Equipment Type

How to Navigate Rental/Lease Agreements

Terminology and timing help determine which financial instrument to choose

January 31, 2012

 

Reprinted with the permission of Equipment Manager magazine, the magazine of AEMP.

For the uninitiated fleet manager, rental and lease agreements may look about as different as Tweedle Dee and Tweedle Dum. But they are not the same.

Without a basic understanding of those differences, equipment managers run the risk of being set adrift in unfamiliar waters. Knowing the pros and cons of each type of agreement, and knowing what to watch out for, can go a long way in safely running the rental/lease rapids.

That’s the opinion of Andy Agoos, principal at Orlando-based Agoos Consultants and former fleet executive with Neff Rentals and Hubbard Construction. In comparing rental and lease agreements, he says, end users have to step lightly through the tangle of terminology.

Rental agreements, for example, are usually based on monthly rates. What the end user may not know, however, is that a rental company’s idea of “monthly” isn’t necessarily 30 days. Many times,  “monthly” is considered 28 days.

“You want to negotiate the full 30-day duration,” Agoos says. “You also want to almost always build in a rental-purchase option for any length rental. You may think you need the machine for only three months, but in the meantime, if your company lands another contract, you may find out you need the machine for a year. If you don’t include that rental-purchase option (RPO) up front, your purchase price and terms may worsen once you’re into the rental period.”

Obtaining an RPO from a rental house is tough, he says, because they’re not used to option-to-buy contracts and all of their rental fleet is used.

“They don’t routinely know the fair market value of each machine,” Agoos says. “When they give you a quote, they don’t even know the brand of machine they’re giving you. They don’t know what specific machine will be available that month, so how do they know what it costs? Also, during up-front agreement discussions, be sure you negotiate 200 hours of use per month, or at least the industry average of 175 use hours a month (22 days at eight hours per day). Otherwise, the rental company could place monthly use hours at 150, for instance. That will help avoid an excess hour fee at the end of the rental.”

Another factor fleet managers should consider with rental agreements, Agoos says, is what happens when you return the machine. Unlike leased equipment, which is almost always new, lots of rental equipment basically is made up of used machines. Frequently, for example, an agreement will require that tires of the undercarriage must be 50 percent or better at the end of the rental.

“A lot of people sign those documents not knowing that they really are signing a contract, not a receiving document,” Agoos says. “There’s nothing wrong with that tire requirement—if the equipment is new. Suppose the tires are already 45 percent worn when you get the machine? Then one month later, you may have exceeded the 5 percent left on the tires.”

He explained that the trend depths are measured in thirty-seconds of an inch—20/32,”  for instance; so 10/32” would be 50 percent. “If that happens, now you’ve got yourself in a tough situation,” he says. “Pay attention to that.”

Also pay attention to indemnification; that is, who is responsible for damage to the equipment.

“This is a huge bone of contention,” says Agoos. “Bear in mind that if you are renting a machine from an OEM dealer or a rental house, they are in the business of renting and do it every day. But you don’t do that every day, so guess where all the liability lies?

“Remember that their agreement is prepared by their attorneys,” he says. “The liability lies on the contractor who is renting the machine. The end user should only accept responsibility or liability for issues that he causes. For instance, if an operator runs the machine into a pole or damages a blade, or if two machines hit each other, then, of course, that liability rests with the end user. His operator created the damage so he can expect to pay.”

But what happens if there is a latent defect on the machine? What happens if the machine has an undetected damaged tire that blows out? “That’s not the end user’s fault,” Agoos says. “He didn’t overheat the tire, didn’t puncture it. The tire just blew out. And, worse, suppose the blow-out hurts someone right next to the machine. Now, we have a $1 million loss. Who is responsible for that?

“I promise you that 99 percent of rental agreements contain an indemnification clause, or a ‘hold harmless’ clause,” he says. “That part of the contract usually states that the end user is responsible for everything—including acts of God, such as lightning strikes or floods. End users need to know that these terms are negotiable and should be negotiated fairly. The end user should accept only those liabilities he causes.”

Managers should take a similar look at lease agreements, Agoos says. For example, what happens if an OEM builds a machine that is defective when it comes from the factory?

“I know of one real case where the seat on a piece of OEM equipment was defective,” Agoos says. “It collapsed under a 300-pound operator, causing him to drop about a foot, seriously injuring his back. Whose fault is that? Who should the operator sue—and he is going to sue.”

Unless the end user negotiates this detail up front, the leasing company is going to expect the end user to indemnify its loss. “If they have to pay $200,000, they are going to send a bill for $200,000 to the end user,” Agoos says. “If the end user doesn’t negotiate the indemnification in advance, he’ll likely wind up paying some of the claim.

“Never sign a hold harmless agreement without reviewing it carefully.”

There are other differences between rental and leased equipment. The biggest, according to Agoos, is the length of the commitment for the machine use. Although there are exceptions to the rule, rentals basically tend to be identified with short-term projects, and leasing or owning the machines are more suited for long-term use. Short-term can mean one month, three months or even 11 months, but typically few rentals go more than a year, he says.

One exception to that generality, however, is specialty equipment.

“Specialty equipment is another reason for renting,” says Greg Kittle, CEM, vice president of corporate purchasing at William Charles. “The type of specialty equipment depends on what kind of contactor you are. A crane might be such a machine if you are a highway contractor. Demolition equipment is another. It all depends on the job scope.”

Kittle considers rental as a primary mechanism for acquisitions.

