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Leasing residuals and dropping resale values


More than I wanted to know about leasing!

I had some questions over a Buzz item I posted yesterday about shrinking resale values of SUVs affecting lease returns, so I thought I'd expand on the subject here.

Back in the day, I was CEO of a software company that was a leading producer of software for automobile dealers. That afforded me with an intimacy with the workings of auto dealerships. Most days, all that's good for is to help friends with they visit a dealer to buy a vehicle. When I saw recent news items about gas prices affecting resale values of SUVs, it was déjà vu all over again.

How a lease works

A lease is a rental contract. The most important part of the lease calculation from a financial standpoint is an estimate of the resale value of the automobile when the lease is terminated. This becomes the residual value. Once the residual is set, a "lease factor" (roughly equivalent to an interest rate) is applied and payments are calculated. The reason lease payments are always less expensive per month than a straight finance payment is the residual is subtracted from the total amount owed before payments are calculated.

Lease financiers use mileage and "excess wear and tear" penalties to protect their residual estimates. Those who have leased are familiar with the number of miles you are limited to in a particular year. Higher mileage cars are worth less at resale, so you get penalized accordingly -- usually at the rate of $0.12/mile. You can "buy up" your miles allowed, a process that essentially lowers your residual.

At the end of the lease, you give the car back to the dealer or pay the residual value. Almost nobody pays the residual value, unless they have gone so far over on the miles allowed it ends up being their only alternative.

The role of the residual

Setting residuals is a little bit of black magic. The customer has the advantage of paying for only part of the auto when she does a lease. The finance company does not. They have to pay the selling dealership for the entire selling amount. In order to avoid losing the profit from the lease factor, they have to make sure the residual is very close to the actual resale value of the car at the end of the lease.

When the lease is over, the finance company sends the vehicle to a wholesale auction. They attempt to get the full value of the residual during the auction. The closer the auction value is to the residual, the more money they make.

If they badly overestimate the residual, the loss from selling the car at auction can wipe out all the profit from the lease factor and then some. Therefore, it is crucial that the residual calculation is accurate.

The role of leasing

You might be thinking the answer is to set the residual value really low. Nope.

Leasing was created to sell more cars. The attraction is the low monthly payment rate, which entices customers to choose renting over buying. Whether the car is leased, financed, or sold in cash looks the same to the books of both the dealership and the manufacturer. Anything that makes that sale easier is a boon for both.

Zero-percent financing means the manufacturer's addiction to leasing is less these days. As auto finance interest rates rise, however, expect leasing to come back in a big way.

How a franchised (new car) dealership works

A study commissioned by the new car dealer's trade group showed the average net contribution to the bottom line of a dealership from the sale of a new car is about $45. No, I did not forget to add zeros. $45. New cars are the ultimate loss leaders.

55% of the profit at a new car store comes from the service department. 40-43% of the profit comes from the sale of used cars. The remainder is new car sales.

Down to business

With that background out of the way, let's talk about the effect of sinking SUV resale values.

The higher the dollar value of the car, the more likely the car is to be leased. With zero-percent financing, the difference between a regular finance payment and a lease payment on a cheaper auto is negligible. On a $40,000+ SUV, it is significant enough so that many people choose the lease program.

The gas crisis is causing resale values of SUVs to plummet. This is an unexpected event for leasing companies, who would not have factored this in to their residual calculations. SUVs currently coming off lease are fetching far less at the wholesale auction than the residual value, shrinking or eliminating leasing company profits. A sustained decrease in SUV resale values will be very bad for lease finance companies.

We saw this last decade when SUV rollovers destroyed SUV resale values. Many leasing companies failed or nearly failed because you couldn't hardly give SUVs away in the aftermarket. It is important to note that this effect was not immediately felt on the bottom line of manufacturers via their big, captive finance arms (Ford Motor Credit, GMAC, etc.). Whether this was financial skullduggery or simply a natural function of the process of reporting finance arm financials, I'll leave up to you.

Where the impact was felt immediately, however, was at the dealership level. In order to deal with the fact their captive financing arms were buried in these vehicles, the manufacturers decided to abandon the auction process and stuff these vehicles down the throats of their dealerships. High-priced SUVs flooded the used car lots of franchised dealers.

The dealers hated these used cars, because the manufacturer always wanted to be paid more after the sale than the dealership could have paid at auction for the same auto. The manufacturers created complex incentive systems to try to convince dealers to sell these off-lease autos, but most dealerships hated the paperwork involved.

As a result of the need for the manufacturer to repair the problem of over-estimating the residual, these cars had much narrower margins than the typical used car. This was a significant harm to the bottom line of the dealership since 40-43% of their profits are derived from the sale of used cars.

So, the effect of unexpectedly dropping resale values hoses the carefully estimated residual value on a lease. That hurts the leasing company, which will eventually trickle into the profit margins of the manufacturer if resale values stay depressed for long enough. Auto dealerships, however, feel the pinch first presuming auto manufacturers return to the practices of the 1990's by forcing over-priced, off-lease SUVs down the throats of their franchise dealers.

And now you know more about the business of auto leasing than you ever wanted to know!
No positions in stocks mentioned.

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