The Current State of Leasing and Residual Based Financing

Ruggles, February 2015

According to the most recent Manheim Market Report, “Lease originations exceeded 3.5 million for the first time since 1999. It will take only a slight increase in 2015 to push new leases above the all-time high reached in 1999.” This is largely the result of Auto OEMs attempting to counteract the negative impact of long term financing, which is also reaching new highs. Both initiatives are efforts by the OEMs to maintain volume and production in the face of rising MSRPs and transaction prices. Increasing finance terms take consumers out of the market for extended periods of time and dramatically decreases the chance the consumer will return to the same dealer and/or manufacturer for their next vehicle.

The new vehicle market is increasingly skewed to high income households. This increases the importance of the late model pre-owned vehicle market. The pre-owned market is currently running at a 42 million unit rate. Compared to selling rates from the depths of the Great Recession, new vehicle volume is up by 42%. Preowned selling rates only dropped by around 20% at the height of the Recession, showing considerably less volatility than the new vehicle market. Despite dramatic volatility in certain segments caused by sudden spikes in fuel prices, the absolute change in residual values over the last 19 years is 3.5% as measured by the Manheim Index. That fuel price volatility has proven to be temporary as consumers adjust to higher fuel prices in a few months. According to Tom Webb, Manheim’s Chief Economist, the change residual values in the last three years has only been 2%. That’s stability.

Is there any real danger in the recent dramatic lease percentages? Most experts agree there is absolutely no danger and considerable upside. There is still considerable pent up demand in both the new and pre-owned markets. Less affluent households, and those consumers who are interested in the greatest value, gravitate to the pre-owned side as evidenced by the explosion in Certified Pre-Owned numbers, which set new records every month. Increased new vehicle short term leasing and/or residual based financing is required to provide the inventory to fuel these increases.

There are many who regard pre-owned vehicle leasing, especially in the CPO area, as the greatest untapped area of opportunity in the auto retail business. There are some who claim the residual based payments on pre-owned aren’t enough less than subventions on new vehicles to justify a consumer to go with the pre-owned. A careful study of this theory shows that is the exception, not the rule. There are many credit unions and other lenders around the country offering residual based programs that dramatically reduces the monthly payment while still shortening the term. The truth is, dealers who are not offering their customers such a program probably aren’t aware of their existence or are held hostage by their own pay plans, which incentive F&I departments to continue to extend term while adding in rate participation. This is short term thinking at its worst. Dealers need to wake up and recognize that this short term “gain” carries with it long term penalties. Scot Hall, Executive Vice President of Swapalease.com, a leading auto lease facilitator is a big proponent of leasing/residual based financing on pre-owned. He says, “Those cars are generally going to be serviced to a high degree and reconditioned to a high degree, so setting up, say, a short three-year lease on those — or maybe even a two-year lease on some of those cars — I don’t think there would be a lot of risk, if it’s done correctly. I think it would benefit the consumer, and especially as more and more leases are coming back off the new end, this would be another avenue to help dealers and manufacturers move those off-lease vehicles from a remarketing perspective.”

For credit unions and other lenders offering a pre-owned residual based program, their yield is considerably higher due to the higher daily balances. This is particularly important in today’s margin compressed environment. Further, there is really no competition allowing for somewhat higher interest rates to be charged while still maintaining the short term low payment objective. They get their borrower back more often while both dealer and lender achieve the objective of retaining the consumer and doing business with them more often.

So what is the future of auto retail? Longer terms with lower volume or shorter terms, higher sales, more pedigreed pre-owned inventory for dealers, more customer loyalty, and ultimately higher profits? After all, it is more expensive to find a new customer than to retain the ones you already have.