Dave Freeh, TCF Equipment Finance
During my nearly 30 years in the equipment finance industry, I have witnessed several financial cycles that have impacted the agriculture equipment market. These ranged from the 1980s, when farm foreclosures and consolidation of equipment dealers and manufacturers marked a low point in U.S. agriculture, to the 2000s where we have seen explosive growth in both size and scope of farming operations and dealer groups.
How farmers view the acquisition and financing of equipment also has changed with the times. Buying decisions that once focused on asset ownership, now stress managing the cost of using an asset. Farmers view equipment as an operating cost driven, in large part, by technology and tax incentives.
As a result, dealers and finance companies must coordinate efforts to ensure they meet the financial goals of farmers. This means identifying the most appropriate financing structure to enable producers to have the equipment they need to operate their business. This includes various types of leasing options.
Poor Financing Practices
As a collection officer for an equipment finance company during the 1980s, I witnessed the result of poor lending practices and their impact on the industry. When the massive accumulation of farm debt of the 1970s collided with the unfavorable economic climate of the 1980s, farm foreclosures became commonplace and many dealers and equipment manufacturers either went out of business or were forced to consolidate.
As U.S. agriculture rebounded in the late 1990s, many farming operations changed to become more specialized. Advancements in technology and equipment efficiency enabled farmers whose emphasis was on crop production to expand the size of their operations. However, the cost of this technology and efficiency increased exponentially and the average price of new, self-propelled equipment increased by more than 40% when compared with the prior decade.
Trying to minimize the effects of these increasing equipment costs, manufacturers began offering lease products through their captive finance companies. This financial tool continued to move new equipment into the market at a manageable annual cost. Many tried to match the terms with the normal trade cycle for upgrading equipment and began promoting 3-year leases with a high walk-away residual for self-propelled equipment.
The product was received well by farmers as it enabled them to acquire new machinery at a minimal annual cost. At the end of the term, the farmer was able to return the piece of equipment at no cost. As popular as this product was, it resulted in a flood of used equipment returned to dealers, which caused the value of used equipment to plummet. Manufacturers were left upside down in their financing while dealers struggled to find buyers for the used equipment.
In the past decade, substantial growth in agriculture has been driven by relatively stable commodity prices and government sponsored tax incentives. These have enabled farmers to expand their operations and strengthen their financial position. In terms of their approach to acquiring equipment, farmers have focused on which loan or lease product provided the lowest interest rate or payment with the biggest tax write-off.
As the price of commodity crops declined during the past 2 years, the sale of farm equipment has slowed. In many cases, farmers are not confronted with the urgent need to acquire machinery in order to lessen their tax obligations. Tax benefits such as bonus depreciation or Section 179 have also been phased out or less certain. As a result, traditional loan financing isn’t as advantageous as it has been in recent years. At the same time, farmers in need of new or upgraded machinery are not being presented with all of the available financing options.
Having access to a financial partner with experience and expertise is essential when choosing the right financial product for a customer. Without this support, dealers are forced to become the financial advisor and understand the options available to the farmer. During a sale, dealers should ask farmers several key questions to ensure they provide the best financing solutions for individual needs and circumstances. A dealer must consider the following factors for each sale as well as structure their operation to focus on the “non-tangible” financing leg of managing the equipment.
Farmer’s Perspective: Listening to the customer is crucial. When farmers consider a new piece of equipment, they think through scenarios and options as they pertain to their farming operation, estate planning and budget. It should be the goal of a dealer sales representative to help the farmer get answers to these questions and determine the most appropriate financing solutions and equipment based on their individual needs.
- Will this equipment enable the customer to be more efficient in production through possible labor savings and technology enhancements?
- What are the customer’s savings if they upgrade a piece of equipment?
- Are there any annual servicing costs the customer needs to consider?
- Will the equipment maintain its value? What is the replacement cost of the equipment?
- Are there macro-economic drivers that could influence the customer’s buying and financing decisions, such as oil prices, chemical costs, tax law changes, farm bill changes, etc.?
- What timetable is most cost effective for the customer to upgrade equipment based on the size and scope of their farming operation?
Financial Provider’s Perspective: Dealers should be versed in both loan and lease products and understand how tax laws affect each transaction. Point-of-sale financing comes with the responsibility of knowing all available financial products and understanding when to call in your financial partner. Farmers want solutions that meet their needs and goals. They do not want to be sold off-the-shelf solutions that don’t take into account their individual situation. Questions to be asked from their perspective include the following.
- Does the farmer need a loan or a lease?
- How long is the farmer planning to use the equipment?
- What is the average trade cycle?
- How could low commodity prices or a bad year impact the customer?
- Is there 50% or 100% bonus depreciation for the new equipment? What is the Section 179 direct expense?
Dealer’s Perspective: Dealers need to look beyond the initial transaction. When selling a piece of equipment, take into account your customer’s future as well as the future of the equipment. Consider all options for the second-use cycle of the equipment and its potential sales prospects. Take the customer’s future needs into consideration as well. If your customer is nearing retirement, help them work the equipment and financing into their succession plan. With each individual transaction, dealers should ask the following questions.
