What is a leveraged lease?
A leveraged lease is a lease funded by the lessor with the help of a third-party financial institution. In a leveraged lease, an asset is leased with borrowed funds.
Understanding back-to-back leases
Back-to-back leases are most often used for the rental of assets intended for short-term use. Assets such as cars, trucks, construction vehicles and commercial equipment are generally all available through the leveraged leasing option. Leasing in general means that a business or an individual will rent an asset.
Leasing any type of asset gives an entity the right to use the asset for the short term. Generally, the entity only leases the asset, although many leveraged leases offer a buy-back option at the end of the lease term.
The leveraged aspect of a leveraged lease is to borrow funds to pay the high cost of the asset value. A leveraged lease is generally used when an entity does not have the funds to buy the asset and does not necessarily want to keep the asset for the long term. A leveraged lease allows a lessee to obtain a loan corresponding to the value of the leased asset during the term of the lease and to repay the loan during the term of the lease. The amount required for the loan may be less than the purchase of the asset outright because the tenant only pays for a specified value associated with the term of the lease.
Accounting standards require that a company differentiate and account for leased assets differently depending on whether it is an operating lease or a leveraged finance lease.
Leverage the lease structure
Leverage leases can be more complex than an operating lease because it is leverage. The structure of leverage lease conditions will depend on the lessor and its funding relationships. The lessor may also be the financial institution providing the loan, in which case it approves the loan for the borrower.
The lessor can also work with a third party lender. In this case, the third party lender remits the borrowed funds to the lessor on your behalf allowing you to take possession of the asset upon approval of a loan. In some cases, a lessor may set up funds combined with funds borrowed from a third party, which can help improve the general terms of the lease.
Once a leveraged lease is approved and agreed, the borrower takes possession of the asset and is responsible for making regular payments on the loan balance. The title of the asset is generally held by the lessor or the lender according to the structure. In any case, a leveraged rental contract does not imply the transfer of the title to the tenant during the rental period.
Keep in mind that a leveraged lease is usually backed by a secured loan. This means that if a tenant stops making payments, the lessor can repossess the asset.
Leasing vs financing
Leverage leasing and leveraged finance are usually the two main options for anyone or business who buys a car or other valuable asset. A leveraged lease provides a loan that covers an estimated value of a car over the rental period. Leverage lease payments can potentially be lower as the loan does not cover the full value of the car.
An entity may also have the option of financing a car; in this scenario, the car loan is similar to a home loan. The car buyer obtains a loan for the full value of the car and payments are created over a longer period to repay the car loan.
Key points to remember
- Back-to-back leases allow an entity to lease an asset for a specified period using borrowed funds.
- A leveraged lease is generally used when an entity does not have the funds to buy the asset and does not necessarily want to keep the asset for the long term.
- In business accounting, a leveraged lease is called a capital lease and specific accounting standards are required.
Special considerations: accounting for back-to-back leases
Individuals generally don’t have to worry about accounting standards for leasing an asset with leverage, but that would be a factor for a business. In corporate accounting, leverage leases are called capital leases.
To determine the difference, four criteria are used:
- The life of the lease is 75% or more of the useful life of the asset.
- The lease includes an option to purchase on favorable terms whereby the tenant can purchase the asset at a price below its fair value in the future.
- The tenant acquires the property at the end of the rental period.
- The current value of rents is greater than 90% of the market value of the asset.
If one of these criteria is satisfied, the rental contract is considered to be a capital lease and, if not, the rental contract is considered to be an operating lease. Capital leases generally involve accounting for the leased asset in the same way as an asset purchase. Accounting for operating leases will generally require paperwork for rental payments as operating expenses.
Operating lease vs finance lease / leasing contract
Individuals or commercial entities may encounter the differences between an operating lease and a leveraged finance lease. In general, an operating lease does not include any option to purchase the leased asset. Common types of operating leases include apartment and building leases.
Leverage finance leases are important in distinguishing from operating leases in business accounting because accounting principles have different standards for the two.