HOW TO GROW A PROFITABLE USED LEASING PORTFOLIO BLACK BOOK WHITE PAPER

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1 HOW TO GROW A PROFITABLE USED LEASING PORTFOLIO BLACK BOOK WHITE PAPER SEPTEMBER 2016

2 1 How to Grow a Profitable Used Leasing Portfolio

3 Black Book Lender Solutions White Paper How to Grow a Profitable Used Leasing Portfolio Once viewed as a way to drive a luxury vehicle at a lower monthly price, leasing today is an alternate form of financing available on just about every car and truck at retail. Lease deals have exploded in popularity and have been a part of the fuel that has helped the automotive industry lead the American economy ever since the recession. Since 2008 especially, leasing as a finance option has grown by 76% according to Experian Automotive 1. Leasing popularity as a share of total sales has grown over this time, but it also means more three-year-old vehicles have come back into the market. In fact, more than 3.1 million vehicles will return to the market by the end of this year alone, and this is expected to increase the number of off-lease vehicles by 20% from the previous year 2. Incentives have been on the rise to offset declining residual value forecasts and thereby keep lease payment amounts low on new vehicle leases. The following paper will help auto lenders identify when and where used leasing makes sense for a portfolio based on incentive information, depreciation trends, residual forecast data, and how to leverage residual data to find profitable used lease candidates, given a variety of vehicle collateral insight. Popularity of Leasing Besides luxury vehicles, leasing has become increasingly popular for non-luxury vehicles as well. The top leased vehicles returning to the market are popular cars by volume, such as the Toyota Camry, Honda Civic, Honda Accord, Toyota Corolla, Honda CR-V, Ford Escape, Nissan Altima, Ford Fusion, Lexus RX 350, and Toyota RAV4. The aforementioned vehicles make up 28% of all leased vehicles that will be returning to the marketplace. That list is indicative of just how widespread interest in leasing has become. The most popular vehicles to lease have been entry-level CUVs, mid-size cars, compact cars, near-luxury/upscale vehicles, and utilities of nearly every size was a record year for new auto sales, with more than 17 million sold. Of these sales, about 85% were financed or leased. Leasing has grown faster than financing. In 2016 Q1, there were more than 31% of retail sales leased, a significant growth from two years prior at 25%. Due to the high amount of financed and leased vehicles, the total outstanding balance on car loans in the U.S. is now more than $1 trillion dollars 3. September

4 Used Leasing Trends Even though new lease volume has increased substantially, used leasing remains small. Used leases, as a percentage of lease market, have stayed relatively flat, 3.90% in Q versus 3.98% in Q1 2016, according to Experian. Used lease options are not only beneficial for consumers wallets, but they also aid in retaining customers for the dealership and the manufacturer. The loyalty rate for leasing is 71.5%, but only 60.6% for loans 4. Now, dealerships like Toyota, Scion, and Lexus are offering certified leases on used cars. Infiniti is rumored to also be working on a certified lease program, but has not announced formal plans just yet. Ally Financial recently announced that they will be offering financing on used leases 5. How Used Leasing Impacts Remarketers & Dealers When someone buys a vehicle, it s not known when the car comes back into the market as a trade-in. However, in a lease scenario, the vehicle does come back on the maturity date. With the increase in new leasing, the supply of those late-model used vehicles will continue to increase in the next few years. As that supply increases, used leasing offers another alternative to remarket the vehicle. If done right, the used-car leasing portion of the market can expect to see moderate growth. With the amount of used cars entering back into the market, any improvements that can be made to the used-car supply issue will be celebrated by consumers and dealers alike. 3 How to Grow a Profitable Used Leasing Portfolio

