Definition of Leases

Definition of Leases

Written or implied contract by which an owner (the lessor) of a specific asset (such as a parcel of land, building, equipment, or machinery) grants a second party (the lessee) the right to its exclusive possession and use for a specific period and under specified conditions, in return for specified periodic rental or lease payments. A long-term written lease (also called a deed) creates a leasehold interest which in itself can be traded or mortgaged, and is shown as a capital asset in a firm’s books. Advantages of leasing include (1) lack of restrictive covenants (common in bank loans and bond indentures), (2) conservation of capital (because the lessor provides 100 percent financing), (3) tax savings (in most cases), (4) avoidance of the risk of obsolescence, and (5) relative ease of obtaining a lease as opposed to a comparable bank loan. In most cases a lease, in effect, is a hire-purchase agreement without the requirement of an initial deposit and the added advantage of tax benefits. See also capital lease, operating lease, and, sale and leaseback.

Leases is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual, periodic, tax deductible payments.

The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy, and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from lawnmowers and washing machines to handbags and jewelry.^[1]

Under normal circumstances, a freehold owner of property is at liberty to do what they want with their property, including destroy it or hand over possession of the property to a tenant. However, if the owner has surrendered possession to another (the tenant) then any interference with the quiet enjoyment of the property by the tenant in lawful possession is unlawful.

Similar principles apply to real property as well as to personal property, though the terminology would be different. Similar principles apply to sub-leasing, that is the leasing by a tenant in possession to a sub-tenant. The right to sub-lease can be expressly prohibited by the main lease.

Term

The term of the lease may be fixed, periodic or of indefinite duration.

If it is for a ‘tenancy for years’, the term ends automatically when the period expires, and no notice needs to be given, in the absence of legal requirements.

The term’s duration may be conditional, in which case it lasts until some specified event occurs, such as the death of a specified individual.

A periodic tenancy is one which is renewed automatically, usually on a monthly or weekly basis.

A tenancy at will lasts only as long as the parties wish it to, and may be terminated without penalty by either party.

It is common for a lease to be extended on a “holding over” basis, which normally converts the tenancy to a periodic tenancy on a month by month basis.

Rent

Rent is a requirement of leases in common law jurisdiction, but not in civil law jurisdiction. There is no requirement for the rent to be a commercial amount. “Pepper corn” rent or rent of some nominal amount is adequate for this requirement.

Real estate

There are different types of ownership for land but, in common law states, the most common form is the ‘fee simple absolute’, where the legal term fee has the old meaning of real property, i.e. real estate. An owner of the ‘fee simple’ holds all the rights and privileges to that property and, subject to the laws, codes, rules and regulations of the local law, can sell or by contract or grant, permit another to have possession and control of the property through a lease or tenancy agreement. For this purpose, the owner is called the lessor or landlord, and the other person is called the lessee or tenant, and the rights to possess and control the land are exchanged for some payment (called ‘consideration’ in legal English), usually a monthly rent. The acceptance of rent by the landowner from a tenant creates (or extends) most of the rights of tenancy even without a written lease (or beyond the time limit of an expiring lease). Although leases can be oral agreements that are periodic, i.e. extended indefinitely and automatically, written leases should always define the period of time covered by the lease. In the 1930s, the British government introduced infinite leases, only to remove the power to create these in the early 1990s. A lease may be:

• a fixed-term agreement, in other words one of these two:
  • for a specified period of time (the “term”), and end when the term expires;
  • conditional, i.e. last until some specified event occurs, such as the death of a specified individual; or
• a periodic agreement, in other words renewed automatically
  • usually on a monthly or weekly basis
  • at will, i.e. last only as long as the parties wish it to, and be terminated without penalty by either party.

Because ownership is retained by the lessor, he or she always has the better right to enforce all the contractual terms and conditions affecting the use of the land. Normally, the contract will be express (i.e. set out in full and, hopefully, plain language), but where a contract is silent or ambiguous, terms can be implied by a court where this would make commercial sense of the transaction between the parties. One important right that may or may not be allowed the lessee, is the ability to create a sublease or to assign the lease, i.e. to transfer control to a third party. Hence, the builder of an office block may create a lease of the whole in favour of a management company that then finds tenants for the individual units and gives them control.

