Risk Rating an Equipment Master Lease Agreement
When a company is preparing to lease capital equipment, rating the risk of each master lease agreement under consideration is an indispensable step.
Most master lease agreements will almost always contain terms and conditions that can escalate total cost of ownership well beyond regular-term rent. Therefore, identifying these risky terms and conditions that drive additional cost is an important step in accurately assessing the total costs to be incurred under each master lease agreement.
Risk rating also allows the enterprise to realistically compare the cost of various lease proposals accurately. Additionally, it allows the company to compare leasing to the cost of purchasing or other forms of debt. When the full scope of the risk in a typical lease agreement is considered, it may become clear that purchasing actually has less total cost.
The problem is that the contractual terms which generate risk are not readily apparent in a standard master lease agreement. Even lawyers often overlook the business language in lease agreements that creates predictable additional cost if they don’t have expertise in how risk is couched in a lease agreement. The consequences can be severe. It’s not uncommon for lessors to end up paying two (or more) times the original equipment cost because of overlooked risk.
On the other hand, a well-structured, risk-capped master lease agreement can result in lower total procurement cost than possible with purchasing.
Considering this wide range of consequences based on how well equipment leasing risk is identified before procurement decisions are made, it’s crucially important to be able to pinpoint—and quantify—the risks in a master lease agreement.
Common Risks in a Master Lease Agreement
A useful strategy is to categorize the severity of each risk in a lease agreement as either “3” (high), “2” (moderate), or “1” (low). This allows the creation of a “scorecard” for the risk levels of each lease agreement.
This is by no means a comprehensive list, but some of the most pernicious risks in lease agreements are:
- Uncapped interim rent.
- Fees not covered in base rent.
- Burdensome notice requirements that are difficult to comply with.
- Return conditions that make compliant return hard to achieve.
- Default provisions that make default likely.
- Unreasonable casualty remedies.
- Lessor-favorable or ambiguous definition of fair market value for buy-out option at end of lease.
Quantifying the Risks
Once the contract risks are identified and assessed a risk rating, it’s then necessary to appropriately weight them based on their financial significance. The only way to accurately do this step is to review the historical costs of each risk. This will involve a full financial analysis of past lease performance, breaking down each lease to see what the real costs of each risk have been.
With this knowledge—combined with an accurate understanding of how risky each master lease agreement is in each area—an enterprise can make intelligent, informed decisions about equipment procurement and negotiate improvements to the contracts.
A Word of Caution
Negotiating a low-risk lease agreement is a great start in reducing the risk of equipment leasing, but it’s not the end of the story. Poor contract management and lax operating procedures can result in additional costs even in a well-structured lease agreement. And, typically, lease schedules amend the master lease agreement, and these schedules frequently contain additional risk. Therefore, ongoing monitoring of lease-schedule language is required.
Controlling risk in an equipment lease is a continual process, but it starts with being able to identify the many terms and conditions that generate additional risk and cost, as well as to rate the severity of these risks in each master lease agreement under consideration. Enterprises that need assistance can turn to leasing experts such as Lease Portfolio Recovery Services LLC (LPRS) to gain valuable cost-saving guidance. LPRS has its own proprietary master lease agreement risk-rating modeling system, which can help you to rapidly quantify the total risk in each of your master lease agreements.