Definition
A leveraged lease is a financial arrangement where a lessor provides an asset to a lessee using borrowed funds. In this agreement, the lessor holds the equity of the leased asset whereas a lender typically holds the debt. This arrangement allows the lessor to claim tax benefits associated with ownership like depreciation deductions, even though majority of the asset cost is financed by the lender.
Key Takeaways
- Leveraged Lease refers to an arrangement involving three parties: the lessor, the lessee, and the lender. The lessor uses borrowed funds from a lender to acquire the asset that is rented to the lessee. This kind of lease helps lessors to mitigate the risk and cost of acquiring an asset.
- In a Leveraged Lease, the lessor holds the ownership of the asset, yet the lender holds a mortgage on the asset. This implies that the lender can claim the rights to the asset if the lessor defaults on their loan repayments.
- The tax benefits from asset depreciation and interest on loan payments often go to the lessor in a Leveraged Lease. However, the lessor also bears the risks associated with the asset, such as damage, loss, or obsolescence.
Importance
Leveraged Lease is a crucial finance term as it outlines an arrangement where the lessee receives financing for an asset through the lessor, which is typically a financial institution, and a third party.
The lessor provides a portion of the asset’s cost, while the third party provides the remainder.
The third party, or equity participant, benefits from the depreciation tax shield of the asset, which can make the lease cheaper for the lessee.
Meanwhile, the lessor has security as they own the asset, enabling them to recover their costs if the lessee doesn’t keep up with payments.
Overall, the Leveraged Lease provides a financial structure that caters to diverse interests and facilitates large-scale investments, while managing risk and tax liabilities.
Explanation
Leveraged lease serves a significant purpose for both lesser and lessee in diverse ways. From a lessee’s perspective, leveraged leases can provide a way to acquire expensive equipment or assets without bearing the full upfront cost.
This approach can notably conserve their capital for other uses where businesses can take advantage of using an asset while paying rent over an agreed term. Hence, they are often used by companies to finance assets that may be too expensive to buy outright.
On the other hand, for lessors, leveraged leases allow for the procurement of income-producing assets using mostly borrowed money. This is beneficial because it mitigates the lessor’s risk by using debt rather than the full equity to finance assets.
Typically, the asset’s income is used to service the debt and other expenses. Leveraged leases thus give a platform for the lessor to diversify the portfolio and potentially earn higher returns from the leased asset’s income and any potential appreciation in the asset’s value over time.
Examples of Leveraged Lease
Airline Industry: A classic example of a leveraged lease in the real world is in the airline industry. Many airlines don’t have the capital necessary to purchase brand new planes, which can cost hundreds of millions of dollars. Instead, they may enter a leveraged lease agreement with a leasing company and a lender. The leasing company purchases the aircraft from the manufacturer and then leases it to the airline. The lender provides the majority of the funding and the airline makes lease payments rather than having to pay the full price upfront.
Commercial Real Estate: Another use of leveraged leases is in commercial real estate. For example, a company wants to expand its operations and needs a new corporate office. However, it may not have enough capital to outright purchase a new property. In this case, the company can enter into a leveraged lease with a real estate investment trust (REIT) who purchases the property, while a bank provides the financing. The company makes lease payments to the REIT and may have the option to buy the property at the end of the lease.
Renewable Energy Projects: Leveraged leases are also used in renewable energy projects, like solar or wind farms. These ventures can be very capital-intensive but the owners may lack the necessary resources. They use the leveraged lease structure, where an equity investor and lender provide the capital to build the project while they make lease payments. This also allows them to take advantage of tax benefits, as the equity investor can claim the tax credits attached to renewable energy generation.
FAQs about Leveraged Lease
What is a Leveraged Lease?
A leveraged lease is a type of lease financing where a financial institution facilitates the lease while also providing a part, normally about 60 – 80%, of the financing. The lesser clarifies the balance of finances through some form of debt.
Who are the parties involved in a Leveraged Lease?
Three main parties are typically involved in a leveraged lease. These are the lessee (the one who leases the asset), the lessor (who owns the asset), and the lender (financial institution that provides the financing).
What are the benefits of a Leveraged Lease?
A Leveraged lease offers several benefits like tax benefits for lessors, possible lower costs which can be passed on to the lessees, and risk diversification for lenders due to the involvement of the equity participant (lessor).
What are the risks associated with a Leveraged Lease?
The risks include changes in tax laws which may affect the lessor’s ability to benefit from the arrangement, and the risk that the lessee may default on the lease payments. The risks for the lender are normally limited due to the non-recourse nature of the debt offered in a leveraged lease.
What types of assets are typically involved in a Leveraged Lease?
Leveraged leases are often arranged for large, expensive, and long-lived assets. These could be aircraft, ships, real estate, and industrial equipment among others.
Related Entrepreneurship Terms
- Capital Lease
- Lease Financing
- Residual Value
- Depreciation
- Lessor
Sources for More Information
- Investopedia – An extensive resource for investing, personal finance, market analysis, and free trading simulators.
- Corporate Finance Institute – Provides online courses and certifications for financial analysts, including detailed articles and resources.
- Financial Times – A British international daily newspaper with a special emphasis on business and economic news.
- The Balance – Offers expertly crafted financial advice and information whether you’re interested in budgeting, investing, banking, tax planning, real estate, insurance, retirement, or career advice.
