The Differences Between Operating and Finance Leases

August, 5th, 2022

Differences between operating and finance leases – Summit Properties

Decision-makers at established and startup companies are tasked with planning capital expenditures to grow their business. Understanding the differences and benefits of an operating lease compared to a finance lease can have a profound impact on an organization’s long-term health. If you are considering a commercial lease, these are things to consider about negotiating a finance or operating lease agreement.

How Does a Finance Lease Work in A Commercial Rental Agreement?

Sometimes called a “capital lease” or “sales lease,” this type of commercial rental agreement allows tenants to secure property ownership when the terms are fulfilled. In a finance lease, ownership of the asset initially resides with the company funding the agreement.

The legally binding contract may be underwritten by a lender or the property owner. Monthly installments are typically made until the terms have been fulfilled. When the final payment nears, the finance leaseholder usually enjoys an opportunity to purchase the commercial property outright.

Benefits of Finance Lease

  • Lessee uses the commercial property without expending capital to purchase it
  • Finance leases may offer lower monthly costs than commercial property loans
  • Monthly payments can be negotiated to fit a company’s budget
  • No 20 to 35 percent lump sum down payment required

A finance lease also creates tax liability benefits, and commercial property renters typically do not see an increase in monthly installments when property values increase.

How Does an Operating Lease Work in A Commercial Rental Agreement?

An operating lease remains the more commonly used commercial rental agreement. It allows organizations to occupy a space or building without conveying ownership. Until 2019, operating leases were considered a type of off-balance-sheet financing in which ongoing rental payments were typically not listed as debt. However, changes to accounting standards require operating lease expenses to appear as a liability and usage expense.

Benefits of Operating Lease

  • Provides increased flexibility in terms of monthly overhead
  • Lease payments may be tax-deductible
  • Not necessarily locked into a long-term contract
  • May include exit strategies to move the business

Businesses that wish to manage office space costs as a pass-through expense often find operating leases suitable.

Operating Lease vs Finance Lease: What are the Critical Differences?

The differences between a finance and an operating lease are not necessarily subtle. An operating lease is treated as an ordinary rental expense and proves a liability in terms of a company’s debt-to-income ratio. The cost of a finance lease also lands on a ledger in a similar way. However, the opportunity to purchase the asset through a final balloon payment may improve a company’s value after acquiring the asset. These are other key differences to consider when entering a commercial rental agreement.

  • Ongoing Costs: In an operating lease, the property owner usually incurs the expense of maintaining and repairing the facility. It’s not uncommon for finance leaseholders to take on those costs.
  • Liability: A business that enters into a finance lease agreement may require commercial property insurance to cover any and all losses. Those renting space under an operating lease usually pay only for their own business liability coverage.
  • Balloon Payment: An operating lease does not provide a pathway to ownership, allowing companies to make static monthly payments. A finance lease provides a pathway to ownership through a final balloon payment. Although the amount can be high, it may prove less expensive than making a down payment and the cost of interest over the life of a commercial loan.

It’s also important to consider that a finance lease can lock in the price of the commercial property. Selecting a finance lease may allow an organization to gain ownership of an asset below market value at the time of the transfer.

Are You Considering a Commercial Lease?

As an industry-leading organization, here at Summit Properties, we work diligently to ensure all parties clearly understand their rights and obligations when entering into a commercial lease agreement. We have many premier commercial properties available in some of London’s leading business districts. If you are considering commercial space as a pass-through expense or lease-to-own opportunity, contact us today to discuss your options.