Evaluating leasing’s strengths and weaknesses

Leasing often represents the alternative to making an investment in a non-financial asset. In many cases when the asset is essential, such as with a car or home, we can perform a buy-versus-lease analysis to determine which approach to take. Here I examine leasing’s strengths and weaknesses, and evaluate its uses for the car or home. I conclude with an appraisal of the home as an investment, using the lease as a benchmark. An introduction As stated many times, the investment values for capital expenditures such as durable goods usually decline in value over time. We tend to purchase them for their benefits for household activities today and for periods in the immediate future. Consequently, our principal purpose is to reap the benefits from the items directly, since owning them doesn’t provide appreciation in those assets as, say, owning stocks could. Therefore, we are often open to considering leasing assets. A lease is a way to acquire the use of an asset without purchasing it. The lease allows you to receive the asset’s operating benefits, generally for a stated period of time, in return for an obligation to make a series of payments over the term of the lease. The maintenance and overhead costs may be paid by the lessor, which is the company providing the equipment. For example, in an auto lease, with the exception of fuel or other items of “wear and tear,” the lessor pays most costs in what can be termed a gross lease. On the other hand, these costs may be fully undertaken by the person using the equipment, called the lessee, in a transaction known as a net lease. Economic reasons There are economic reasons for leasing. The lessor may absorb the risk of technological or fashion obsolescence, or large unforeseen expenditures on the asset. You might want to lease an expensive computer if you think a better one might be introduced soon. Moreover, the lessor is sometimes able to develop efficiencies in specializing in that asset. For example, the purchase price of the asset and its repairs may be less costly to the lessor who buys, say, furniture in volume. Finally, the business owner may receive tax benefits that the lessor won’t. Nonetheless, the cost of leasing generally is greater than the cost of purchasing, including the cost of borrowing money to do so. And perhaps most important, it is greater because another cost structure is included: the lessor’s administrative cost, including the need for profit. It can, however, be the most profitable way to obtain use of an asset when it is needed only for part of the period. For example, it may be less costly to lease a car or house for a month in the summer than it is to own and maintain it all year. Probably the most common reason for leasing an asset is that households are short of capital. Leases may be offered with no down payment. For example, for people in significant marginal tax brackets, buying a house carries substantial built-in tax benefits, and long-term renting may be due solely to the absence of sufficient funds to purchase your own house. Finally, leasing is generally not presented as a liability on the household’s balance sheet, as it often is on the business statement. Therefore, when the household is short of funds and has limited ability to borrow, leasing may not show up in qualifying for a new loan. Automobile leasing Today, one of four cars is leased. Consumers are attracted to the ability to buy with little or no down payment. Moreover, the cost of leasing has become more competitive with purchase; automobile companies have placed more emphasis on it and sometimes offer disguised subsidies to lessees in order to sell more cars. Whether it is preferable to lease or purchase a car is dependent on such factors as: • How long the car is to be held. Depreciation in price of a car moderates after the first few years, which strongly favors purchase of the car if you plan to hold it for more than three or four years. • The age of the car. New cars offer fewer problems and are covered by warranty. Leasing an older used car, where available, can subject you to significant extra costs. • The cost of time. Selling a car that you own involves time and can expose you to price risk at the end of your designated ownership period. A lease can be drawn up quickly that involves merely dropping off the car at the end of its term. • Inspection standards. Lessees must comply with inspection standards in returning the car or face the consequences. What might be an almost unobservable scratch to you or the person that purchases a car from you can sometimes require an expensive repair to bring the vehicle up to inspection standards. • Mileage charges. Leases contain maximum-mileage charges. If you exceed the limit, you can pay expensive extra charges. If you are well under the limit, you receive no benefit. You are, in effect, being charged for mileage that you didn’t use. • Lease obligation. A lease is made for a fixed period of time and may be difficult or expensive to break or to get someone else to assume in the event of a change in your circumstances. Assumption of the lease by a third party also could expose you to liability in the event that the sublessee defaults in payments. However, owners can readily sell their cars at a time of their own choosing. • Ability to make payments. For those who have cash flow concerns, monthly payments for leasing will be lower than loan payments. On the other hand, once your loan payments have been completed, you own the car. On balance, in the absence of manufacturer subsidies, leasing an automobile will generally cost more than purchasing it outright. However, the extra cost for leasing may be acceptable to many, particularly for new cars to be held for around three years. The disparity in cost can be smaller in that period and more than offset by the absence of effort in changing cars and the benefit of having a risk-free sale of the old car. The buy-versus-lease decision for housing is somewhat sophisticated but can be handled without too much difficulty. Unlike the car lease-versus-buy issue, the details for a home are in the purchase decision; the cost to rent is given with no opportunity to find an identical home at a lower lease price as you can for a car. The weakness in taking a less sophisticated approach to decisions about housing is seen below. Home appraisal The return on investment on purchase of a home can be highly attractive. This shouldn’t be surprising, given that the government provides tax benefits for interest and property tax deductions. There is no tax on the gain from the sale of this property — another advantage. Assuming reasonable maintenance costs, the two key factors in making the purchase of a home a generally attractive investment are tax benefits, when the person is in a substantial tax bracket and continued growth of the value of the house at around the inflation rate — and in some cases, significantly beyond that rate. Thus, the house provides a hedge against inflation and a return on the investment. Other factors that people who purchase homes instead of renting them find appealing are pride of ownership and the forced-savings feature of homes. Mandatory repayment of debt as provided for in the mortgage contract is a savings and investment feature that many people overlook. Rental advantages include flexibility in changing your dwelling site and the lack of necessity for a capital commitment. An unanticipated acceleration in the level of inflation makes the purchase of a home even more attractive. It would raise the rate of return because, as mentioned, the house would likely rise in value along with the newer higher cost of building new homes. Thus, the home deserves its reputation as a good hedge against inflation. The disadvantages of homeownership include (1) its lack of short-term liquidity should immediate sale become necessary; (2) the responsibility for maintaining the home and grounds; and (3) the cyclical nature of home prices over shorter periods of time that can result in a loss when, for example, you purchase a home and then a change in where you work results in an unexpected sale. On balance, for expected holding periods of, say, three years or more, owning a home historically has been a highly rewarding investment. Lewis J. Altfest, CFP, CFA, CPA/PFS, is the president of New York-based L.J.Altfest & Co. Inc. This article was excerpted from his book “Personal Financial Planning” (McGraw-Hill/Irwin 2006).