The customer either arranges lease financing through the manufacturer, vendor, or installer of the energy equipment being purchased or, if unavailable, directly with a third-party lessor. The customer and lessor sign a lease agreement once the project terms are agreed upon, and the lessor then provides the capital to purchase the equipment and associated installation services from a contractor. Once installation is complete, the customer begins making regular (typically monthly) fixed payments to the lessor on an agreed-upon schedule. Beyond those similarities, the four types of leases work differently:
Capital Lease: In a capital lease, the customer is the owner of the equipment for most legal and accounting purposes during the term. Therefore, the customer must declare the equipment as an asset and the lease payments as a liability on its balance sheet. The customer may depreciate the equipment as an asset to provide a tax benefit, but the lessor typically takes a security interest in the equipment so that it can be reclaimed in the event of default. At the end of the lease term, the customer can purchase the equipment for a discounted bargain price, typically a $1 "buck-out" payment. A capital lease functions much like a loan and is therefore sometimes called a "finance lease." However, capital leases can offer a few advantages over bank loans such as little to no upfront cost, less paperwork, and quicker approvals.
Operating Lease: In an operating lease, the lessor owns the equipment and the customer rents it at a fixed monthly payment. These rental payments are treated as an operating expense for tax purposes and are therefore tax deductible. In order to qualify as an operating lease, a transaction must pass several tests set by the Financial Accounting Standards Board (FASB). At the end of the lease, the customer can extend the lease, purchase the equipment for fair market value, or return the equipment.
NOTE* FASB issued an update to accounting standards in February 2016 that will eliminate off-balance sheet treatment for most operating leases, requiring customers to report the associated asset and liability on their balance sheet as of 2019-2020. These new standards will apply to any operating lease with a term of over 12 months. The standards do not include a grandfather provision, meaning that any leases signed before the change will also be affected.
Tax-Exempt Lease: Also known as a municipal lease, a tax-exempt lease-purchase agreement is a common financing structure that allows a public organization to pay for equipment using its annual revenues. This option is an effective alternative to traditional debt financing but is only available to municipalities and other political subdivisions that qualify. Tax exempt leases have two unique attributes. First, the lessor may claim a federal income tax exemption on the interest they receive from the customer under the lease, allowing them to offer a lower rate. Second, the lease contract usually stipulates that if the customer fails to appropriate funds to make payments on the lease in any given year, its obligation to the lessor ends and the customer must return the equipment to the lessor. In most states, this non-appropriation clause means that (a) a tax-exempt lease is not considered debt and therefore voter approval is not required, and (b) lease payments may be made from operating rather than capital expense budgets. Although the financing terms for tax-exempt leases may extend if 15 to 20 years, they are usually shorter than 12 years and are limited by the useful life of the equipment. The customer has title to the equipment throughout the term of the lease and retains ownership once the lease is paid off.
Solar Lease: A solar lease is a type of lease specific to solar energy systems where the lessor owns the solar equipment, and the customer rents it at a fixed monthly rate. Solar leases are very similar to standard operating leases in contract structure and tax and balance sheet treatment, with some specific verbiage or provisions for solar equipment. Customers may have the option of paying nothing upfront, making a custom down-payment, or prepaying the entirety of the lease amount. Any tax incentives and/or rebates for solar are retained by developer. A solar lease is a common alternative to a power purchase agreement (PPA) for customers looking for third-party ownership of a solar energy system. Because PPAs are not legal in every state, a solar lease may be a customer's only option for a third-party owned system depending on location.
ADVANTAGES
WIDELY AVAILABLE AND QUICK TO CLOSE-Manufacturers, vendors, and installers frequently offer lease financing as part of the equipment sale, making it easy to find financing and close the deal quickly.
SIMPLE STRUCTURE-Leases are simple documents that require a low level of effort to execute and administer, particularly for smaller scale projects. They are well understood by most finance teams.
END-OF-TERM FLEXIBILITY-With an operating lease, the customer has the choice at the end of the lease term to buy the equipment, renew the lease, or return the equipment.
BALANCE SHEET FLEXIBILITY-Leases can be structured as on-balance sheet or off-balance sheet depending on need, pending the accounting rule changes that will bring all leases with terms of more than 12 months onto the balance sheet in 2019-2020.
ENTERPRISE-SCALE FINANCING-Leases can be a good solution for portfolio-wide initiatives. Most lessors can finance projects across many facilities simultaneously. Some offer enterprise-scale structures where a single master lease is signed with the customer, allowing addenda to be added easily for each individual project.
DISADVANTAGES
SOME SIZE LIMITATIONS-Leases don't have rigid or consistent project size limitations. However, some lessors are unwilling to provide loans below a certain value, and others specialize in small-ticket leasing.
CREDITWORTHINESS-Creditworthiness can have a large impact on availability of financing and the rates offered. While leases are secured by the equipment, they do not provide additional security for lenders to the extent that some other financing structures do (e.g. PACE, On-bill).
NO SPECIALIZED BENEFITS-The straightforward structure of leases means that they do not provide the benefits of some of the more specialized financing options, such as performance guarantees (e.g. ESAs, EPCs) or automatic transferability (e.g. CPACE)."