Under common law, a lease should have three essential characteristics:^{[clarification needed]}

1. A definite term (whether fixed or periodic)
2. At a rent
3. Confer exclusive possession

Tangible personal property

An owner can allow another the use of a vehicle (such as vehicle leasing of a car, a truck or an airliner) or a computer either for a fixed period of time or at will. This can be a simple leasing transaction, or it can be a transaction intended to allow the user the right to buy the item at some future time.

• In a simple lease (rental) of a car, the lessee pays the lessor a rental for the use of the car during the agreed period which may be a few days (e.g. for a holiday trip) or longer where it is more economic to pay for use rather than pay for the ownership of an asset of depreciating value. Normally, only the lessee will be allowed to use the vehicle and, in such a case, the lessee has possession and control. But, the lessor could be an employer who allows a third person the use of the car to visit clients.

• In a lease with the possibility of purchase, O could allow P to lease the car for a specified period of time. If all the rental payments are made in full, P will then be allowed to buy the car at the contractual purchase option price. In a consumer lease subject to the federal Consumer Leasing Act and the Truth in Lending Act, the purchase option price can not be a “bargain” purchase, that is, it cannot be less than the originally estimated fair market value. A “bargain” purchase creates an installment sale, to which the Truth in Lending Act (TILA) applies including the standardized disclosures, most importantly the Annual Percentage Rate (APR). Typically, the vehicle dealer or other personal property seller offers the leasing terms and contract of a third party finance company. Hence, O leases the vehicle to P, and upon execution of the contract simultaneously sells ownership of the car to F and assigns the lease contract to F. It is standard for the contractual terms to prohibit P from parting with possession or control of the car to another (if P does part with possession, this can be a theft of the car from F).

There are two principal types of leasing, depending upon the party taking the risk of the value of the vehicle (or other leased property) at lease end. In the U.S. this is called Closed-end leasing. In other jurisdictions, it is called hire purchase, lease purchase or finance leasing. These transactions are complicated. The most common problem arises when O makes specific representations as to the quality and reliability of the car to P during the initial negotiations. If what is said induces P to buy the car from O, those representations would usually be enforceable against O. But, in this transaction, O first sells the car to F who makes no representations to P. The laws vary from state to state on the extent to which P might be allowed a remedy if the car proves to be of poor quality.

To clarify the concept, the owner of tangible movables has the power to keep possession and only to transfer control. This may be for:

• short- or long-term storage (e.g. leaving a passport with hotel staff or depositing valuable property in a bank vault — a hotel or bank holding property is a bailee); or
• for delivery purposes (e.g. using a carrier to transport goods to a specific destination); or
• it may be a form of mortgage — a pawnshop holds a pledge over the goods deposited until the money lent is repaid.

Leasing is a common method by which airlines acquire their aircraft, usually from companies that specialize in the field of Commercial Aircraft Sales and Leasing. Aircraft leasing transactions are typically divided into finance leasing and operating leasing.

Leasing is also used for ships, in which case the agreement is structured as a bareboat charter.

Businesses often choose to lease rather than buy office equipment, including computers. Since office equipment depreciates rapidly, leasing can be more cost-efficient than ownership.

In addition, more and more unconventional items are becoming available for lease, such as handbags and luxury watches.

Real property

Whether it is better to lease or buy land will be determined by each state’s legal and economic systems. In those countries where acquiring title is complicated, the state imposes high taxes on owners, transaction costs are high, and finance is difficult to obtain, leasing will be the norm. But, freely available credit at low interest rates with minimal tax disadvantages and low transaction costs will encourage land ownership. Whatever the system, most adult consumers have, at some point in their lives, been party to a real estate lease which can be as short as a week, as long as 999 years, or perpetual (only a few states permit ownership to be alienated indefinitely). For commercial property, whether there is a depreciation allowance depends on the local state taxation system. If a lease is created for a term of, say, ten years, the monthly or quarterly rent is a fixed cost during the term. The term of years may have an asset value for balance sheet purposes and, as the term expires, that value depreciates. However, the apportionment of relief as between business expense and depreciating asset is for each state to make (all that is certain is that the lessee cannot have a double allowance).

