What it means
There are three parties. The lessee uses the asset and pays rent, the lessor buys the asset and owns it, and a lender funds a large part of the purchase.
The lessor typically contributes around 20% to 40% of the cost as equity and borrows the rest. The borrowing is usually non-recourse, meaning the lender can look only to the asset and the lease payments for repayment and cannot claim against the lessor's other assets.
The lender often takes a security interest in the asset and an assignment of the rent. The lessee pays the rent, and part of it goes straight to the lender as debt service.
Leveraged leases were attractive because the lessor, as owner, could claim tax benefits such as depreciation and interest deductions on the full cost of the asset, even though it had paid only a part of it. Some of that benefit could be passed to the lessee through lower rent.
The structure worked best for lessors with enough taxable profit to use the deductions. Accounting for them was complex, because under older US rules a lessor recorded a net investment made up of the rents receivable, residual value and tax effects, less the non-recourse debt, and recognised income over the lease term.
Under the current lease standards, new leases are classified under the standard lessor categories, while many existing leveraged leases kept their earlier treatment. The IFRS lease standard has no separate leveraged lease category.
Because the structure involves several parties, tax law and legal documents, finance staff meeting a leveraged lease should involve specialist tax and legal advisers. The key risks are lessee default, changes in tax law and a residual value at the end of the lease that is lower than expected.
A shortfall in any one can erode the lessor's return.
In practice
Real-world examples.
Example
A national airline needs a new passenger jet costing $90,000,000. A leasing company buys it using $27,000,000 of its own money and a non-recourse bank loan for the balance. The airline pays rent for 12 years and has the option to renew.
Example
A power utility leases a new generating unit from an investor group that borrows most of the cost. The lease payments are structured to cover the lender's debt service first. The utility avoids a large upfront outlay on its own balance sheet.
Example
A shipping company arranges a leveraged lease for a tanker. A bank lends 70% of the cost, secured on the ship and the charter income. If the shipping company defaults, the bank can take the vessel but cannot pursue the lessor's other assets.
Formula
Calculation
Lessor equity = Asset cost - Non-recourse debt
Cash yield on equity = (Annual rent - Annual debt service) / Lessor equity
A lessor buys an aircraft for $50,000,000, financing $35,000,000 with a non-recourse loan, so its own equity is 50,000,000 - 35,000,000 = $15,000,000, or 30% of the cost. The airline pays annual rent of $5,000,000, and the lessor pays $3,800,000 a year of loan interest and principal to the lender. The cash left for the lessor is 5,000,000 - 3,800,000 = $1,200,000. The cash yield on its equity is 1,200,000 / 15,000,000 = 8%, before taxes and any residual value at the end.Case study
Seen in the real world.
Northgate Rail Leasing is an illustrative, fictional company that owns locomotives and rents them to freight operators. It was offered a chance to buy ten new locomotives costing $60,000,000 to lease to a regional railway. Paying cash would use up a large part of its capital.
The finance team structured the deal as a leveraged lease with a $42,000,000 non-recourse loan from a bank and $18,000,000 of its own equity. The rent was set to cover the loan payments with a margin left over for the lessor. The illustrative result was that Northgate could take on three similar deals with the same capital, though it had to model carefully what would happen if the railway failed to pay.
Watch out
Common mistakes.
- Treating the lender's non-recourse loan as the lessor's general debt, when the lender can look only to the asset and rent.
- Ignoring the residual value risk, so the lessor's return falls short when the asset is worth less than forecast at the end.
- Assuming the tax benefits are guaranteed, when they depend on tax law and on the lessor having enough taxable profit.
Questions
People also ask.
Why is it called leveraged?
Because the lessor uses borrowed money for most of the purchase price, which magnifies both its returns and its risk.
Who bears the risk if the lessee stops paying?
The lender bears most of the credit risk because it has no claim on the lessor's other assets, though the lessor can lose its equity.
Is a leveraged lease the same as a finance lease?
Not exactly, because a leveraged lease describes the funding structure with a non-recourse lender, whereas a finance lease describes how risks and rewards of ownership pass to the lessee.
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