When it comes to upgrading fleets, the most difficult decisions may have little to do with brand or features.

By Lori Lovely

The answer is a complex calculation of estimated capital usage, available cash flow and flexible options.

Despite any trends or fluctuations in the market, ultimately, only the individual contractor can determine the best alternative.

Rent
Technically, renting is a short-term (up to one year) lease. As the Cat Rental Store representatives explain: “Rental provides an inexpensive means to use a new piece of equipment without a long-term commitment.” The Cat Rental Store, with more than 470 North American locations, has a full range of Caterpillar and other brand-name equipment and specialized tools that are fully serviced by expert mechanics. Typically, rental periods are daily, weekly or monthly, and rental contracts cover maintenance, which reduces customer risk. Some also contain provisions for purchase options. The downside is that it’s costly compared with longer-term agreements. “As rental terms extend, the economic benefits diminish,” Caterpillar experts point out.

Nevertheless, 38% of all construction equipment is rented, and the rental market continues to grow at a faster rate than equipment sales, according to Nick Mavrick, vice president of marketing sales and strategy with Global Rents, a division of Volvo Construction Equipment since 2001. He believes the reason for that is because people are outsourcing. “There’s a fundamental shift from owning to renting. Unless you use a piece of equipment more than 75% of the time, it’s better to rent.”

With 77 rental stores in the US and nearly as many in Mexico and Europe, Global Rents keeps tabs on the rental industry. Mavrick says customer numbers are up: from 85,000 in 2006 to 135,000 in just the first three quarters of 2007. He cites figures tracking the steady increase (1990, $6.6 billion; 2000, $24.8 billion; 2007, $30 billion) that conclude with a projection of $34.6 billion in 2011. Put another way, “Projections indicate that by 2010, 50% of all equipment will be rented,” he predicts.

According to marketing material compiled by Wells Fargo Construction (formerly CIT Construction) in conjunction with the AED Foundation, construction equipment users are more inclined to rent machinery today than they have been over the past two decades. Many factors contribute to the trend:

• Equipment has become very expensive; with new brands and new machines introduced more frequently, resale value is less assured.
• Machines have become more specialized, making it difficult to find long-term use for them.
• For customers unfamiliar with new technologically advanced equipment or unable to commit to a purchase, renting is a good option.
• Large-scale, long-term projects requiring extensive equipment are fewer. More jobs demand quick turnaround. It’s easier to rent according to the precise requirements of each job.
• Rental is a smart option for contractors with limited capital resources. They can use the equipment without the associated debt and without affecting their bonding capacity.
• One-time needs and short-term contracts alike point toward the rental option.
• Because the economy is unstable and the construction business is cyclical, some contractors are wary of major financial commitment associated with purchase.
• Rental payments can be expensed to a job without effect on the balance sheet. Similarly, in some situations, there may be tax benefits.
• Contractors can be more flexible in bidding jobs if they can diversify with rental equipment.

Cary Barrows, branch manager of RSC Equipment Rental in Olathe, KS, believes the decrease in equipment sales, with a corresponding rise in rental, is due to multiple factors. “More companies are finding that renting is better than buying. All of the responsibilities of ownership are taken off of the customer’s shoulders: maintenance, transportation, taxes, et cetera.”

Jeff Crouse, district manager for United Rentals, says the rental choice depends on the customer. “Construction activity also plays a part, particularly large, long-term projects and the outlook for new starts. If the market economy of an area seems to be leveling off or declining, and future cash flow could be an issue, many contractors choose to rent ahead of that curve and not commit to fixed costs.”

Equipment and job needs often dictate the rental decision. That said, what’s being rented is more industry-specific than geography-based. RSC Equipment Rental caters predominantly to the commercial and industrial markets, so, as Barrows relates, scissor lifts, booms, forklifts, and skid-steers are the most-rented pieces of equipment.

Crouse says backhoes are a popular item for both rental and purchase. But while skid-steer loaders are more often purchased, “most aerial equipment and forklifts are rented,” in United Rentals’ experience. “Mini-excavators used to be a major rental item, and we still see strong demand for rentals, but this class is becoming popular to own. Mini-excavators have become increasingly versatile through manufacturer R&D [research and development], so their applications are broadening and they don’t sit idle for long. The big excavators and compaction equipment are still popular rental items. We don’t expect that to change.

“At United Rentals,” Crouse continues, “we frequently rent heavy equipment to contractors who own one or two machines. These machines go out on every job to initiate the basic work, and we top off the fleet with rentals. The rented equipment may be the majority of the equipment onsite, but the contractor is still getting use and value out of his owned fleet.”