Private property

Rental, tenancy, and lease agreements are formal and informal contracts between an identified landlord and tenant giving rights to both parties, e.g. the tenant’s right to occupy the accommodation for an agreed term and the landlord’s right to receive an agreed rent. If one of these elements is missing, only a tenancy at will or bare licence comes into being. In some legal systems, this has unfortunate consequences. When a formal tenancy is created, the law usually implies obligations for the lessor, e.g. that the property meets certain minimum standards of habitability. With a bare licence, some states do not imply any significant lessee protections

A tenancy agreement can be made up of:

• express terms. These include what is in the written agreement (if there is one), in the rent book, and/or what was agreed orally (if there is clear evidence of what was said).
• implied terms. These are the standard terms established by custom and practice or the minimum rights and duties formally implied by law.

Commercial property

Generally speaking in the modern US legal framework, commercial real property leases fall into one of just a few categories: Office, Retail, Warehouse, Ground, and a catch-all hybrid often referred to as “Mixed Use”. Each has certain typical characteristics, although Ground leases may differ somewhat, taking on some characteristics of Retail leasing when associated with a retail project, like a shopping center; and although Mixed Use projects can vary greatly depending upon the various inclusions and the size of the overall project, among other things. It is widely appreciated by those who specialize in commercial leasing, including the business side and the legal side, that, other than hybrids such as Mixed Use project leasing, Retail leasing can have the most complexity.

Mixed Use projects often have elements of most or all of the other categories, not infrequently including a hotel, office building, ground floor retail with residential condominium above and a parking garage. The interplay of all these different components with each other and the underlying property documents which describe, define, and control their interactions, operation and management, as well as the division of costs for the operation of the site, are typically very complex.

Retail leasing often requires the parties to address issues typically not addressed at all in other types of commercial leasing which have no retail component. These additional challenges include such topics as exclusives and restrictive covenants, radius restrictions on near-by self-competition, co-tenancy, no-build areas and visibility corridors, parking ratio assurances, signage concerns (including pylons, monuments, and criteria), CAM and CAM caps and controls (including the “cumulative” and “non-cumulative” concepts), continuous operating covenants, and much more.

Comparison of buying and leasing

There are many distinct differences between buying and leasing, regardless if such a transaction or agreement applies to property, machinery, equipment or other assets.

The difference lies in that a lease is conceptually very similar to the principle of “borrowing.” The ownership of the leased property (be it land, equipment, merchandise, or etc.) is not transferred under the terms of the lease agreement. The lease gives the lessee the right to use the assets covered under the agreement for the duration of the contracted term, however, upon the completion of said term the lessee is required to return the assets in question to the lessor, thereby completing the terms of the agreement. In a general example having to do with an automobile lease, the vehicle is due back to the dealership at the conclusion of the lease term. Once the vehicle is returned, the automobile lease agreement is completed and the parties (lessor and lessee) separate with no further obligations to each other (assuming there is no damage on the vehicle entitling the dealer to some further compensation). The lessee has no further claim or right to use the vehicle and the lessor, or car dealer no longer collects any payment from the former lessee – the previous driver.

Many lease agreements contain clauses and addendums that outline additional rights, or options for the lessee, to be exercised at will upon the conclusion of the lease (there are numerous equipment lease types^[2] with individual features). In automobile leases^[3] as a general example, a lessee may have an option to purchase the vehicle, thereby restructuring the agreement and ultimately obtain the ownership of the asset previously leased. In the example of a property lease, the renter (or lessee) may have the option to extend the lease, under pre-determined terms. Such scenarios are numerous and are typically pre-set during the initial creation and negotiation of the agreement between the parties.

Purchasing, on the other hand, involves an agreement that outlines the terms under which the purchaser acquires ownership of the desired item, property or asset. The purchase agreement delineates the purchase price and the terms under which it is to be paid for by the buyer. The overall purchase price can be amortized over a period of time as in the case of financing, or it can be paid in full, resulting in the instant transfer of ownership to the purchaser. In the event that the purchase is financed over a period of time, the ultimate price paid for the item or asset can be greater than the original price due to interest. For an individual deciding between buying or leasing, it is crucial to understand the pros and cons of each.