“As you establish what your core fleet size looks like, added equipment comes in,” he says. “Your mix is based on whatever your utilization history is and what your marketing plan is for the upcoming year. I always like to have a varying percentage of the fleet that is owned, rented and leased so the fleet size can grow or decrease in relationship to utilization and work load without affecting fleet equity.”

Agoos says, “Typically on general construction equipment, if your expected utilization rate is below 40 percent, you don’t own those machines. You rent them. If your utilization rate gets as high as 40 to 60 percent, you could rent or lease. If it gets over 60 percent, you typically will own or lease the machine.”

The primary considerations in making a decision on whether to rent, lease or purchase are the expected utilization and the rent or lease rates.

Determining the expected utilization rate can be done in numerous ways, Agoos says, but a simplified way to do it is to use the industry standard calculation of operating equipment 22 days or 176 hours per month.

“Thus, equipment operated for 14 out of 22 days has a utilization rate of 64 percent,” he says. Once you have an ongoing need, the driver for most contractors is money. If you have the cash, you buy. That usually gives you the lowest cost per hour. If you don’t have the money, or don’t want to spend the money, you lease.”

Robert Andrade, CEM and heavy-equipment consultant, also cites fleet mix.

“You need to have the right mix, and that mix is always changing,” he says. “What’s right for you this year may not be right for you next year. Business models and contracts are in constant flux. You have to have an equipment manager monitoring and managing that for you. If you don’t, you’ll be top heavy one way or another, the wrong equipment asset base at the wrong time.”

Other differences between rented and leased units are:

RENTALS: They are usually more expensive than a lease. For instance, if you rent a 4-yard wheel loader for three months, the rental house more than likely is going to get that equipment back in 90 days or less. Then the rental company will have to find somebody else to take that machine, operating costs that will be folded into rates.

Rental rates depend on local market conditions. Backhoe loaders generally rent between $1,500 and $1,800 a month in good times, Agoos says, “but I’ve seen them rent for $500 a month because of a depressed market. If $500 recovers the amount of the decrease in the machine’s use value, then anything the owner gets above that contributes to the base cost of the machine. Rental rates are almost entirely dependent on what’s happening in the marketplace.”

Maintenance on rental machines is generally the responsibility of the rental company. “They don’t know how many hours you are putting on the equipment every day, although some of the technology on newer machines will report meter hours,” Agoos says. “So the rental company has to maintain it. They can’t depend on the end user to do it.” Most rental companies require the salesman to visit the machine once a month just to make sure the machine is okay and is being used as it was intended to be used, and to record the meter hours. If an end user knows he will be running the unit on a double shift, he can usually negotiate a reduced excess hour charge up front. But that must be done during the original negotiation.

Another positive point for rental agreements is that they usually include maintenance. Rentals also allow the end user to test and evaluate equipment. If a contractor prefers, he can request a different OEM brand or model machine each time he rents. That helps determine which brand unit operates better than others or which ones cost less to operate than others, Agoos says.

Another advantage of rental is that the agreement is month-to-month. “You can walk away from the machine,” Andrade says. “Rentals are not meant to be more than that—just a rental.”

On the negative side, rentals mostly do not offer purchase options at the end of the rental agreement. Also, if the end-user requests a specific brand machine and it’s not available, he has to take whatever brand the rental company has.

LEASES: Leases tend to be less expensive than rentals because the end-user commits for multiple years, which lowers the rate. In determining the lease rate, leasing companies, like rental firms, have to buy the machines, so they tend to charge for depreciation and some return on what they have invested. There is also an administration charge and an interest charge.

Maintenance of leased units is the responsibility of the end-user since a lease commitment is for a longer period of time. When deciding what type of equipment should be leased, Kittle considers the asset class that has high residual risks, “meaning that they have a lower residual value related to purchase price. They do not retain as much of their value,” he says. “In certain classes of excavators, for instance, I have a much higher percentage in lease than owned.”

Another plus in leasing, says Andrade, is that “you are building equity in the machine and you can capture that cash back.” Although you might not have a scheduled need for the unit immediately, if you do land an extra job, the lease unit can be rolled over into that application. “You have a lot of flexibility because you are in control of that asset,” he says.

On the opposite hand, leases could pose a problem for smaller businesses. “You might have booking or bonding capabilities you are concerned about, or credit lines you are concerned about. Having that lease out there hurts your capacity to do business,” Andrade says. “Outside of that, as far as I’m concerned, leasing is the better of the two. And it’s the lowest-cost option when your cash or cash flow is limited.”

Whether or not an asset manager can put a rental unit on his balance sheet, for example, is determined by the Financial Accounting Standards Board Standard 13 (FASB 13), Agoos says. This standard, recently renamed ASC 840, defines the difference between an operational lease and a capital lease. If a lease meets four criteria, it is deemed a capital lease and the full purchase value of the machine must be put on the leasee’s balance sheet as a liability.

If the machine shows up on the balance sheet, the company has more debt, which affects its asset-to-liability ratio, and that adversely affects bank covenants. “So, asset managers want to get rental or leased machines off their balance books,” he says.

 “There are some places where leasing simply does not make sense,” Kittle says. “In Illinois, where I am, the entire leased amount of the machine is taxed, rather than just the lease payment. The lease option is much less affordable. You are adding a great deal of cost to an asset that has sharp market depreciation anyway. Leases are not nearly as effective in that case.”

Kittle says there are so many tax issues involved in the rent/lease/own decision making process that the best approach for asset managers is to discuss them with their accountants.

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