Mavrick agrees. “If they’re doing lot of roadwork, they’ll probably buy some equipment and fill in with rental.” For highway work, he says, the most-rented equipment is the 66-inch smooth-drum roller, followed by trench rollers, air compressors, vibratory plate compactors, concrete saws, air tampers, rammers, air drills, concrete rollers, and vibrators. General contractors, on the other hand, rent the rough-terrain forklift most often, followed by excavators, dozers, earthmovers, backhoes, compressors, lifts, telescoping boom lifts, rollers, and skid-steers. They also rent 20–30 additional items, including compaction devices and trowels, Mavrick adds.

The job itself can be a consideration, according to Bill Connolly, manager of Financial Integration for John Deere Credit. “Renting is often the option if a contractor has a large new project, but cannot be sure that the company's workload will remain the same once the project is finished. Rentals also differ by the size of the contractor. Typically, smaller companies in a growth phase rent more; companies with 25–100 employees represent the biggest group of renters. But Mavrick says that’s changing. “Bigger companies are now doing more rental. They outsource positions to specialists because they don’t want to tie up assets in ownership.”

According to Crouse, there are plenty of compelling reasons to rent. Rented equipment has no fixed cost, requires minimal capital outlay compared with ownership, and carries none of the ancillary costs such as storage, maintenance, parts, inspection, insurance, and vehicles for transport. “A contractor can evaluate the soil conditions and other requirements of a given job and choose from a range of rental models that reflect the latest technologies,” he says. “This matches modern, safe, productive equipment precisely to the job. If multiple projects are active simultaneously, or if a large job needs multiple machines, this can be addressed without any delay.”

There’s another, often unmentioned reason to rent: It’s an opportunity to try out equipment without the commitment of purchase. “Renting is an economic equation,” Mavrick admits. “Renting provides an opportunity to ‘test drive’ new brands and models; it allows comparison before purchase.” By renting, the contractor has the flexibility to learn whether the equipment is right for the job, says Connolly. In that respect, he believes that renting provides even more flexibility than leasing.

United Rentals is aware that many contractors do that and Crouse says the company is “fine with that. Our job is to do the best thing for the customer in every case. A rental is often the best way for a contractor to evaluate a machine’s capabilities in a practical application, in the hands of his or her crew.”

Perks always attract business. Global Rents’ franchise stores focus on VIP-level service to a small group of customers, emphasizing service and flexibility for the VIP customer, often with few rules. “We’ll schedule delivery at midnight or on Sunday,” Mavrick acknowledges.

Similarly, RSC sometimes offers free delivery, but Barrows considers “loyalty pricing” to be the main way of rewarding repeat customers. A personal reward sheet is the perk for clients who make RSC “their first call every time.”

Crouse believes United Rental’s quality of service is incentive enough, but adds that a fleet in superior condition is also attractive to contractors. “It pays off in productivity and safety for the customer, and is the best incentive possible for repeat business.” Across the board, rental houses pay attention to maintenance. “We focus on our equipment because customers expect the best equipment in the best shape,” Mavrick states. “We maintain out assets by keeping up on maintenance and retaining all maintenance records. That’s why our equipment sells for a premium at auctions.”

Almost as a dis-incentive, Mavrick adds a few detriments to purchase that might incline some contractors to rent instead: Owning entails buying, maintaining, storing and transporting the equipment.

Buy
On the flip side, says United Rentals’ Crouse, there are positive aspects to owning equipment: tax advantages; owned equipment becomes an asset of the business, so it adds to net worth; and some portion of the capital outlay can be recouped through resale. Additionally, he notes, “Pride of ownership is also a surprisingly strong motivation to purchase equipment outright.”

Studies show that many contractors prefer ownership. CIT Construction’s 2007 Construction Industry Forecast revealed that 45% of US contractors taking part in the annual survey planned to purchase equipment before year’s end, with more expected to acquire heavy equipment than in previous years. The forecasts, prepared by CIT consistently indicate that contractors prefer to own the equipment they use. Contractors in 2007 expected to meet 86% of their needs with purchased equipment, up 2% from the previous year’s predictions. Rentals and leases were anticipated at 6% each.

Not only do contractors like the idea of owning equipment, they like the idea of building equity in it. “Often, when a contractor is starting out,” Connolly explains, “the company's equipment is its biggest asset. So buying equipment is one way of increasing the equity of the company.” Because construction equipment lasts an average of 30 years, Petta points out that there’s little risk of obsolescence to deter purchasing “yellow iron.”

Other factors influencing the decision include whether the contractor has several long-term contracts or a history of steady work so that equipment will be consistently used and if the contractor is replacing an often-used piece of equipment that does his “bread and butter” work.