• Responsibility: In a scenario involving business entities that typically rely on functional equipment for ongoing operations and to stay ahead of competitors, responsibility is a key factor. In a purchase, the responsibility for the equipment falls solely on the shoulders of the business owner. While there are various insurance plans and warranties available to protect the owners, in case of damage or faulty manufacturing, the ultimate responsibility for the life of the equipment, after a purchase is complete, falls on the buyer. In a lease scenario, a lessee is only responsible for the equipment for the duration of the lease and while he or she remains in possession.
• Resale value: In case of a purchase, the full value of the asset is transferred to the purchaser, as the new owner. This means that in case of resale at a subsequent time, the full price for which the asset is resold can be collected by the new owner. In case of an automobile purchase, for example, an individual can, at a later date freely resell the vehicle and collect its value, albeit a depreciated amount from the original purchase price. In a lease, the lessor has no claim to the asset upon the conclusion of a lease, thereby the monies that were paid in the course of the lease cannot be, in part or in whole be recouped through a resale of the asset.
• Depreciation: Depreciation is a major consideration for individuals deciding between buying and leasing. For assets that suffer from significant depreciation, either as a result of regular wear and tear or through becoming obsolete upon the release of newer versions of the same materials (particularly applicable in the case of technology) leasing can prevent a significant loss of value. In business, there exists a basic rule of thumb: “If it appreciates, buy it. If it depreciates, lease it.” Leasing could permit the use of the equipment while it is new and upon the completion of the lease, it can be simple to upgrade by virtue of a new lease. In case of a purchase, however, an individual may be “stuck” with an obsolete asset with no means of recouping the cost of its acquisition.
• Maintenance: Because in the instance of a lease the ultimate ownership is retained by the lessor, it is in the lessor’s best interest to maintain the asset in its best working order. Therefore, lessees can often benefit from comprehensive maintenance programs offered by lessors while still paying a discounted premium due to the fact that the asset is being leased, not purchased.
• Cost: In the event of a purchase, the full value of the asset must be paid to the seller. In the event of a lease, however, only a portion of the full value is assessed, typically around 50%, however the figure varies based on the duration and type of lease. As a consequence, a lessor can gain the use of a much needed asset for a fraction of the full price of ownership. In many instances, this can better serve the lessee that an outright purchase would. As a corollary, a lessor could be granted the use of an asset that could otherwise be cost prohibitive.

Advantages

For businesses, leasing property may have significant financial benefits:

• Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than by purchasing property.
• Leasing can help businesses safeguard cash flow by paying for equipment as it generates revenue.
• Capital assets may fluctuate in value. Leasing shifts risks to the lessor, but if the property market has shown steady growth over time, a business that depends on leased property is sacrificing capital gains.
• Depreciation of capital assets has different tax and financial reporting treatment from ordinary business expenses. Lease payments are considered expenses rather than assets, which can be set off against revenue when calculating taxable profit at the end of the relevant tax accounting period.^[4]
• In some cases a lease may be the only practical option; for example, a small business may wish to open a location in a large office building within tight locational parameters.
• Leasing may provide more flexibility to a business which expects to grow or move in the relatively short term, because a lessee is not usually obliged to renew a lease at the end of its term.

Disadvantages

For businesses, leasing property may have significant drawbacks:

• A net lease may shift some or all of the maintenance costs onto the tenant.
• If circumstances dictate that a business must change its operations significantly, it may be expensive or otherwise difficult to terminate a lease before the end of the term. In some cases, a business may be able to sublet property no longer required, but this may not recoup the costs of the original lease, and, in any event, usually requires the consent of the original lessor. Tactical legal considerations usually make it expedient for lessees to default on their leases. The loss of book value is small and any litigation can usually be settled on advantageous terms. This is an improvement on the position for those companies owning their own property. Although it can be easier for a business to sell property if it has the time, forced sales frequently realise lower prices and can seriously affect book value.
• If the business is successful, lessors may demand higher rental payments when leases come up for renewal. If the value of the business is tied to the use of that particular property, the lessor has a significant advantage over the lessee in negotiations.

International usage

The practice of leasing is well established in most countries of the world.

However the benefits (in particular the tax benefits) to the lessee and lessor will vary widely depending on national accounting standards and tax regulations. These largely divide into countries observing:

• Legal form: the lessor’s legal ownership of the property
• Substance: the leasee’s legal right to use the property

National accounting standards vary in the tests that decide if the lease is a:

• Capital or finance lease, which is considered a financing transaction – as the lessor has less of the risks of ownership, such as the value of the equipment in future years.
• Operating lease, whose term is short compared to the useful life of the asset, where the lessee does not have to show the lease on their balance sheet.

References