Capital Lease

What Is a Capital Lease?

A capital lease is a contractual arrangement involving two key parties: the lessor and the lessee. In this agreement, one party, known as the lessor, grants the other party, referred to as the lessee, the temporary use of their property for a defined period.

This type of lease typically spans an intermediate to long-term duration. The lessor, who owns the property, permits the lessee to utilize it within specified terms and conditions. To access this property, the lessee is obligated to make regular rent payments.

The lease agreement contains several critical elements:

1. Financial Terms outline the amount of rent, any security deposit, and other financial transactions involved in the lease.
2. Lease Duration and Renewal specify the lease's duration and whether there is an option to renew it.
3. Inventory of Fixtures includes a list of fittings and fixtures that are a part of the lease.
4. Restrictions enumerate activities or behaviors that are not allowed while using the lessor's property.
5. Requirements are activities that the lessee must fulfill while utilizing or vacating the lessor's property. For instance, the lessee may be required to repaint the property before leaving or terminating the contract.

A security deposit is typically required to safeguard the lessor's interests. This deposit comes into play if the lessee defaults on rent payments or causes damage or alterations to the lessor's property.

In such cases, the lessor has the right to use the security deposit to cover the unpaid rent or repair costs. The security deposit should be returned to the lessee upon lease termination.

Both parties should agree to the terms of the lease agreement and formally sign the contract. The lessor may also be referred to as the landlord or owner, while the lessee is often called the tenant.

A capital lease represents a financial obligation for the lessee, while the lessor earns rental income from this arrangement.

Typically, capital leases are long-term contracts involving regular monthly rent payments, and they often offer the possibility of renewing the lease with adjusted terms, including updated rent rates based on the current market conditions.

Understanding Capital Lease

The leases can be structured as either a net lease or a gross lease.

Net lease differs from the gross lease as follows:

• Net lease: In a net lease, tenants must pay taxes, utilities, and maintenance in addition to monthly rent to the landlord. The rent amount fixed in such a form of lease is generally low.
• Gross lease: The owner pays for maintenance and other charges in a gross lease. The rent amount fixed in the gross lease is, therefore, high. 

There are two types of lease, as mentioned below:

1. Operating lease: In this lease type, the lessee is allowed to use the property for a specific period, and the lessor does not transfer ownership rights after the lease period.
2. Capital lease: In this lease type, the lessor permits the use of the property, and the lessee is given the option to buy the asset at the end of the lease term; ownership is not automatically transferred. It is also called a financial lease or sales lease.

Four criteria must be met to classify a lease as a financial lease:

• An option is with the lessee to buy the asset at lease termination, ownership of the property is not automatically transferred.
• Lesse gets the option to buy the lessor’s leased property at a discount (i.e., at a price lower than the property’s market value) at lease termination.
• The lease period is a minimum of 75% of the property’s economic/useful life
• The minimum present value of lease payments is equal to at least 90% of the property’s fair value.

If a lease meets these criteria, then it is classified as a capital lease. If any of these criteria are not met, then it is appropriate to classify a lease as an operating lease.

Capital Lease Example

Let’s take an example: ABC company (lessee) leased a property worth $860,000 for monthly lease payments of $1,560 from PQR Limited (lessor). The useful life of the property is 15 years.

The lease term is 12 years. ABC company has the option to buy leased property at the price of $900,000, and the Market value of this property is $1,000,000. 

Benefits of holding a capital lease for lessee: Lessee can buy leased property at lease termination for a discount. 

As the lease period is supposed to be at least 75% of the property’s useful life, the longer the useful life of the property, the longer the lease term and the lessee’s effort and cost are reduced as he/she can stay in the same leased property for a longer period.

Benefits of holding a capital lease for a lessor: Lessor’s liquidity risk is reduced as the lessee exercises the option to buy leased property at lease termination from the lessor.

Calculating Capital Lease Liability for Lessee

The capital lease liability is the lessee’s liability and is mentioned on the balance sheet under the liability section and treated as long-term liability/debt.