As Crouse and Connolly mentioned, purchasing offers the benefit of ownership, as well as the tax advantage of deducting depreciation. With benefits come responsibilities, however, such as maintaining, servicing, and insuring the equipment. In addition, there’s sales tax to be paid. Other factors should also be considered. “Cash,” Cat Financial notes, “which could be used for other business purposes, is reduced.” Although outright cash purchase with funds provided from working capital is normally the least costly method of acquiring equipment, in part because service fees, interest charges and expenses are eliminated, it “substitutes a fixed asset (equipment) for liquid asset (cash), thereby weakening the buyer’s balance sheet.”

As Connolly observes, the deduction of interest and depreciation must be weighed against the high cost, which can be a strain on resources. Fortunately, there are options to ease the sting of sticker shock.

A financed purchase offers similar advantages to a cash purchase: The buyer takes the depreciation and tax benefits. However, it incorporates some features of a lease, in particular, the limited cash outlay, despite the required down payment. As explained by Cat Financial, a wholly owned subsidiary of Caterpillar Inc., “Although a finance purchase can be the best acquisition when cash is not available, the disadvantage is that it is typically the highest payment for the customer. The greatest benefit is the fact that the equipment user owns the machine at the end of the term.” Sexson disagrees, claiming that “because you’re committed to the term, you have a lower monthly payment with financing or leasing.”

Regardless of the size of the monthly payment, Connolly lists additional options to soften the financial blow. Accelerated payments minimize upfront costs by allowing the contractor to pay a smaller down payment, followed by larger payments for the first few months to build equity quickly. Alternately, “By pledging a free-and-clear machine as additional collateral, the contractor can provide increased security with no out-of-pocket costs.” Benefits of financing a purchase include:

• Conservation of working capital. Only the down payment is deducted from available assets and only the first year’s payments are added to current liabilities. Assets can remain intact if a trade-in is substituted for the down payment.
• Maintenance of credit lines. The contractor doesn’t have to reduce the availability of bank credit lines to meet payroll or other short-term expenses.
• Interest is tax-deductible.
• Equipment can be put to use immediately, increasing profits.
• With long-term, fixed-cost credit, the buyer pays for immediate value with tomorrow’s dollars.
• Ownership may be considered a plus, including the ability to claim depreciation.

According to the Equipment Leasing and Finance Association’s Equipment Demand Forecast, compiled by Global Insight, financing methods vary by the size of the business, the amount of the purchase, the type of equipment, and the amount of sales income, with the tendency of companies to finance purchases dropping significantly when annual sales fall below $1 million. Businesses with high profits relative to sales are more likely to finance equipment purchases.

Small firms (51–100 employees) and medium firms (101–1,000 employees) use equipment financing for 74.1% and 73.3% of purchases, respectively. For small businesses, cash flow is overwhelmingly the main reason for financing, with tax advantages also a major concern for construction and agricultural machinery. Across the board, however, financing was more likely to be used to purchase expensive equipment. According to the ELFA report, equipment priced at $5 million or more has more than twice the financing share of items priced under $25,000.

Despite the popularity of ownership, purchasing has its risks. Disadvantages of purchasing include:

• capital requirement;
• growth or contraction inflexibility;
• obsolescence of equipment;
• operational responsibilities; and
• stricter financing requirements.

Lease
Some companies see ownership as the best alternative, claims Wells Fargo, but for companies in growth mode, putting their capital to work by using financial resources for expansion could be a better use of funds than purchasing equipment. In other words, money earmarked for equipment purchases might be better used to fund other initiatives, projects or opportunities.

“A lot of contractors rent initially,” Petta contends, “then turn it into a lease or purchase if they have enough work and enough equity.” There are many options at the end of a lease: Lessees can re-lease the equipment with a low payment, return the equipment to the owner (probably a finance company), or buy it. “It’s frequently done that way because the payments are small since you’re only paying for the portion of the asset being used.”

Leasing can be a less risky, but often confusing option. As a method for evaluation, a 2007 publication by Compass Commercial, located in Bend, OR, recommends computing the internal rate of return of a potential purchase and a potential lease over the same period of time. Comparing the differential, or cross point, with the opportunity cost of the business—preferably in after-tax dollars. This establishes an opportunity cost at which the cost to own and the cost to lease are equal, allowing an easy evaluation of both options in comparison. If the opportunity cost exceeds the cross point, leasing is the better option; if the opportunity cost is less than the cross point, then it’s better to buy.

