Lease Myth Busting: Fair Market Value is a well understood concept that establishes the equipment value at any point in time

“Fair Market Value,” or FMV, is often referenced, and frequently capitalized in lease documents and therefore looks like a defined term in a contract. Most lessees reading a lease contract which contains FMV assume it’s defined in some reasonable and straightforward manner. In many leases, FMV is not defined and when it is defined it is often defined in a manner which is extremely lessor-favorable. Many apparently benign elements of the definition such as “as mutually agreed” actually create material risk for the lessee and can result in extensions since the lessor’s incentives are affected by the fact that monthly rents continue to be paid while negotiations go on. Other contractual approaches to more tightly defining FMV like hiring an appraiser or a few appraisers have similar risks – the whole process leads to extensions since these definitions rarely include a time frame. The bottom line is that while FMV can be well structured to reflect the lessees understanding of Fair Market Value –this is almost never properly addressed in lease documentation from the lessee’s point of view. If you want to put your FMV definition to the true test– just ask your lessor for an FMV quote on all of your remaining leases and see what you get back. If the number is surprising you may need help from an expert.

The FMV myth has a particularly pernicious effect in IT leasing where the value of IT equipment at the end of lease term is commonly understood to be a fraction of the original cost. Because “Moore’s Law” is well known, lessees assume all parties understand and agree that computer equipment rapidly declines in value and that “fair” means a very low value. However, it is very common that the FMV quoted by lessors at the end of lease does not reflect the cost to buy a piece of replacement equipment. When IT lessees actually ask for a lease buy-out amount for a substantial amount of equipment at the end of lease, they are commonly shocked when the lessor’s fair market value quote is 20-30+% of the original value of the gear. Every lease which contains ill-defined FMV language contains substantial risk and the negative financial consequences can be material.

Example – One way that FMV language can be constructed to favor the Lessor is for the FMV definition to be “in-place” versus “de-installed and available for delivery.” Consider a retail store which leased much of its store fit out and display equipment and signage. If valued on an in-place basis if purchased by the lessee, the equipment clearly has significant value to the company. How would the public know where the store is without the signage? However, how much would an old sign be worth on the secondary market to a third party? Similarly, computer equipment sitting on desktops and in the overhead compartments of airplanes above traveling sales people across the country have relatively high “in-place” value to the lessee but their real secondary market value is likely minimal.

Here is an example of some Lessor favorable language for an IT lease: “Fair Market Value means the price obtainable for the Equipment in an arm’s length sale or lease transaction (as applicable) between informed an willing parties, neither under compulsion to contract, for the sale of Equipment utilizing the assumption that the Equipment is installed and under continuous and uninterrupted use by the buyer / user.”

In a situation in which the Lessee wants to purchase the equipment at end of lease, the equipment has significant value when in use / in place, but virtually no value on the secondary market.

Conclusion: FMV is an element of lease contracts which can create significant risk for lessees. The most certain way to quantify FMV risk on existing leases is simply to ask your lessor(s) for an FMV quote on all of your remaining leases if they were bought out today. This effort will have the additional benefit of giving you a reasonable picture of the downstream financial exposure which exists in the portfolio.