Structuring Leases in Challenging Interest Rate Environments – Like Today

Winning business by giving customers rate options

The commercial leasing industry began in the 1960s but started to blossom in the 1970s, led by bank-owned leasing companies and a few large finance and captive finance companies. The primary offering in the industry was a fixed-rate lease. The interest rate environment in the 1970s was stable but high, with a normal yield curve when compared to the environment of the 2000s. My experience was that, in the 1970s, lessors were funding most of their business with a combination of short-term funds and some long-term bonds, which created nice high spreads. Treasury risk was not considered a major issue. The industry used a “fixed at proposal” business model, meaning you quoted a rate to a customer, the customer accepted and you funded when the asset was delivered, and that could be weeks or months apart. Lessors were subject to lots of rate risk, but everyone was happy.

The 1970s interest rate crisis

Interest rates spiked in 1978 and became choppy and extremely high, the yield curve inverted and people became very, very unhappy. The shock caused a quick change in policies to deal with rate risks. Leases were changed to being quoted fixed at takedown or fees were charged to lock in a rate. Fixed at takedown quotes included rent calculation formulas tied to like-term treasury yields to maturity to set the rate when the asset was delivered. Lessors match funded new business to a large extent, as their short funding strategy had put many of their spreads into negative territory. Prepayment clauses were changed to include mark-to-market terms also based on like-term treasury yields, matching the remaining term to compensate lessors for economic losses when re-deploying higher rate funds associated to the terminated deal. It all worked but it took a while and was painful.

I was responsible for product development and sales support at the time, working for some very smart and creative bosses. We realized the volatile rate environment could be an opportunity. We figured we could differentiate ourselves and have a competitive advantage by offering rate options to customers. We began offering leases that could be floating rate, fixed rate, floating with an option to fix, or fixed with a one-time option to re-fix or float. Fortunately, we had a flexible operating system and a great operations staff to handle new options. We figured out how to do the structures for FMV leases as well as finance (non-tax) leases. The rent-setting calculations were all based on using like-term treasury yields to maturity. We researched the relationship of our cost of funds to treasury yields to limit our treasury risk in our structures. We charged modest fees in the deals with options that customers accepted as long as the fee did not defeat the benefits of the unique structures.

Business was great. The options allowed customers to take a view on the direction of interest rates to get lower lease rates. The rates for the various options were widely different depending on the shape of the yield curve, so a floating rate rent rate could be much lower than a fixed rate rent rate. There was risk but the customers were taking the risk, and they were happy with their choices. Also, the float with an option to fix rents were usually lower than a normal fixed rate deal (depending on the shape of the yield curve). The fix and re-fix (the re-fix occurred at a mutually agreed upon point in the lease term) deal rents would be lower if rates declined at the re-fix date, a risk lessees were willing to take. The rate environment is much the same now.

Where we are now

The interest rate charts below show that the stable low-rate environment is no more. We are in a similar environment as the 1970s and 1980s, where the yield curve is inverted at times, and short-term and long-term rates are higher and may still rise. Future rates, although hard to predict, should come down and calm down once the inflation rate comes down. I do think the Fed will have a hard time given all the factors involved in the inflation of today, many out of their control. The tight labor market is an added issue, meaning rate volatility could be around for a long time. All this means big opportunities for lessors willing to offer rate option lease structures. The higher interest rates also make lease rates for true leases more attractive, as the value of tax benefits increases the higher the cost of funds.

Historical Federal Funds Rates (Short-Term Rates)

Historical 3-Month and 10-Year Treasuries
(the gap is the yield curve)

What works and when?

Below is a “heat map” color-coded to show which structure may be the best option under a given view of the rate environment (green = good, red = bad, amber = could go either way). We used this chart to train our sales staff. We also used it as part of our consultative selling process, showing it to customers. That sales process traditionally meant probing for the customer’s accounting, tax, financial reporting and asset use issues. We added rate preference to make the structuring process more robust.

I know these ideas are a lot to swallow. It may be a hard sell internally for lots of reasons. I was fortunate as I had great senior management willing to listen and take controlled risks related to new ideas. We tracked these deals to ensure we limited the exposure. I was also surrounded by like-minded peers in all the business disciplines like operations, systems, credit, tax, accounting and asset management. They all shared the common goal of growing the business without anyone actually setting formal goals. I know that all the disciplines I mentioned don’t always work as well together on new ideas, as it is safer and easier to say no—it means less work and no chance of screw-ups they could get criticized for. But no risk, no reward.