While the concept is similar to renting, leasing generally entails a long-term (typically 2–3 years) contract. But the differences involve much more than mere contract length. Based on depreciation rather than on value, a lease offers accounting advantages, tax benefits, flexibility in equipment usage, and other financial considerations. “Leasing used to be a last-resort option,” muses Ralph Petta, vice president of Industry Services for the Equipment Leasing and Finance Association. “But for the last 20 to 25 years, it’s been a mainstream, strategic financing alternative.” In fact, a new study shows that leasing is a $600 billion per year business. Greg Giauque, marketing manager for Wells Fargo Construction, says all sizes of companies use leasing to fit the job, the amount of workflow and their business, adding that leasing has remained at the same level for several years.

Its popularity might be due to the fact that entrepreneurial leasing companies in such a competitive market focus on service, offering things a bank can’t. “Leasing is very flexible—it’s not a cookie-cutter bank loan,” Petta continues, explaining that leases can be structured to mirror the seasonality of the construction business in a “skip loan,” where payments aren’t necessarily monthly.

That’s only one example of the flexibility offered by leasing. Because, as Petta explains, a lot of businesses like to match the use of an asset to the income derived from it, leasing provides a convenient and flexible way to use equipment and match the income from the its use without the risk of owning the equipment.

Sidney Sexson, senior vice president of manufacturing and dealer services unit for Wells Fargo Construction, calls that an operating lease, in which the customer does not accept the risks or benefits of ownership. The lease is structured so the customer uses the equipment for the term of the lease with options to renew, return the equipment or purchase it at fair market value at the end of the term. That can contribute to keeping a fleet newer, which theoretically reduces downtime. “Being able to change out equipment more often can really help a contractor, because downtime is a killer,” Connolly confirms.

Leasing can free up cash and increase liquidity, Connolly adds, because less money is required up front and monthly payments are usually lower. “Contractors should also consider that, in most states, instead of paying sales tax on the full purchase price, you only pay ‘use tax’ on the monthly lease payment. In leasing, the contractor is able to pay for the use of the equipment without making a long-term commitment to buy.” Even if you exercise the purchase option at the end of the term, you've deferred the sales tax for many years.

But, as Sexson points out, “not all leases are true leases; some are installment sales contracts (purchase option lease) or loans, where the customer owns the equipment for tax purposes.” A capital, or finance, lease represents nominal ownership and is often structured with a bargain purchase option that can be as low as $1 or some amount below the expected fair market value.

Common terminology involves the tax/nontax designation. A tax lease allows the lessee to expense the rental, but conveys no ownership. All payments are deductible as operating expenses. The nontax lease permits the lessee to list equipment as an asset and depreciate it but not the rental expense. It can be an advantage for companies with limited resources, because they pay no sales tax on the lease and there’s less down payment, but only the interest is deductible.

When the choice comes down to leasing versus financing, Petta advises considering bonding capacity and debt ratio. “Many large companies or companies in growth mode can’t make a large purchase, but they can rent or lease.”

While lessees experience a certain amount of vulnerability to lease terms, there are advantages to leasing:

• Low initial cost conserves cash for business growth and helps improve bonding capacity.
• It allows for flexible accounting. Equipment payment can be designated as capital or operating expense and need not appear on the balance sheet.
• It minimizes risk of technological obsolescence, since the equipment can be returned at end of term.
• Accelerated depreciation can be a tax benefit.
• Lease expenses are tax-deductible.
• It allows flexibility for expansion or contraction.

Blurring the Lines
Flexible options lead to complicated choices. Research conducted by Wells Fargo in conjunction with Associated Equipment Distributors indicates that more than half of construction equipment buyers consider a sales person’s ability to intelligently discuss financing as a major influence on their decision to do business with that company. Supporting that finding is research from CIT indicating that 57% of distributors help their customers secure financing, whether loans or leases.

To aid customers in their buying decisions, Cat dealers utilize various marketing programs, ranging from reduced rate financing to rental purchase options to various warranty programs. The most commonly utilized product is the Installment Sale Contract (finance purchase). Typically, the decision is based on whether or not the customer wants to use the equipment for the short term or wants to own it long term, whether or not the customer wants to depreciate the equipment or wants to expense the payments, and whether or not the customer wants to make a full repayment or wants to conserve capital.

“A contractor making the decision whether to buy, lease, or rent equipment needs to take into account how he will be using the equipment, how the equipment fits into the company business plan, and what are the financial ramifications of the decision,” Connolly summarizes. “The first step for contractors should be talking with their accountant or tax advisor to help work through what is the best choice for them.”

Lori Lovely writes on transportation and technical subjects.

GEC - February 2008

Home | Search | Subscribe | About | News | Advertise | Register | Services | Industry Events
Keep Informed | Contact Us | Current Issue | Back Issues | ForesterPress | StormCon

© FORESTER MEDIA, INC.
P.O. Box 3100 • Santa Barbara, CA 93130 • 805-682-1300