaction Costs Affect the Cost of Borrowing?
In deciding which strategy will provide funding at the lowest cost, both the stated
interest rate and the transaction costs must be taken into account. Adding transaction
costs to a financing increases the ultimate cost above that indicated by the stated
interest rate.
-TOP-
9. What are the Essential Components of a Successful Lease-Purchase Financing Program?
Lease-purchase financing should be regarded as one element of an overall financial management strategy. A well-designed program can help balance capital expenditures over time, and, if the Effective Interest Cost is below the investment rate earned on fund balances, it can actually extend limited capital resources. There are several key steps to designing and implementing a lease-purchase program. The most important of these are:
- Establish the legal authority to lease-purchase and the limits to this authority.
- Determine which capital expenditures are appropriate for lease-purchase financing.
- Decide whether to finance each acquisition separately, or to undertake a single financing to fund all of the lease purchasing for a fiscal year.
- Monitor all transaction costs.
- Understand the transaction terms.
-TOP-
10. What are the Basic Elements for Concluding a Lease-Purchase Financing?
- Reaching agreement on acceptable lease rate of interest (annual percentage rate), payment frequency, repayment term and method of funding.
- Obtaining authorization by Lessee's governing body including adoption of resolution.
- Obtaining legal review of lease documents by Lessee's counsel and issuance of legal opinion.
- Executing and delivering to Lessor the Lease documentation, legal opinion and insurance
certificates.
-TOP-