What is Lease Financing?
A lease is a simple financing structure that allows a customer to use energy efficiency equipment without purchasing it outright. The two most common types are on-balance sheet capital leases and off-balance sheet operating leases. Public sector organizations can also take advantage of tax-exempt leases. At the end of the lease, the customer may have the option to purchase the equipment, return the equipment, or extend the contract, depending on the type of lease used. Lease financing is offered by many equipment manufacturers and vendors as well as third-party lessors. (Note that operating leases must be reported on balance sheet as of 2019-2020.)
A lease may be a good fit if your organization...
- Wants a simple, quick, accessible financing option with minimal contract complexity
- Is considering working with a manufacturer or contractor that offers lease financing
- Is relatively credit-worthy and willing to take on equipment performance risk
- Wants off-balance sheet treatment via an operating lease, prior to the accounting rule changes in 2019-2020
To compare leases to other financing options that might be a good fit, answer a few questions about your organization.
How it Works
The customer either arranges lease financing through the manufacturer, vendor, or installer of the efficiency equipment being purchased or, if unavailable, directly with a third-party lessor. The customer and lessor sign a lease agreement once the project terms are agreed upon, and the lessor then provides the capital to purchase the equipment and associated installation services from a contractor. Once installation is complete, the customer begins making regular (typically monthly) fixed payments to the lessor on an agreed-upon schedule.
Beyond those similarities, the three types of leases work differently:
Capital Lease: In a capital lease, the customer is the owner of the equipment for most legal and accounting purposes during the term. Therefore, the customer must declare the equipment as an asset and the lease payments as a liability on its balance sheet. The customer may depreciate the equipment as an asset to provide a tax benefit, but the lessor typically takes a security interest in the equipment so that it can be reclaimed in the event of default. At the end of the lease term, the customer can purchase the equipment for a discounted bargain price, typically a $1 “buck-out” payment. A capital lease functions much like a loan and is therefore sometimes called a “finance lease.” However, capital leases can offer a few advantages over bank loans such as little to no upfront cost, less paperwork, and quicker approvals.
Operating Lease: In an operating lease, the lessor owns the equipment and the customer rents it at a fixed monthly payment. These rental payments are treated as an operating expense for tax purposes and are therefore tax deductible. In order to qualify as an operating lease, a transaction must pass several tests set by the Financial Accounting Standards Board (FASB). At the end of the lease, the customer can extend the lease, purchase the equipment for fair market value, or return the equipment.
**NOTE*** FASB issued an update to accounting standards in February 2016 that will eliminate off-balance sheet treatment for most operating leases, requiring customers to report the associated asset and liability on their balance sheet as of 2019-2020. These new standards will apply to any operating lease with a term of over 12 months. The standards do not include a grandfather provision, meaning that any leases signed before the change will also be affected.
Tax-Exempt Lease: Also known as a municipal lease, a tax-exempt lease-purchase agreement is a common financing structure that allows a public organization to pay for efficiency using its annual revenues. This option is an effective alternative to traditional debt financing but is only available to municipalities and other political subdivisions that qualify. Tax exempt leases have two unique attributes. First, the lessor may claim a federal income tax exemption on the interest they receive from the customer under the lease, allowing them to offer a lower rate. Second, the lease contract usually stipulates that if the customer fails to appropriate funds to make payments on the lease in any given year, its obligations to the lessor ends. In most states, this non-appropriation clause means that (a) a tax-exempt lease is not considered debt and (b) lease payments may be made from operating rather than capital expense budgets. Although the financing terms for tax-exempt leases may extend as long as 15 to 20 years, they are usually shorter than 12 years and are limited by the useful life of the equipment. The customer has title to the equipment throughout the term of the lease and retains ownership once the lease is paid off.
Advantages and Disadvantages
State of the Market
Leases have existed since nearly the beginning of recorded civilization, with the first known commercial leasing law set down in Hammurabi’s Code in Babylon almost 4,000 years ago. Leases are used to finance a variety of assets, and they are one of the most common methods to finance energy efficiency measures. Due to the very large size of the leasing industry and the fact that many leasing companies do not track which of their leased assets qualify as efficiency equipment, it is difficult to estimate the size of the energy efficiency leasing market. However, the market is very large, in part because leases are commonly used to provide underlying financing for energy performance contracts (EPCs) and other structures. Within the Better Buildings program, the Financial Allies completed nearly $1.7B in energy efficiency leases from 2012 to 2016. Leases will likely continue to play a major role in energy efficiency financing for years to come.
Learn More about Leases
|Capital Lease||Operating Lease||Tax-Exempt Lease|
|Basic Attributes||Applicable Sectors?Which economic sectors does this option commonly serve?||All||All||Government|
|Geographic Scope?Is the financing option available throughout the U.S., or limited to certain areas that have the appropriate policies and programs in place?||Nationwide||Nationwide||Nationwide|
|Building Ownership?Does this option work well for projects in leased space, owned space, or both?||Owned or Leased||Owned or Leased||Owned or Leased|
|Typical Project Size?What range of project sizes does this option typically serve?||Any||Typically smaller projects, but no explicit restrictions||Any|
|Contract Structure||Contract Complexity?How complex is the financing option from the customer’s perspective, in terms of the size and complexity of the financing contract, the number of parties involved, and other factors?||Low||Low||Low|
|Parties Involved?Which types of organizations are typically involved in executing the financing option?||Customer, Contractor/ESCO, Lessor||Customer, Contractor/ESCO, Lessor||Customer, Contractor/ESCO, Lessor|
|Payment Type?Are customer payments fixed over time or might they be variable based on factors such as energy savings or utility rates?||Fixed||Fixed||Fixed|
|Guaranteed Savings?Is the customer typically guaranteed some amount of savings net of payments on the financing contract?||No||No||No|
|Measurement & Verification?Is measurement and verification (M&V) of project savings typically provided as part of the financing contract?||No||No||No|
|Tax & Balance Sheet||Budget Source?Do customer payments made on this financing option typically come from an operating budget ("opex") or capital budget ("capex")?||Capex||Opex||Opex|
|Balance Sheet Treatment?According to industry best practices, does the financing option typically appear as a liability on the customer’s balance sheet, or is it off-balance sheet?||On balance sheet||Off balance sheet||Off balance sheet in most states|
|Tax Deductions?Which amounts can a customer typically deduct from its taxes under this financing option? In some cases all payments are deductible, and in other cases only interest and depreciation are deductible.||Depreciation, Interest||All Payments||Lessor may claim deduction on interest paid by customer|
|Equipment Ownership?During the financing term, is the efficiency equipment typically owned by the customer (internal) or by an outside party such as the lender or contractor (external)?||Internal||External||Internal|
|Collateral Source?Which customer assets can the lender use as collateral to secure repayment?||Equipment||Equipment||Equipment|
|Contract Terms||Typical Duration?How long does a typical financing contract last?||Often 3-5 years, but flexible||Often 3-5 years, but flexible||Flexible|
|Typical Close Time?How long does it typically take to secure financing once you start speaking with providers?||Short (1-3 months)||Short (1-3 months)||Short (1-3 months)|
|Market Attributes||Market Size?What is the total cumulative dollar value of projects financed under this option?||Very large||Very large||Very large|
|Time in Market?How long has this financing option been available in the market?||Since ~2000 BCE||Since ~2000 BCE||Longstanding|