The leasing industry in the UK – and throughout Europe – is changing. Driven in part by the upcoming change in accounting rules, which is pushing companies to reassess their leasing strategies, companies are focused on generating significant savings by concentrating on the total cost of vehicle ownership.
Historically, accounting rules in these regions have permitted organisations to exclude certain leases from being disclosed on a company’s balance sheet. When IFRS 16 goes into effect in January 2019, companies will be required to report all leases on their balance sheet.
Traditional European fleet lease product
The traditional fleet lease product in these regions, typically referred to as a closed-end lease, is very similar to the product offered to consumers by captive finance companies and banks. ARI, a global fleet management company, estimates that more than 80% of vehicles leased in the UK are classified as closed-end leases.
The closed-end lease model boasts a predictable, seemingly simplistic cost structure that most fleet managers find both familiar and convenient. This predictability, however, comes at a price.
Companies that prioritise these characteristics are essentially paying a premium to avoid risk. In order for the lessor to be comfortable covering that risk, two charges are embedded into the cost of the lease - potentially significant end-of-term charges and a premium for the residual value risk. Both adjustments usually result in favourable economics for the finance companies and banks at the cost of the lessee.
Open-End Lease Alternative
Fortunately, there are alternatives available that are both cost effective and convenient. An open-end lease is a flexible, transparent leasing structure that offers more options to manage operating expenses and, ultimately, reduce the total cost of ownership.
How might an open-end lease save money?
Here is a breakdown of where significant cost savings (ranging from 10 to 25%) may be realised:
1. Contract adjustments
The closed-end lessee is bound by a rigid, prescribed contract with fixed mileage parameters. Deviations result in contractual penalties and expensive rewrites. In the open-end model, these penalties can be completely avoided due to the product’s tremendous flexibility. Lease term, interest rate and other lease terms can be adjusted as dictated by business needs and changing economics.
2. End-of-contract costs
The closed-end lessee is required to pay for vehicle damages and wear and tear above and beyond “contractual use.” No such concept exists in most open-end leases.
3. Residual value margin
In a closed-end lease, the residual value risk is retained by the lessor. In order to reduce this risk, the lessor will set a low residual value to minimise the potential loss upon vehicle disposal. If the residual value of the vehicle is set too low at the lease’s inception, the lessee will bear this additional cost through the life of the lease. This practice typically results in a gain on the sale of the vehicle at the end of the lease, a benefit rarely communicated or passed on to the lessee. This is not the case with an open-end lease, where the lessee’s monthly payments are based solely on the projected value of the vehicle and any proceeds from remarketing benefit the lessee.
4. Early termination
Typical closed-end lease structures prohibit demand-based adaptation of the number of leased vehicles under a given contract, which translates to early termination penalties in the event of economic fluctuations or staff turnover.
5. Tacit contract extensions
If the vehicles are in use longer than the original terms of the contract, the monthly payments continue per the original terms, potentially causing the lessee to overpay well beyond the vehicle’s value.
6. Bundled services
The payments under a closed-end lease provide for a full range of services, such as tyre replacement, brake service and other repairs, regardless of need. Most companies will very rarely use all the services they have purchased through this bundled closed-end scenario. The pay-as-you-go option under an open-end lease generally makes more financial sense and provides greater visibility of the true operating costs of a fleet.
The open-end lease option offers complete visibility into the total cost of ownership, resulting in significant opportunities to control and optimise fleet-related total operating costs.
The structure allows the lessee to choose the duration of the lease contract and modify it based on how the vehicle is actually being used.
Moreover, it ensures there are no hidden costs. The lessee is not charged for excessive wear and tear at the end of the lease and any positive proceeds upon vehicle disposal are credited to the lessee, not the supplier.
Time for a change
The low overall cost, flexibility and transparency to cost drivers is the reason the open-end model is so popular in the United States, where ARI manages more than 1.4 million vehicles.
There, closed-end, full-service leases do not align with the intense focus on reduced cost and flexibility adopted by most fleet managers in the region.
The fleet providers who strive to reduce the customer’s total cost of ownership, without hidden fees, are the preferred partners in the industry.
As IFRS 16 takes effect and open-end lease options become better known in the UK, ARI forecasts a significant shift away from the closed-end product to open-end solutions over the next 10 years.
We expect most companies will find the open-end model to be an attractive solution with potential to significantly improve their bottom line.
* Jesse Mann oversees ARI’s global lease portfolio, helping to develop leasing-related strategies that align with the needs of both new and existing ARI clients. He joined ARI in 2013 and has held a variety of roles within the Treasury group. Prior to joining ARI, Mann worked for more than 15 years in the banking sector holding positions with industry leaders such as Bank of America, Advanta Corp., and Fitch Inc.