Lease or Purchase? Handling Residual Expectations to Reduce Risk
Just three months ago, Class 8 truck orders fell to their lowest level in almost a quarter century, and trailer orders collapsed to their lowest in 30 years. At the time, COVID-19 was a frightening new risk that modern generations lacked experience in addressing in a rational, strategic way. Just like commercial truck orders, we went into a preservation-first mode – making no commitments, assuming the worst, and minimizing risk anywhere we could.
We are hard-wired to respond to risk without a long-term perspective. For undisciplined stock market investors, this drives a tendency to “sell at the low” because they tend to value immediate risk avoidance over potential longer-term opportunities for gains. Similarly, when market conditions are good, uninformed investors often adopt a short-term view that “I’m missing out” – so they “buy at the high.” Anyone who invested in the stock market last year and decided to sell in mid-March knows all too well how this played out!
Making decisions with long-term implications based on how things are in the moment is a phenomenon called the recency effect. It bankrupts the undisciplined investor – and it leads to fatal mistakes for those choosing between the options of leasing or purchasing commercial truck equipment. Why? Residuals.
Residuals and the Lease vs. Buy Decision
Every fleet CFO factors expected residual value into her lease-versus-buy calculation. All other things equal, high residual value expectations favor a purchase, and low expectations will usually favor an operating lease. Further, CFO’s who don’t have a firm grasp on residual expectations, or otherwise prefer certainty in asset costs, will also favor an operating lease.
Variability in the expected residual value plays a key role in a vehicle’s Total Cost of Ownership (TCO). The average class 8 truck is driven 62,751 miles per year – about 314,000 miles over a five-year ownership period. According to ACT Research, the average resale price of a class 8 truck fell to $36,954 in May of this year versus $47,887 in May 2019. Everything else equal, for a medium-size fleet of 100-500 power units (using average TCO of 55 cents/mile), this translates into over six percent variance in the per-mile TCO!
All too often, fleet financial planners lack a good grasp on estimating future residual values. Instead of digging deeper into this question, they make a default assumption that today’s resale value will be the residual in 3, 4 or 5+ years into the future – setting the stage for a flawed, risky lease-versus-buy decision. This is the recency effect in action in the fleet planner’s world, and it can be a catastrophic mistake. In our example above, a fleet planner using the spot resale market for his residual assumption in a lease-versus-buy decision in May of this year would have arrived at a per-mile TCO for the “buy” option over six percent higher than he would have calculated just one year prior. If the per-mile TCO for the “buy option” in this flawed lease-versus-buy approach can move by over six percent in just a year – imagine how far it can move in a 3, 4 or 5+ year ownership span! As the saying goes, “past performance is not indicative of future results.”
Notably, a financial analysis of the leasing route is unlikely to be biased by the recency effect. Because leasing companies are asset experts, and their core competency is managing asset-based risk, they do not “chase” the market, they evaluate risk based on the long term and not just the snapshot of today. Ultimately, asset lease experts provide fleet operators with predictability that allows them to more accurately manage their costs year over year.
A truck acquisition plan that uses an uninformed residual assumption (defaulting to today’s market conditions) will either succeed on account of luck or fail on account of its ignorance. In the long run, neither luck nor ignorance are sustainable ways to run any fleet.
Take an Informed Approach to lease vs. buy decision
Estimating the residual value of a truck years in advance of its disposal date is notoriously difficult. It’s not the most precise science, but with the right expertise a credible, informed analysis is far better than uninformed assumption. Residual analysis is best conducted by fleet lifecycle experts who have the benefit of long experience with diverse and large equipment portfolios.
An informed approach uses a combination of well-established historical patterns in the resale market, with forward-looking adjustments based on known factors such as upcoming emissions regulations, the growth trajectory for specific industries and the attendant demand for vocation-specific equipment, and imminent changes to financial regulations that may alter the relative demand for new and used equipment well into the future.
Don’t Go It Alone
The lease-versus-buy decision is more difficult now than it has been in several decades. Both private and for-hire fleets are struggling to make sense of what represents a “right sized” fleet for the years ahead. Merely getting to the point where a fleet is confident enough to commit to new truck orders will be a struggle for the foreseeable future. Prior to the onset of COVID, fleet financial planners were already reckoning with pressure from insurance costs, HOS regulations, and the dramatic changes to lease depreciation in ASC 842. Today, they are focused on continuity of business while working from home, cash flow risk from customers seeking longer payment terms, and stimulus legislation that (hopefully) can assist fleet operators with payroll. It’s a challenging moment to find the time and resources needed for optimal asset decision-making.
At Corcentric, we stand ready to help any fleet bridge that gap. Now, more than ever, it’s crucial to make the right lease-versus-buy choice – those who do are more likely to emerge from the COVID crisis as industry champions positioned for growth. To learn how we can help, contact Corcentric today.