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Leases BUOY Market, Add Factory Risk : News

Leasing is back in a big way -- and that comes with risks as well as rewards.

Through June, almost 26 percent of new-vehicle deals in the United States involved a lease, up from 21 percent for all of 2010 and way up from the recession trough of 17 percent in 2009, says Edmunds.com.

On the upside, leasing moves the metal because monthly payments are low. But guessing wrong on what those vehicles will be worth three years later means heavy losses.

"It's inherently risky," Dave Zuchowski, head of sales at Hyundai Motor America, says of predicting residual values.

"A lot of things can happen over the course of a 36-month lease term," he says. "Some you can recognize, some will be a complete surprise, and all will affect resale value. Nothing is wrong with risk as long as you price for it."

Toyota is one of the risk-takers. It introduced the redesigned 2014 Corolla with low lease payments and residual values that are higher than those of the previous model. Toyota is betting the 2014 Corolla will be worth 63 percent of the sticker price three years from now compared with 53 percent for the 2013 model.

Zuchowski says Hyundai is "comfortable" with its 25 percent lease mix in the first half, up from 20 percent for all of 2012, 16 percent in 2011 and under 5 percent in 2007.

Ally Financial Inc. raised its leasing business to 28 percent in the second quarter of 2013, up from 19 percent in the second quarter of 2012, the company said in its July 31 earnings conference call with analysts.

Bill Muir, president of Ally Financial, said Ally's lease ratio is a reflection of the industry overall. "It dropped dramatically when a number of major players more or less got out of the leasing business for a year or two," he told analysts.

"Now it's getting back toward the territory between 25, 30 percent for the industry. Given our position, we're going to mirror that."

Jessica Caldwell, an analyst at Edmunds.com, says the ratio of vehicles that are leased to those purchased with loans is "OK" now but should not go too high.

"I don't think there is a right number for leasing," she says. "It's one of those delicate balances."

Residuals matter
When it comes to new-vehicle leasing, residual values matter a lot. That's because lease customers borrow the difference between the cost of the vehicle and what it is expected to be worth at the end of the lease.

The higher the residual value, the lower the monthly payment because the customer has to borrow less.

Lenders sometimes inflate residual values to reduce monthly payments, and they set aside reserves for potential future losses. Higher-than-expected vehicle values at the end of the lease mean lower-than-expected losses.

Conversely, lower-than-expected vehicle values mean higher-than-expected losses. That happened in 2008 and 2009 when gasoline prices spiked, used-car prices tanked and the economy plunged into a deep recession.

Lenders suffered heavy losses when off-lease vehicles, especially large SUVs, brought thousands of dollars less than projected. At the same time, the finance sector crashed and lenders tightened credit, making it hard for auto companies to finance leases.

Leasing all but dried up when credit tightened and U.S. sales of new light vehicles plunged to 10.4 million in 2009. That drop in new-vehicle sales lowered the future supply of late-model used vehicles, which pushed used-vehicle prices to record levels.

Buoyed by looser credit and a recovering economy, leasing began to come back in 2010 and has been growing steadily.

Being conservative
Automakers say they are being more cautious about residuals this time.

They use ALG data as a benchmark but set residual values conservatively, Hyundai's Zuchowski says.

"In fact, they over-reserve," Zuchowski says of manufacturers in general. "If ALG says, 'We think this car is going to be worth 50 percent at the end of 36 months,' in the old leasing world a manufacturer might say, 'We think it's going to be worth 54 percent.' And when it came back in three years it's only worth 48 percent. They had a 6 point problem on a $20,000 car.

"Now when ALG says, 'We think it's going to worth 50 percent,' the OEMs say, 'We're going to reserve this at 3 points below, so we're going to put it on our books at 47 percent.' It comes back at 48 percent, and there is no risk at all -- and you make a little money."

Still, some companies are willing to gamble. In its quest to gain market share in the compact-car segment, Toyota Motor Sales U.S.A. and its captive finance arm have projected residuals for most trim levels of its redesigned 2014 Corolla at 63 percent at the end of a 36-month lease.

ALG data indicate Toyota's projection is at least 3 percentage points too high. If ALG is correct, Toyota could lose $600 on every $20,000 2014 Corolla it leases.

In an interview, Bob Carter, senior vice president of automotive operations for Toyota, defended the strategy: "We don't monkey around with 'buying up' residuals. That's not to say we aren't aggressive."

Luxury is steady
Geoff Robinson, vice president of marketing at Mercedes-Benz Financial Services, says that even during the worst of the recession leasing accounted for about half of all sales of new Mercedes-Benz vehicles -- and that the figure consistently hovers around 50 percent.

Leasing works for Mercedes-Benz and its dealers because it promotes customer loyalty, Robinson says.

More than 50 percent of customers who lease a new Mercedes-Benz vehicle lease another vehicle from the company. That's about 10 or 12 percentage points higher than the number who return to the brand after purchasing.

Robinson expects new models, such as the new compact CLA that goes on sale this month, to attract a slightly younger customer and build more leasing momentum.

"Leasing fits so well with the brand; it's strongly ingrained in what we do," Robinson says.

ALG predicts that Mercedes-Benz vehicles will hold 50.5 percent of their sticker prices after three years.

Eric Lyman, an ALG vice president who oversees the company's residual values forecast, predicts residual values will drop from where they are now but remain higher than where they were for most years since 2000.

He cites an aging fleet of vehicles that will have to be replaced, a new generation of drivers entering the market and a strengthened economy as reasons.

He adds: "We didn't see this big increase until the 2010 calendar year, when used-car values catapulted up to these stratospheric heights."


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