Understanding Risk in closed and open end leasing

Sometimes it’s good to revisit the basics and spend some time on concepts that we all should know, but maybe have forgotten about. Or, we’re new in the fleet management sector and we welcome a heads up about some of the differences in leasing contracts. Today: open end leasing versus closed end leasing.

Residual Value

The residual value is the contractual value of a vehicle at the end of its contract. For the laymen, it’s difficult to foresee or guess this value, but leasing companies have years of experience determining the market value of any specific vehicle at most of the mileage/duration parameters. They receive input from their remarketing experts, the second-hand dealer networks and market studies. In addition, all of the leasing companies are experts in reselling vehicles.

The residual value of your specific new car is calculated based on an assumption of this future market value, taking into account factors such as the contract parameters (mileage and duration), the vehicle’s equipment (a Mercedes S Class without leather upholstery might sell more difficulty), its colour (some markets prefer blacks and greys, other markets don’t) and the general popularity of the vehicle in the second-hand markets.

In addition, leasing companies need to understand trends in legislation in the second hand markets and be able to deal with unexpected events, such as recessions. During the second half of the 2010s, for example, leasing companies had to deal with a general decline in demand for second hand cars, increasing their exposure. Many of the leasing companies launched campaigns, offering cheap contract extensions to customers, in order to divert and spread the exposure.

In other words, for those for whom the glass is half empty, the residual value is a type of risk you’d pay money for to avoid. If this is you, a closed end leasing is your product.

Open end leasing

North-America loves open end leasing (90% of all lease contracts), or as they call it “Terminal Rental Adjustment Clause or TRAC” leasing. In this type of leasing, the clients bear the risk on the residual value, which means that they can either purchase the vehicle at a pre-determined pricing or decide to find out what the market is willing to pay for it. If the market value exceeds the residual value, the client is rewarded, if not, the client will need to pay the difference.

The biggest advantage of true open end leasing is the control over the usage of the asset. Duration is fixed, but mileage is flexible, which suits the North-American tool-of-trade market. Leased vehicles in the US and Canada are rarely benefit cars and their use is less predictable.

An open-end leasing is considered as an operating lease (i.e. off balance in pre-IFRS terms) unless one of 4 conditions is met:

• The ownership of the asset is transferred to the client
• the client purchases the vehicle at a value below market price ( the “bargain purchase option”)
• the lease term is at least 75% of the useful life of the asset
• the present value of the minimum lease payments plus any lessee guarantee is at least 90 percent of the fair value of the asset at the start of the lease

Closed end leasing

Europe loves closed end leasing, but also agrees to more stringent conditions of the leasing contract. The residual value is carefully calculated by the leasing company based on the vehicle, the contract duration and the mileage. If the vehicle returns with more kilometres on the counter, the leasing company will defend that this will impact its remarketing value and the client will have to pay a pre-agreed fee per additional kilometre. Similarly, changes in duration or returning the vehicle in a worse state than expected for a vehicle at contractual age and mileage, will generate an end-of-contract invoice.

The hybrids

• The open calculation leasing starts in a similar manner as the closed calculation leasing: with a fixed monthly payment and contractual mileage / duration parameters. It offers however a risk and reward sharing. When the vehicle is sold with profit, the lessor will share the profit with the client. In the opposite case, the potential losses will also be shared.
• A closed end leasing contract with matrix allows the client to calculate at any point in time the monthly lease rate in case of changes in duration or mileage. This solution is presented as a matrix with, on one axe, different durations and, on the other axe, different mileages. The contractual parameters will be in the centerpoint of the matrix. The client can decide during the contract to change the contractual parameters of the contract or can wait until the end of the contract for a mileage/duration settlement, again according to the matrix.

Risk

At the end of the day, someone needs to bear the residual value risk. European providers have commercialised solutions that reduce the risk on the client side and North-American lease providers have understood that their client base is looking for flexibility, rather than TCO security. The difference between the (cheaper) NA lease cost and the (more expensive) EU lease cost, is exactly the price of hedging the residual value risks.