In general, the term commercial leasing either refers to renting equipment, such as computers and hardware or heavy construction equipment; or commercial real estate, such as an industrial building or retail space. The types of leases that are written for these purposes are inherently different respective to what they are referring to. While there are many different variations as to what kinds of commercial leases exist throughout a wide range of industries, for the purposes of this article we will focus on the two primary forms that commercial leases take.
Although you may already be familiar with commercial leases, let’s just quickly touch on basics first. An equipment lease is, in essence, an extended rental agreement wherein the owner of the equipment (the lessor) allows the user (the lessee) to operate or otherwise make use of the equipment in exchange for periodic lease payments.
Business owners will inevitably encounter the question, ‘What are the benefits of leasing versus purchasing the equipment outright?’ The answer to this question varies greatly depending upon the current standing of the individual and their company. In basic terms, to evaluate which option is best, there are several considerations that must be made:
ADVANTAGES OF LEASING EQUIPMENT
Less Initial Cost – Logically speaking, purchasing a piece of equipment outright would require a massive cash expenditure up-front. Of course, there is the option of acquiring a bank land, but it can be difficult to even find a bank that is willing to offer equipment loans. Even if you do, the likelihood is that you will still have to put a minimum of 25% down. With equipment costs running into the hundreds of thousands of dollars, one can appreciate that it will still cost a great deal of money. When leasing equipment, a down payment of any kind is rarely a requirement, so you are able to acquire the equipment without significantly affecting your cash flow. Leasing also avoids the heavy hit to the available credit a business owner has on their credit report.
Tax Deductible Payments – Depending upon how your lease is structured, most lease payments are tax deductible, which can help reduce the net cost of your lease. This often garners better results than the depreciation of owned equipment.
Flexible Terms – Leases are typically far easier to obtain, and have more flexible terms than loans for buying equipment than any other type of purchase option. This can be a significant advantage if you have bad credit, or need to negotiate a longer payment plan to lower your costs. Not to mention many leasing companies will offer flat rate payment options, which is great for the bottom line.
Ability to Upgrade and Keep up with the Newest Technology – Leasing allows businesses to address the problem of obsolescence, and avoid the costly maintenance and consistent issues that arise with aging equipment and technology. If you use your lease to obtain items that may be outdated in a short period of time, such as computers or other high-tech equipment, a lease passes the burden of obsolescence onto the lessor. You are free to lease new, higher-end equipment after your lease expires.
Low Cost Purchases – At the end of the lease, should you desire to purchase the equipment outright, often times you’ll receive a discounted rate that is cheaper than buying the equipment elsewhere, and this will help significantly in that you will likely get to know the equipment well over the duration of your lease.
Service Additions – Many companies will negotiate installation, maintenance, and other services associated with the equipment into the lease. This is important because the leasing companies are typically outfitted with specialists in the field, both in leasing and financing, as well as repairs and in=the-field maintenance.
DISADVANTAGES OF LEASING EQUIPMENT
Higher Cost Over the Long Term Than Purchasing – While leasing has many benefits, the downside is that the business owner will likely end up paying more for the equipment over the long term, factoring in all costs associated with the lease. There’s no getting around it, leasing an item is almost always more expensive than purchasing it. A quick example: A computer with a cost of $4,000, purchased outright, the cost is clear. If you were to negotiate a commercial lease for that same computer with the same cost at a standard rate of $40/month per $1,000, it will cost you a total of $5,760. So, there’s no getting around the fact that leasing is more expensive. The bottom line is simple, either keep the cash in your pocket and pay more over time, or buck up and pay the total cost up front to save money in the long run.
You Don’t Own It, So There’s No Equity – Something to consider with leasing equipment is that the business owner doesn’t technically own the equipment, so it gives them no equity. There is no option to sell the equipment once you are finished with it, so there is no potential to make any money back. Unless the equipment has become obsolete by the end of the lease, this lack of ownership is a significant disadvantage.
Obligation to Pay for the Entire Lease Term – The available length of lease terms may be longer than you need. Strict agreements may force you to pay for and keep a piece of equipment for a longer time frame than you require, resulting in wasted funds and space. You are obligated to make payments for the entire lease period even if you stop using the equipment. Some leases give you the option to cancel the lease if your business changes direction and the equipment you leased is no longer necessary, but large early termination fees almost always apply.
You May Not Get Exactly What You Want – Availability of products may be limited depending on the stock of the leasing company. Your choice of brands or models could potentially be out of stock or not carried at all, so you could have to settle for something else.
TYPES OF COMMERCIAL EQUIPMENT LEASES
The two primary types of leases are operating leases and long-term leases.
Operating Leases – These types of leases are generally characterized by short-term, cancelable terms, and the lessor bears the risk of obsolescence. Regardless, these are generally the preferable option when the company requesting the equipment needs it only for a short period of time. Under the usual terms of such agreements, a lessee can usually cancel an operating lease, assuming prior notice, without a major penalty.
Long-term, Non-Cancelable Leases – These types of leases are also known as capital, full payout, or financial leases. They are sources of financing for assets where the lessee company wants to acquire and use the equipment for longer periods of time. Most financial leases will be net leases, meaning that the lessee is responsible for maintaining and insuring the asset, as well as paying all property taxes, if applicable. Financial leases are often used by businesses for expensive capital equipment.
In addition to these two basic leasing models, there are a considerable variety of other lease arrangements that are often used. These leases, each of which combine different financial and tax advantages, are actually hybrids of financial and operating leases that reflect the individual needs of lessor companies. Examples of these are:
Full-Service Leases – These types of leases are typically structured so that the lessor is responsible for insurance and maintenance (these are commonplace with office equipment or vehicle leases).
