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HMRC internal manual

Business Leasing Manual

Introduction: Leasing: Operating leases - risks

In many cases the operating lessor will make an asset available for a relatively short period of the asset’s useful life and it will hope to do better than make a finance lessor’s banker’s interest return. The operating lessor takes a residual value risk and hopes the market for its asset will reward it accordingly at the end of the lease period. But nothing is certain. The operating lessor’s risk is that no-one will want to hire its asset, or they won’t be prepared to pay the price it expects, or the asset is defective or wears out faster than expected. But the operating lessor could make a lot more money than a banker if it is successful and there is a big demand for its asset at good prices, the asset is durable and so on.

With some assets this may not involve much risk; for example, a fleet of cars tends to have, in the aggregate, a relatively predictable minimum residual value in two years’ time. Alternatively, risk can be reduced by insurance arrangements but the lessor needs to take care that such arrangements do not convert the lease into a finance lease, see BLM11000 onwards.

Broadly, an operating lessor needs to manage its leased assets actively and needs expertise in the potential market for their use, choosing them, and maintaining them. For example, a plant hire firm needs to understand the market for the short-term hire of trucks, bulldozers, compressors etc. They need to have the right selection of plant to meet the demand without being left with a surplus. They need to pick plant which is reliable, easy to service and will have a good resale value. They have to understand the hardware as well as the market.

This is in contrast to typical finance lessors who generally don’t need to know anything more about the plant or machinery or the market for it. They generally simply make a lender’s financial judgment about the ability of the lessee to pay the rentals. Any value in the asset is returned to the lessee if the asset is sold.

In some cases, particularly where the lease has a substantial final rental, a finance lessor may need to have some knowledge of the asset’s market value. This is because the lease will be structured so that the asset is sold at the end of the lease term, with the sales proceeds being used to pay all or part of the final rental. If the asset’s value is well below the final rental it leaves the lessor exposed to default by the lessee.