Many lessees enter into lease transactions that they believe to be competitive based on faulty rate assumptions. Most lease rate calculations do not take interim rent into account. The provisional rent is the trap door that allows landlords to receive increases in the rental price. It is unpredictable and the amount can be arbitrary. By understanding how interim rent can affect your lease, you can close this trap door and enjoy the rental price you thought you negotiated.
What is provisional income?
Interim rent, also known as partial rent, is the rent that a lessor charges a lessee from the time the lessee accepts the leased equipment until the official start date of the lease. Most leases begin on the first day of the month following acceptance of the equipment. In a lease with monthly payments, the interim rent is calculated as follows: multiply the number of days in the interim period by the amount of the monthly payment and divide the product by 30. In the extreme case, the interim rent can add almost a full periodic payment towards the rent. In these cases, it drastically raises the effective lease rate.
The impact of the provisional rent in the extreme case can be seen in the following example: Suppose you agree to a 36-month lease for equipment that costs $100,000. Also assume that the monthly payment is $3,113 per month, paid on the first day of each month. Suppose the lease allows you to acquire ownership of the equipment for $1 at the end of the lease. Therefore, your effective lease rate is 8%.
Now suppose that the temporary lease period is 29 days. For simplicity, we’ll round the period up to a full month and add it to the lease. The new effective rate for 37 installments of $3,113 is 9.7%. The new rate is more than 20% higher than the rate originally quoted by the landlord. This higher rate represents a trap door in your lease that results in more costs for you and greater profitability for the landlord.
The purpose of the provisional rent
Many lessors justify interim rent as compensation for forcing themselves to pay equipment vendors on behalf of lessees in connection with leasing transactions. As additional justification, these lessees state that the lessees have use of the equipment during the interim period.
Problems with the temporary rent
There are two flaws in the reasoning offered by these landlords. First, the interim rent is exorbitant, since it is based on the periodic lease payment rather than the tenant’s borrowing rate. Since each lease payment has a principal return component, the periodic payment is not an appropriate standard to use in interim rent calculations. A calculation based on the renter’s borrowing rate is probably a fairer measure.
The second flaw in this reasoning is that lessors have often failed to pay for the equipment in the intervening period. They cannot have incurred any additional costs during this period. The net result is that lessees incur significant increases in their effective lease rates, while lessors are able to sneak additional yield through a lease trapdoor. Interim renting can turn a competitive lease into a relatively high-rate transaction.
Smart tenants look for ways to limit or eliminate the temporary rent. They try to make sure they get the lease they negotiated for. Here are five strategies to mitigate the impact of interim rent:
1. Eliminate provisional income. Try to negotiate a lease that excludes the interim rent. One way to eliminate interim rent is to make the interim period count as a partial payment period. Another partial payment period can be added to the end of the lease so that the two periods constitute one full payment period.
2. Pay interest instead of provisional rent. Instead of paying an interim rent based on the periodic payment, base the interim payment on the implied transaction fee or your loan rate. This method will eliminate the principal return component that affects most interim rent calculations.
3. Limit or fix the amount of the provisional rent. If you can’t eliminate the temporary rent, you can try to negotiate a limit. You can offer the lessor a fixed interim period, regardless of the date of acceptance of the equipment.
4. Manage equipment deliveries. Another strategy is to coordinate with the equipment supplier to schedule the delivery and acceptance of the equipment towards the end of the month. End-of-month acceptances would ensure a reduction in interim rent as interim periods would be short.
5. Sale-leaseback at the end of the month. As a final strategy, if the landlord allows it, you can schedule a sale and leaseback of the newly purchased equipment at the end of the month. This strategy would also ensure a short intermediate period.
It is important to understand the impact of interim rent on your lease. Rather than assume that you will receive the quoted lease rate, review the lease carefully. If your lease includes a provisional rent, plan to negotiate this feature. Use one of the strategies above to reduce this potentially costly aspect of your lease. Even if you can’t remove the temporary rent trapdoor, you may be able to seal it.