Everything You Need To Know About Residual Risk With Used Car Prices Coming Down
Trevor Watson | January 18, 2023
The Lease-Here, Pay-Here used car leasing model is a unique business model, entirely different than the new car leasing model or an indirect purchase leasing model. What creates that difference, and competitive advantage, is having a dealership as the fleet lessor. Dealerships are uniquely positioned to essentially eliminate what is known as “Residual Risk” in the leasing model.
Residual risk is one of the primary risks involved in new car leasing, and a risk that has sunk many lenders who incorrectly predicted a new car’s value three or four years into the future. If a lender predicts the residual wrong and sets the residual value too high, they will lose money, potentially thousands of dollars, on every single vehicle that comes back at the end of each lease. Lenders without platforms to lease the vehicle a second, third, or fourth time on full term leases, must resort to liquidating the vehicles at auction and accepting whatever the market value is at that moment, thus locking in their losses (or gains) if there are any.
How does leasing from a dealership change that equation? Having a dealership as the fleet hub and lessor provides the ability to bring back lease returns, recondition them, and put them back out on the road for another full-term lease with a reset residual value. Imagine the following scenario, illustrated in the chart below, where you start with a vehicle that you purchased for $12k and leased out for $15k for three years (note, the chart only shows the gross cap cost, it does not include the money factor/interest). You initially set your residual at $5k, or 33% of the agreed upon value, a reasonable estimate for a vehicle with this Actual Cash Value (ACV). At the end of the three-year term, the customer returns the vehicle to you (as required with a lease) and has two options; (1) they can purchase the vehicle for the Residual Value of $5k, or (2) they can return the vehicle to you and lease something else or walk away entirely.
If the customer chose option 1 and buys the car for the residual, you have made all the money you had in the deal regardless of what the actual ACV of the car is at that moment (no loss on the residual value). If the customer chooses option 2, you take the vehicle back, recondition it, place it back on the frontline and lease it out to the next consumer.
On this second lease, you will have an agreed upon value (retail price) of perhaps $10k since it has depreciated from the original $15k three years ago. Now you reset the residual value to 25% of the retail price as it is a little older vehicle, which would place the residual value at $2,500 and set the term for 30 months. Thirty months later, when the customer’s lease matures and they bring the vehicle back to you, they have the same two options, buy the car for the residual value or give it back to you.
You can continue this process until either a customer purchases the vehicle for the residual value, in which case you are never exposed to the residual risk, or until you feel the vehicle has used up its useful life and needs to be liquidated. The residual value is now so low that when you wholesale this unit you will likely receive your entire residual value from the last lease, or in a worst-case scenario, miss it by only a few hundred dollars. After having successfully leased this vehicle for 2-4 full term leases, the residual value has come down to such a minimal level it is inconsequential. This is why used car leasing has proven to be a successful model for dealerships to operate without the fear of residual risk in the lease.