Net Leases – These types of leases are structured so that the lessee is responsible for maintenance and insurance in lieu of the lessor.
Leveraged Leases – These are arrangements wherein the cost of the leased asset is financed by issuing debt and equity claims against the asset and future lease payments.
Lease rates for any type of equipment can vary considerably depending upon the type of equipment and the lease company selected to underwrite the lease. There may also be different rates for the same piece of equipment, depending on various characteristics of the business that is seeking the lease.
FACTORS THAT CAN IMPACT YOUR LEASE RATES
- Credit history of the lessee.
- Nature of equipment requested by the lessee.
- Length of the lease term.
- Primary beneficiary of tax credits.
- Other factors considered will vary amongst lease providers.
TYPICAL ELEMENTS OF AN EQUIPMENT LEASE (TEN MOST COMMON)
- Duration of the lease
- Total rate or lease payment due the lessor
- Specific financial terms (date of the month that payment is due, penalties for late payment, etc.)
- Residual values and purchase options
- Market value of equipment (necessary for insurance purposes in the event of lost or damaged equipment)
- Tax responsibility
- Equipment updating or cancellation provisions
- Lessee renewal options
- Penalties for early cancellation without good cause
- Miscellaneous options (security deposits, warranties)
The most important factor in selecting your leasing company is to do your homework, and research a number of companies, their backgrounds and reputations, who they’ve leased to; and perhaps even speak with some of their customers if possible to learn about how they feel their relationship with the company has developed through the duration of their respective leases.
COMMERCIAL REAL ESTATE LEASES
Inevitably when in business for yourself, it’s likely that you will eventually require a place in which to operate. This typically means either purchasing a building to work out of, which not many business owners will have the required funds to do so, or leasing a rental space whether for industrial purposes like manufacturing, or retail space for selling products. This can be intimidating, especially if you don’t understand the terms used and types of leases you may run into.
Generally speaking there are five types of commercial real estate leases:
Percentage Lease – These are based upon the monthly rent, plus a percentage of the monthly sales generated by the lessee’s company. Typically these are used for retail businesses, such as the stores found in common shopping malls.
Net Lease – In addition to the monthly rent paid, the tenant pays some or all of the taxes, insurance, and/or maintenance associated with the leased property. This kind of lease will often be found with industrial properties, and will almost always favor the landlord’s interests.
Double Net Lease – With this kind of lease, the tenant will pay their monthly rent, plus taxes and insurance. Again, this kind of lease will be found most often with industrial properties and, like net leases, will almost always favor the landlord’s interests.
Triple Net Leases – Similar to net leases, and double net leases, the tenant will pay their monthly rent, plus taxes, insurance and maintenance. Once again, this kind of lease is generally associated with industrial properties, and will almost always favor the landlord’s interests.
Absolute Triple Net Lease – This is a less common option that is more rigid and binding than the triple net leases, where tenants carry every existing real estate risk. For example, being responsible for construction expenses to rebuild after some sort of catastrophic event, such as a fire or flood, or for continuing to pay rent even after the building has been condemned. Some business owners call this the “hell-or-high-water lease” because tenants ultimately have a responsibility for the building regardless of the circumstances.
Fully Serviced Lease (Gross Lease) – In this type of lease, the landlord directly pays all or most of the usual costs associated with the property. These costs are then passed on to the tenant as a “Load Factor.” A load factor is just a method of calculating total monthly rent costs combining usable square feet with a percentage of the square feet of common areas used by all tenants. Common areas will most often include restrooms, lobby, elevators, stairwells and hallways. So, an example of this would be if you share a building with three other tenants and each of your usable square feet (meaning your actual rented space) is substantially equal, the percentage you might contribute toward the common areas could be around 25%. Fully serviced leases will generally be found in association with office buildings and retail spaces, although it’s not uncommon to find them connected with industrial buildings as well.
Modified Gross Lease – Where the gross lease is often more tenant-friendly, and the net lease tends to be more landlord-friendly, there exists what can be considered a compromise lease for the convenience and benefit of both parties. This type of lease is sometimes referred to as a modified net lease, and is similar to a gross lease in that the rent is requested in one lump sum that can include any or all of the “nets.” The “nets” would be things such as property taxes, insurance, and CAMS. Utilities and janitorial services are typically excluded from the rent, and covered by the tenant unless otherwise agreed upon by both parties. Tenants and landlords would negotiate which “nets” are included in the base rental rate prior to signing a lease.
SO, WHICH LEASE IS RIGHT FOR YOU?
When evaluating options for office space leasing, understanding and comparing the different lease options with an eye toward all expenses is critical. And not just the base rental rates. Triple net base rental rates tend to be much lower, with additional expenses added for the real monthly rate. The overall market in your area will likely even out the rental rates for comparable properties, regardless of type of lease. Tenants should expect to pay roughly the same amount once expenses are included with a triple net, modified gross, or full service lease for office, retail, and industrial spaces of equal size in the same general area. The most important rule of commercial leases is for tenants to read their leases carefully, and make sure they are entirely clear on exactly for what expenses they are responsible, especially with regards to the circumstances under which additional charges could occur!
ACCOUNTING FOR CAPITAL LEASES
Any companies with operating lease arrangements must classify lease payments as a rental expenses by debiting rental expense accounts and crediting lease payable accounts. In February 2016, the Financial Accounting Standards Board (FASB) revised rules governing lease accounting by requiring that all leases, except for short-term leases with terms less than a year, must be capitalized. The new rules become effective for public companies for their fiscal periods beginning on Dec. 15, 2018.