Lease Myth Busting: Leasing is a cost effective hedge against technology obsolescence
The reality of rapid technology obsolescence raises important questions regarding the role of leasing, specifically: which of the parties (Lessor or Lessee) in a lease transaction processes the most financial and technology risk as a result of technology obsolescence and how does this compare to the risks a Lessee may process if the equipment was purchased instead of leased. In this installment of Lease Myth Busting we take a common sense based approach to examining how leasing affects technology risk and financial risk for Lessees relative to Lessors.
Technology Risk: Leasing an IT asset over a set lease term reduces risk of obsolescence if the lease term ends at the optimal point to replace old technology with new equipment. If this occurs then the Lessor is processing technology risk and leasing can be an effective hedge against technology obsolescence for the Lessee. However, the Lessee’s technology based risk is arguably increased by leasing because the lease term – an arbitrary period of time – locks in the date in the future when any upgrade or technology refresh will need to take place whether that moment in time is optimal or not. By contrast owning equipment allows a company to upgrade equipment at any point. The company may choose to refresh or upgrade – after 1 year, 2, 3, 5 years …. This flexibility puts the user and owner of the equipment in the power position in upgrade negotiations. The user and owner can evaluate upgrade offers at any time and if the deal is not a good one, the user and owner can refuse to buy from any vendor. Few considerations beyond the user and owner’s needs, the condition of the equipment and related maintenance cost as well as the attractiveness of the refresh proposal demands that the client take the offered refresh deal. However, if the equipment is leased, the lease term and the contractual conditions shift the balance of power. When equipment is leased the Lessor controls the clock – not on the first transaction – but on every subsequent transaction. Does leasing deliver enough value to the Lessee to justify giving up significant control over the timing subsequent transactions to the Lessor?
In practice lease terms typically drive the timing of upgrades. The Lessee is compelled by the lease commitment to either make upgrade decisions on a timetable which may not be optimal or pay extension rents. This reduces the Lessee’s leverage in negotiations regarding those upgrade transactions and increases the likelihood that sub-optimal decisions regarding technology will be made.
Financial Risk: If the Lessee can return all of the equipment at end of the lease term with no additional costs beyond the committed payments, then in most technology lease transactions, the Lessor is processing the financial risk and leasing can be an effective hedge against technology obsolescence for the Lessee. However, an analysis of the all-in cost of leasing programs can often rapidly establish that due to end of lease and other costs, leasing is not a cost effective hedge against technology obsolescence for the Lessee. All-in cost analyses of past leases have almost always shown that despite the fact the Lessor owns the equipment; the Lessee is processing the most financial risk.
The idea that leasing is a cost effective hedge against technology obsolescence is fascinating because it acknowledges that from a financial point of view, leasing is potentially a zero sum game in which the Lessor will lose if the Lessee returns the equipment on time per the terms of the lease contract. To achieve targeted reasonable return, and cover the refurbishment and other costs, the Lessor who receives equipment back on time at end of lease must typically sell old used equipment for at least 35%+ of the original equipment cost – often an impossibility. In contrast, a Lessor can achieve targeted return by collecting extension and other payments AND still maintain interest in the end of lease charges as additional financial upside. Lessors’ typical profitability is commonly based on the Lessees having paid extension rents and other charges. Further, Lessors’ future profitability are commonly based on the expectation that Lessees will continue to pay extensions in the future. By contrast Lessees typically expect to return equipment on time at end of lease and their Lease vs. Buy analysis is generally built on this expectation – adding up the regular-term lease payments and comparing that to the cost to buy the equipment and achieving a financial benefit at the expense of the Lessor who would be stuck with old worthless gear. But leasing companies are almost universally very profitable which suggests their clients must process the most risk in leasing arrangements …
The fact is Lessees DO process the most financial risk in lease arrangements. Leases are commonly more expensive than clients anticipate since most lease portfolios experience some material amount of extensions and other charges beyond the base term payments. Worse still, most Lessees do not track these costs and often continue to believe leasing reduces their financial risk when it actually increases it.
Example: Below is an example of a refresh program in which the key driver for the Lessee was reducing technology obsolescence risk. The company wound up paying over $8.5 million for $6 million in Original Equipment Cost (OEC) of IT equipment over 6 years.
Conclusion: Leasing is NOT necessarily an effective hedge against technology obsolescence and may actually increase both technology and financial risks. Companies must be very careful when entering into leases with the intention of refreshing their IT gear at the end of lease. A key step in evaluating how leasing might reduce cost and technology obsolescence risk is to evaluate the all-in cost of existing and past lease programs.