Lesson 3: Types of Railcar Leases

Cargo Freight Station At Night (Small)

Railcar leases exist solely because there is a need on behalf of a shipper to move product. Due to the wide array of industries that move product via rail, there are many types of railcar leases available. The lease, which typically lasts three to seven years, will detail who is responsible for maintenance and repair responsibilities, taxes, and insurance.

Railcar leases fall into two categories; operating leases and capital (or finance) leases. An operating lease is considered a "right of usage" lease since the lessor only conveys the right to use the equipment, not the right to eventually own the equipment. Conversely, a finance lease is a "right of ownership" lease since both the right to use and own the equipment is conveyed to the lessee.

To determine whether the lease is an operating or finance lease, four tests are applied to the lease. They are:

  1. Is the term of the lease greater than 75% of the remaining life of the car?
  2. Is the present value of the lease stream greater than 90% of the fair market value of the car?
  3. Does the lease provide for a change in ownership from the lessor to the lessee?
  4. Does the lease contain a "bargain purchase" (or below market price) option to the lessee?

If the answer to any of these four tests is yes, the lease is considered a finance lease, otherwise it is an operating lease.

Operating Lease

An operating lease generally is a shorter-term lease in which equipment is returned to the lessor at the end of the contract period with no further commitment required. In this type of lease, the lessor assumes all the risk as they are essentially letting the lessee borrow equipment for a monthly fee. 

Lessors may choose to lease equipment under operating leases because it allows them to keep the equipment on their balance sheets and consider rental payments as revenue. Tax implications are one of the many factors that must be considered by two parties entering into a lease. 

On the other hand, lessees may seek this type of lease if they will need continually upgraded equipment. A lessee can choose to repeatedly renew an operating lease, resulting in access to new equipment at the end of the lease every few years.

Operating leases can be either Full-Service or Net Leases.

  • Full-Service Lease: In the most common type of railcar lease, the lessor is responsible for all maintenance and repair of equipment. This includes ensuring compliance with government and industry standards, safety, insurance, and taxes. A monthly fee per railcar is charged for the duration of the lease agreement.
  • Net Lease: In contrast to a full-service lease, the net lease requires the lessee to handle maintenance and repair responsibilities. Because the lessee will incur the additional expenses related to these responsibilities, the monthly rental rate is typically discounted when compared to a full-service lease.

Finance Lease

The purpose of a finance lease is to ultimately gain ownership of the leased equipment. Finance leases are useful when a lessee does not have the necessary capital to purchase the equipment or the term of their business need is shorter than the expected life of the equipment. Monthly payments made throughout the duration of the lease will amount to a sizable portion of total purchase cost or fair market value of the equipment and at the end of the lease there is generally a purchase option that the lessee can exercise to gain ownership of the equipment. 

Finance leases allow the lessee immediate access to use the leased equipment. Should the lessee cease to make the required monthly payments, the lessor may choose to repossess the equipment. A finance lease is not a loan.

Finance leases are almost always net leases with the lessee having responsibility for all maintenance and repair costs associated with the equipment under this type of lease, as well as taxes and insurance. 

Purchase (or Sale) Leasebacks

The rail industry serves a wide variety of markets. Volatility within these markets can sometimes result in a shipper possessing a surplus of unused cars. Railcars in storage do not generate revenue and therefore may hurt a shipper’s financial position. Also, it is not uncommon for a shipper that owns its own railcars to decide that it wants to reduce its financial exposure and monetize some of its equipment, while still maintaining the usage of those railcars. 

An option for shippers facing these dilemmas is to seek out purchase or sale leaseback opportunities. This type of lease occurs when a lessor purchases unused cars from a shipper. The cars are then leased back to the shipper by the lessor. The purpose of this type of lease is to free up capital while retaining access to cars. In some cases, the shipper may eventually purchase the cars back from the lessor, though this is not an absolute.

Per Diem Lease

Most operating, and all finance leases, are fixed-rate, "promise to pay" leases. Per diem leases do not have fixed rates. Rather, the rental stream for usage of the cars is paid to the lessor through the collection of railroad car hire payments which are both hourly and mileage rates. As such, per diem leases are done between lessors and railroad lessees, and involve railcars that operate on railroad reporting marks. Some shipper lessees have per diem leases but generally through short line railroads that they own. By their nature, per diem leases do not generate even monthly lease payments and add an element of market risk to the lessor. They are most commonly used for leasing boxcars, but some gondolas and covered hoppers are leased on a per diem basis.