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When the SUV craze gained steam in the late 1990’s, automakers leased them out by the trailer-load. Low lease payments expanded the number of people who could drive these $30,000+ trucks off dealer lots. It was estimated that Ford’s (F) gross profit on the Expedition and Lincoln Navigator was an astounding $12,000 and $15,000 respectively. According to PBS Frontline:

“One factory that makes the Ford Expedition and Lincoln Navigator was making more profits than any other factory in any other industry in the world, and was making more profits than all but several dozen entire corporations in the world.”


Not only that, cars coming back from leases in the late 1990’s were being sold back into the marketplace at prices higher that automakers originally anticipated. For example, cars leased for three years in 1994 were expected to be worth 47% of the original MSRP at the end of the lease. When the cars were remarketed after the lease matured, they fetched 53% of MSRP. Figure 6% on a $20,000 car – that’s an additional $1,200 profit per car that the leasing companies (think GMAC, Ford Motor Credit, plus other “captives” and banks that were getting into the action) booked as additional profit at the end of the lease (assuming the car was turned in and resold).

Car Leasing 101

In a nutshell car leases work as follows (very simplistic). Unlike auto loans which generally amortize principal down to $0, leases amortize principal down to a residual, or salvage value. Therefore, a 5 year lease will have a lower monthly payment than a 5 year loan.

The main factors that go into pricing a lease are purchase price (less any down payment, called a “capitalized cost reduction”), interest rate, term and residual value. As an aside, many people do not realize that they can reduce their lease payment by negotiating the purchase price of the car first, and then look at the lease option. If two cars have similar MSRPs and purchase prices, the car with the higher residual value will have the lower payment.

For example, according to Edmunds, a 2006 Toyota (TM) 4Runner SUV will have a residual value of 49.3% (of original MSRP) after 5 years. In contrast, the corresponding residual for General Motor's (GM) Buick Rendezvous is 31.9%. So the (estimated) residual value for a Buick Rendezvous with a $25,060 MSRP is $7,994, losing $17,066 of its value over 5 years. In contrast, while the Toyota 4Runner has a higher MSRP of $27,635 $2,575 higher), its residual value is $13,624 ($5,630 higher), losing $14,011 of its value.

Without manufacturer incentives, the 4Runner will be less expensive to lease, despite costing almost $2,600 more (assuming cars are purchased at MSRP).

Setting Residual Values

The big unknown in leasing is trying to figure out what the car is going to be worth three years down the road. Enter companies like Automotive Lease Guide (“ALG”). ALG publishes estimates for car and truck residuals. Auto finance companies use ALG as a resource to help them price their leases correctly.

Auto Finance Companies Get Burned

Going back to the late 90’s, all good things come to an end, as did the lease gravy train. As the following chart shows, as 3 year old cars coming off leases in 2000 were worth 3% less than originally anticipated.

If we look at the full size SUV sector, the news was worse. SUVs coming off lease in 2001 were worth 10% less than originally thought.

Multiply that by a $30,000 MSRP, and you are talking about losing $3,000 per vehicle. Captive finance companies (GMAC, Ford Motor Credit etc.) had some cushion in the huge profit margins of SUVs when the vehicles were initially sold, but banks and other car leasing companies got burned pretty badly.

Pricing it Right

Going back to Chart 2, after swallowing the huge losses, ALG & the car leasing companies lowered their residual values to the point where resale prices started coming in at higher than ALG forecast for cars leased in 2002 (36 month leases). For SUVs, it actually started in 2001 (see Chart 3). Notice that ALG forecasts residual values on SUVs to continue to decline, while overall residual prices are expected to firm over the next few years. ALG’s SUV forecast seems amazingly prescient, given the recent slowdown of full size SUV sales when gas topped $3/gallon

This firming of prices jives with a recent report by residual value insurance specialist RVI Group. In a recent report, RVI references the recent Bureau of Labor Statistics Used Car CPI, which shows May 2006’s Used Car CPI 1.5% higher than May 2005’s. RVI anticipates that trend to continue for the remainder of the year. Rising gasoline prices has created diminished supply of available used compact cars, driving up their prices as well.

As the following chart shows, leasing has picked up as well, almost doubling penetration from Q4 2004 to Q1 2006. RVI attributes renewed interest in leasing to rising interest rates. As interest rates rose, consumers revisited leasing as a way to lower monthly payments.

In conclusion, while the domestic auto industry faces some serious problems, they seem to have learned their lesson from the residual value debacle they faced at the beginning of this decade.

Related Links: Toyota Gets Knocked Off Its PerchWith the GM Merger a No Go, What Kerkorian's Next Move?Ford's Burn Rate Worries AnalystsToyota: Running Over the CompetitionDespite a Great Year, GM is Still Trailing Japanese Counterparts Like ToyotaJapan's Big-3 Auto to Further Expand Fuel Efficiency

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Source: Detroit Gets it Right This Time