Capital lease liability is the sum of the present value of future lease payments or lease cash flows. The discount rate represents the lessee’s cost of borrowing or the return required by the lessor. It is used to determine the present value of future lease cash flows

PV of future lease CF = CF year 1/(1 + DR)1 + CF year 2/ (1 + DR)2 + … + CF year N/ (1 + DR)N

Where,

• PV = Present Value
• CF = Cash Flow
• DR = Discount Rate
• N = Lease Term

To understand better, let us take an example of calculating capital lease liability with:

• Lease term = 3 years
• Discount rate (DR) = 10% = 0.10
• Cash flow (CF) = $20,000
• Useful life of the property = 4 year

Capital lease liability = [CF year 1/ (1 + DR)1 + CF year 2/ (1 + DR)2 + CF year 3/(1 + DR)3

= $20,000/ (1.10)1 + $20,000/ (1.10)2 + $20,000/ (1.10)3

= $18,182 + $16,529 + $15,026 = $49,737

Let’s take another example and find Cash flow if:

• Lease term = 1 year 
• Discount rate = 8% 
• Capital lease liability = $6,700

Capital lease liability = CF/ (1+DR)1

$6,700 = CF/ (1.08)1

CF = $6,700 * 1.08 = $7,236

Let’s understand by taking another example by following the table below:

Let’s calculate capital lease liability.

Discounting factor = 1/(1+Discount rate)Year

Capital lease liability = Sum present value of future lease cash flows 

= $40,181 + $35,874 + $32,031 + $28,598 + $25,533 = $162,217

Impact Of Capital Lease On Financial Variables

A lease that is based on a low-quality property has high risk. There is a positive relationship between risk, interest rates, and discount rates meaning as risk increases, interest rates and discount rates increase as well.

Lease term and interest rate exhibit a positive correlation. If the lease term is longer, then the lessor will require a higher interest rate due to increased risk exposure for the lessor. The longer the lease term, the higher the interest rate.

Lease payments also depend on macroeconomic factors, such as the business cycle phase. At the bottom of the business cycle that is in recession, property declines in value, and lease payments also decrease.

At the peak of the business cycle that is in expansion, property value rises, and lease payments also rise.

The Landlord/lessor is exposed to the risk of the tenant/lessee's nonpayment of rent. To avoid this risk, the lessor should assess the creditworthiness of the lessee before entering into a lease agreement.

This assessment can be done by looking at the lessee's financial statements (Income statement, Balance sheet, and Cash flow statement, the lessee's payment history can be checked to assess whether liability payments were made on time without default.

Other ways to avoid this risk are:

• To ask for a higher deposit amount from lessees with poor creditworthiness. 
• Demand collateral from the lessee to get secured against non-payment risk.
• Increase the amount of rent required from such tenants.
• To quantify this risk in percentage terms, the lessor should calculate the probability of default (if the lessee defaults on rent payment) and the associated expected loss).

To avoid higher lease liability, the lessee should maintain good creditworthiness and pay liabilities and other payments on time. An increase in lease liability will affect long-term liability ratios adversely since a financial lease creates a large liability on the balance sheet.

Capital Lease And Ratios

The capital lease liability is considered as debt and included in long-term liabilities on the balance sheet. It is treated as long-term debt in the total debt context and impacts all debt-related ratios, such as the Debt/Equity ratio and debt ratio.

Let’s examine how the lease liability impacts the lessee’s financial statements. The lessee must pay rent to the lessor, which will be recorded as rent expense on the lessee’s income statement, reducing the lessee's net income/profit. 

A lease is a liability for the lessee and increases the lessee’s balance sheet liabilities. This would negatively impact the lessee if the lessee does not meet this obligation.

To understand, we need to take a Debt/ Equity and Debt ratio example:

Total debt = Long-term debt + Capital lease liability + Short-term debt

In this case, 

Total debt = $2,000,000 + $350,000 + $70,000 = $2,420,000

Debt/ Equity = Total debt/ Equity

Debt/Equity = $2,420,000/ $7,000,000 = 0.35

This indicates debt as a percentage of equity = 0.35 or 35%.

Debt ratio = Total debt/ Assets

Debt/Assets = $2,420,000/ $15,000,000 = 0.16

This indicates debt as a percentage of assets = 0.16 or 16%.

Let’s further the understanding by taking another Debt/ Equity ratio example:

Assume now capital lease liability has increased from $350,000 to $500,000, and all other variables are the same: 

• Long Term Debt = $2,000,000
• Short Term Debt = $70,000
• Equity = $7,000,000
• Assets = 15,000,000

The impact of the increase in capital lease liability would be a higher Debt/Equity ratio and a higher Debt ratio.

In this case,

Total Debt = $2,000,000 + $500,000 + $70,000 = $2,570,000

Debt/Equity ratio = Total Debt/ Equity 

= $2,570,000/ $7,000,000 = 0.37

This indicates debt as a percentage of equity has increased from 0.35 to 0.37 or 37%.

Debt ratio = Total debt/Assets

=$2,570,000/ $15,000,000 = 0.17

This indicates debt as a percentage of assets has increased from 0.16 to 0.17 or 17%.

Researched and authored by Priya Chafekar  | LinkedIn

Reviewed and edited by Naveeth Rishwan Habeeb | LinkedIn

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