- Taking the farmer’s long-term goals into account, which financial product makes sense for this customer for this particular piece of equipment?
- Who is the next user of the equipment?
- How much used inventory do I want to carry?
With falling commodity prices and changes in tax laws, farmer cashflows have tightened, creating a situation that will require dealers to offer customized financing solutions to farmers who need to upgrade their equipment. This means that dealers understand which financial product will provide the best financing solution for the individual farmer’s situation and financial goals — a loan or a lease.
As a lender, I find that most farmers and dealers are familiar with standard loans; however, often times a lease is the best option for the farmer and is worthwhile to take the time to be better understood. During a recent conversation with a dealer, he said, “We have been spoiled and have forgotten how to sell financing. During the past 10 years, most farmers either paid cash or took out a loan for their equipment.”
As leases are once again being viewed as a viable financial alternative, it is important to understand the basic principles and benefits leasing have for farming operations. I often hear the term “lease” used when farmers and dealers are discussing both seasonal or short-term rentals as well as longer-term agreements with a residual based on either the fair market value or a $1 buyout lease purchase option. In a lease, the lessor is the owner of the equipment, usually the finance company, and the lessee is the customer or user of the equipment, usually the farmer.
As an advisor to the farmer, dealers need to know the differences between fair market value leases, operating leases, first amendment leases, terminal rental adjustment clause (TRAC) leases and non-tax leases. Each should be made available depending on the farmer’s financial situation, goals and the type of equipment they want to acquire.
When reviewing lease products, both the farmer and dealer should discuss the intent for the use of equipment as it relates to the farmer’s long-term operational and estate planning goals. Should the farmer look at the acquisition as an operating expense or as a long-term investment in their operation? Operating expenses can enable farmers to set a budgeted cost per hour/acre to achieve a desired margin of profitability. This puts the focus on usage of the equipment, rather than ownership of the equipment. A long-term investment uses the equipment for a longer period of time with the option to purchase the asset at the end of the lease term.
Determining Lease Type
Dealers must understand the intricate parameters each lease product has to offer when recommending financing. Dealers should also partner with a finance company who can offer all the lease products, be flexible throughout the lease and be relied upon to respond timely as product questions arise.
- Which lease product is best for this individual farmer’s personal goals and the type of equipment he or she is purchasing?
- What options do the financing providers have that would fit the customer’s goals?
- Would a 5-7 year lease vs. a short-term lease benefit the customer with their particular situation? Could the customer benefit from an early buy-out option with this lease?
- If the customer wants an early buy-out option, will the finance company’s buy-out amount be more than the value of the equipment, leaving them upside down?
- Does the customer have options to assign the lease to another farmer for minimal costs in the lease terms if they decide to do an early buy-out?
Larger ticket items such as tractors, combines and self-propelled sprayers now are being viewed more as an operating expense due to the high acquisition costs, required down payment amounts and annual servicing costs, thus opening the door to a lease.
In the past, a short-term, high-residual lease was an acceptable product. Today, farmers and dealers should investigate the longer 5- and 7-year lease terms with residuals based on the fair market value of the equipment. This allows for better asset management for all parties.
Longer-term leases enable the customer to achieve the same goals as shorter-term leases but with more options. For the dealer, a longer-term lease manages used equipment inventory by mitigating the number of units being returned to the dealership at the same time. For the farmer, a longer-term lease also offers more flexibility by exercising an early buyout of the lease, having the dealer find another customer who can assume the lease, or continuing lease payments to the designated residual option.
An example of a financial product for self-propelled equipment would be to lease a new-to-late model, self-propelled sprayer for 7 years with a 35% terminal rental adjustment clause (TRAC) residual. The TRAC lease allows the farmer to acquire the piece of equipment with lower payments, and normally no hour limitations, for a longer period of time.
The TRAC residual mitigates risk in future equipment value because the farmer and the financing company share in the residual risk. If the farmer goes full-term in the lease and then returns the equipment at the end of the lease period, the farmer benefits from the gain and is responsible for any loss in the sale of that equipment against the residual value.
A TRAC lease is a good product if the dealer and the farmer understand it and manage it well. The key factor is to set a residual that is based on the fair market value of the equipment using sound historical information.
For pull-type equipment, a 5-7 year term product can be employed using a First Amendment lease. With a First Amendment lease, the farmer can set up a 5-year equipment lease at lower payments with an option at the end to either buy it outright for a set residual or automatically renew it for an additional 2 years with a residual based on the fair market value of the equipment.
Signing on the Dotted Line
Before signing on the dotted line, dealers and farmers should know how to minimize unforeseen costs when considering a lease. Leases can have fixed or variable payments, a required upfront security deposit, early buy-out options and end-of-term options, as well as varying residuals based on the financing company.
As an advisor to farmers during equipment acquisition, it is essential to understand the available financing options and how they affect your customer’s bottom line. Dealers should look to finance companies for guidance and support on available leases and loans. Dealers need to know what questions to ask to better support their customers to ensure they are getting the best financing solution for their needs. It starts by doing your homework on the lease products before executing the actual deal. Having access to the right financial advisor for your dealership is important now more than ever.