Canadian Consulting Engineer

Big Question

Deciding whether to lease or buy your next car is a thorny question that never seems to go away. Purchasers assume, reasonably, that if they just understood the complete, real, total difference betwee...

August 1, 2006   By Hank Bulmash, MBA, CA.

Deciding whether to lease or buy your next car is a thorny question that never seems to go away. Purchasers assume, reasonably, that if they just understood the complete, real, total difference between leasing and buying, they’d have the secret to getting the cheapest price for a vehicle. Then they’d be happy.

But it’s not that simple. The problem is that leasing is all about risk — not risk to the buyer, risk to the seller. It may seem odd to think about car companies being worried by leasing, but it’s the truth. Manufacturers are irresistibly drawn to leasing. Leasing is so useful at stimulating sales, it’s impossible for companies to ignore it. But it’s also very dangerous for the companies because of the repurchase guarantee they’re forced to make.

When you lease a car from a manufacturer, the company promises to buy it back from you at a set price. That means the manufacturer has to guess what the car will be worth three or four years in the future. It has to make that guess — which is a bet really, since money is involved — without knowing if safety or reliability problems will emerge, or even if gasoline prices will make its fleet less popular and therefore less valuable. A serious mistake in estimating future values might imperil the future of the company. This wager is hugely risky to the manufacturer. And at the same time it’s informative to the buyer.

Let’s say you want to buy a Nissan Quest with a list price of $36,645. However, your wife wants a BMW 3 Series that costs $36,500. How do you decide which car is the better financial choice? Price alone isn’t much help; the cars cost nearly the same. That leaves you the traditional way of deciding. You look up reviews in Road and Track and Consumers Reports. You get into conversations with strangers at gas stations. You try to find out what J.D. Power says. Maybe your brother-in-law has an opinion.

Or you could simply examine the information contained in a lease contract. Economists are fond of saying that financial markets are really information systems. In that case, lease prices are information summaries, and one of the things they summarize is the market’s estimation of future value.

To compare the lease costs of Quest and BMW, I visited their Canadian web sites. The numbers I found there are based on the manufacturers’ retail list prices. Nissan told me that with a down payment of $7,645, I’d pay $421 for a 48-month lease. That’s using Nissan’s interest rate of 3.8%. BMW’s interest rate was much higher: 7.7% for a 48-month lease. But with the same down payment as the Nissan, the monthly cost was only $381. Because of its higher monthly payment over the entire lease, I’d end up spending about $700 more on the Quest than on the Bimmer. That was a shock since the manufacturer’s list price for the Nissan is only $145 more than the BMW and the lease interest rate is lower than BMW’s.

Why is the BMW cheaper? To understand the difference, we have to look at the mechanics of a lease. Assume you’re going to lease a $30,000 car for just one month. Let’s say the company needs to make $200 profit for the month. Also the company has to finance your lease of the car. (It probably cost about $24,000 to build the car that the dealer will sell for $30,000. The company has to finance that investment in the property it’s leasing to you.) We’ll say the monthly interest cost to the company is $150. Using its market projections, the leasing company expects the car will be worth only $29,000 in 30 days, making depreciation cost $1,000. Taken together, these three components add up to a total cost of $1,350. And in the real world, lease charges are largely based on this model, the sum of three items — interest, profit margin and expected depreciation (which reflects over time the cost to manufacture the vehicle).

Back to our question. Why does the Nissan cost so much more to lease than the Bimmer? It’s not the cost to the manufacturer or the profit margin. They’re included in the manufacturer’s list price, and, as we saw that number was about the same for both cars. Nissan’s interest rate is cheaper than the Bimmer’s, which lowers the cost of the Quest lease. The only thing left is depreciation — and that’s where our answer lies.

Nissan is willing to guarantee a repurchase price for the Quest of $14,176. That’s called its residual value. BMW is willing to buy back its car for $19,195. This $5,000 difference between the two residual amounts is the key. As we saw, the car’s expected decline in value must be incorporated into the lease cost. If the Quest depreciates faster than the BMW, its monthly cost will have to be higher. BMW’s higher residual value allows it to charge less for its lease.

It may seem ironic that you have to pay more for a product that will actually be worth less in the end. The difference in future values is not reflected in the cars’ list prices, but it’s there for all to see in the lease cost. Bringing that insight to the attention of your Quest dealer may give you some negotiating leverage. And it can help you in another way as well. Examining the residual value will give you a very realistic idea of what your car will be worth in the future even if you intend to buy rather than lease. It can help you make an informed decision when choosing your purchase.

Any manufacturer making a risky bet on the future value of its cars will try to protect itself. That means car companies should deliberately underestimate the residual value. Of course, underestimating residual value makes selling cars more difficult because it makes lease costs higher, but erring in the other direction — increasing sales by making lease costs lower — could be catastrophic. Imagine what would happen to a company that had to overpay just $1,000 per car on a million cars. That’s a $1 billion mistake, enough to give anyone sleepless nights.

So the bias of all manufacturers must be to produce a safe residual, say 15% below the expected market value of a four-year old car just out of its lease. It means that if you’re in the habit of getting a new car every time your lease runs out, you’re overpaying each time. In essence you’re being forced to pay an insurance premium on behalf of the manufacturer. This insurance cushion built into the residual value is the only reason that lease deals are possible. Otherwise the risk would be too great for manufacturers. But like any insurance, it’s not cheap. On a $40,000 new car expected to be worth $20,000 after four years, a 15% insurance cushion would be $3,000. The company will therefore offer a residual value of $17,000 — not $20,000.

Normally, when you lease, the automobile company gets the benefit of this insurance and you get the bill. But you can avoid this problem. You can choose to buy your car — or you can lease the car with the ultimate intention of buying. Auto leases allow you to purchase for the amount of the residual. That means you can recover your insurance premium by buying at the residual price. Whether or not this leasing-to-buy is a cheaper strategy than simply buying is dependent on your actual deal — but it does give you some added protection. Consider: if you bought a large gas guzzling SUV several years ago, your expected resale value in four years might have been half the list price. Now with the increase in gasoline prices, the resale value may have dropped considerably. If you had leased rather than bought, the manufacturer would be on the hook for some of the loss in value. Leasing would have provided you with downside insurance. It’s something to think about when contemplating your next vehicle.

Hank Bulmash, MBA, CA is a principal of Bulmash Cullemore, chartered accountants of Toronto. To receive more information, e-mail Hank at hank@businesslab.ca


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