What is Lease Financing? How does it work?

Lease financing is a type of financing in which the owner of an asset contracts with a customer who wishes to rent that asset for a specific period of time. Sales leases and capital leases are contracts in which a company provides an asset in exchange for recurring payments. The payment of rental is referred to as lease rental, the owner is referred to as a lessor, and the user is referred to as a lessee.

Examples of lease financing

The following financial lease examples can be found in a wide range of industry sectors and require a large lump sum:

  • Apartments
  • Ships
  • Diesel engines
  • Heavy machinery
  • Plant equipment

Financing Types of Leases

Lease financing can be classified into three categories: risk transfer, lease period, and number of parties involved.

  1. Finance lease
  2. Operating lease
  3. Sale and Leaseback
  4. Leveraged Leasing

The lessor transfers all substantial risks and rewards associated with ownership of assets to the lessee in lease rentals. Leases over a long period of time are usually not able to be canceled before they expire. Financing leases consist of two phases: primary and secondary. 

Lease rentals ensure that the lessor recovers his investment during the initial period that lasts indefinitely. If you choose the peppercorn rental option, you will pay a smaller lease rental during the secondary period.

Financing Lease Features

  • As per the main lease agreement or a separate contract, property ownership passes to the lessee upon termination of the lease term.
  • LESSORS charge a lease rental during the primary lease period to cover their investment.
  • Maintenance and management of the asset must be handled by the lessee.
  • The lessor assumes no asset-based risk or reward.

Operational Lease

Leases are contracts in which the lessor allows the lessee to use a particular asset for a specified period of time without transferring ownership. Operational leases are short-term and cancellable, so they are a better choice than finance leases.

Features of operating a lease

  • There is a notable difference between the lease term and the economic life of an asset.
  • The lessee will not incur a penalty if the lease is terminated within a short notice period.
  • Ownership of an asset comes with risks and rewards for the lessor.

Sale and leasebacks

In financial leasing, an asset is sold to another party who leases it back to the seller for a specific rental amount. The sale and lease back arrangement is typically used by sellers and lessees of real estate who are facing short-term liquidity crises.

Leveraging a loan

Leveraged leasing, which involves three parties-the lessee, the lessor, and the lender-has become increasingly popular in recent years. Lessors contribute equity towards the cost of the leased asset, while third-party lenders provide the financing balance. Equipment such as oil rigs, aircrafts, and railways are commonly financed this way.

The benefits of lease financing are numerous

Investable

In a leasing arrangement, the rate of return is much higher than the interest payable on financing, ensuring a balanced cash flow and a highly profitable business. By reducing one-time significant cash payments, businesses maintain a steady cash flow profile.

Qualitative assets

Lessees remain owners of assets that are leased by lessors to lessees. Business owners who wish to invest in quality assets can benefit from this agreement.

Assuring income

The lessor receives an assured and regular income within the specified timeframe as soon as the lessor and lessee sign the lease.

The benefits of taxation

Lessors include rent or lease payments in their profits since they are considered operating expenses.

Planning is essential

By keeping the lease expenses constant over the asset’s life or increasing them in line with inflation, businesses can plan expenses actively.

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