5 MSRP: $35,000 Markup and CPO costs $4,000 $31,000 Retail Price Subvented finance charge $3,500 NEW Rebates Capitalized cost after incentives $52 $278 USED $10,000 60% of MSRP Residual Depreciation change New Monthly Lease Payment: $330 $9,100 Depreciation Highly subvented residual after 30 months Example A Depreciation Monthly Lease Payment Calculation At a high level, the following steps determine the calculation of monthly lease payment amounts. The majority of the monthly payment is due to the depreciation charge, but finance charges and mileage charges can make a difference as well. 1. Start with the retail price of the vehicle. For new vehicles, rebates are subtracted from MSRP. For used, adding markup, CPO costs, and other costs to wholesale price determines the retail selling price of the vehicle. This is the capitalized cost of the vehicle. 2. Determine the contract residual value of the vehicle at end of term (assuming 36 months). For new, it s common to have subvented residuals which, in some cases, may be substantially higher than the projected residual. 3. The difference between the capitalized cost and the contract residual value is the Depreciation Cost (assuming no down payment) which, when divided by the number of months in the term (say 36 months), gives the depreciation charge per month. 4. Add Finance Charge per month determined using money factor, which is typically lower for a new lease due to subvention. 5. Add any additional mileage charges over the allowed mileage per year. Wholesale Price $17,500 Retail Price Finance charge Capitalized cost: $21,000 $67 $253 $11,900 Residual Depreciation change Used Monthly Lease Payment: $320 Residual after 36 months Example A Where Used Leasing Does Not Make Sense Example A represents the same vehicle offered as a new lease, as well as a used lease option (at 36 months of age). Based on the comparative financing options, you can see where the monthly payment calculations come out to very little difference between new and used. In this case, the residuals on a new lease are highly subvented, resulting in a lower depreciation assessment. Demand would be soft for this vehicle as a used lease option, since most people would opt to pay just a few dollars more for the new lease. September

6 NEW Where Used Leasing Would Make Sense MSRP: $35,000 $4,000 $31,000 Retail Price Subvented finance charge Rebates Capitalized cost after incentives $50 $34 $326 $11,750 55% of MSRP Residual Depreciation change Depreciation Highly subvented residual after 30 months Example B, again, represents the same vehicle offered as a new lease, as well as a used lease option (at 36 months of age). Based on the comparative data in these financing options, you can see where the monthly payment calculations offer a larger difference between new and used. In this example, the residuals for a new lease are not highly subvented. Furthermore, the vehicle is driven 6,000 miles more per year than the base allowed miles, and it is clear that the mileage charges are lower for a used lease. Factors such as a different contractual residual value and different used depreciation rates play a key role in determining the likelihood that this vehicle would be a more attractive price point as a used lease. As such, demand would most likely be stronger for this vehicle as a used lease option. Additional mileage charge Markup and CPO costs Wholesale price $3,500 $17,850 New Monthly Lease Payment: $410 USED Capitalized cost: $21,000 $7,700 $13,650 Example B Depreciation Residual after 36 months How to Leverage Residual Data to Find Used Lease Candidates Residual forecasting can be key in determining a good used lease vehicle candidate. Not all vehicles depreciate alike. Those vehicles that face steeper depreciation within the first months, and lesser depreciation after 24 months, are more likely to represent better candidates for a used lease program and portfolio. The key is to identify collateral data that can spot these comparative residual forecast trends to help determine the depreciation lifecycle of a given vehicle. Retail Price Finance charge $70 $20 $215 Additional mileage charge Residual Depreciation change Used Monthly Lease Payment: $305 Example B Despite the growth in leasing, as well as the prospects for a structured used lease program and network, lenders should understand that not every vehicle will offer the same profit potential for a portfolio. This is simply because not every vehicle will be a good candidate for used leasing, based on a variety of finance, depreciation, and payment factors. In much the same way that not every vehicle depreciates alike, not every car or truck offers an attractive used lease opportunity. When considering a used lease program, dealers, remarketers, and lenders need to pay particular attention to residual values. Unlike terms on the lease of a new vehicle, residuals on a used lease need to be studied and projected into a vehicle s performance through 60 months. 5 How to Grow a Profitable Used Leasing Portfolio

7 DEPRECIATION CURVES $25,000 $23,000 $21,000 Vehicle 1 Vehicle 2 $19,000 RESIDUAL VALUE $17,000 $15,000 $13,000 $5,400 $6,600 $11,000 $9,000 $7,000 $5, AGE (MONTHS) Because of this, combined with the current state of the automotive market, lender and remarketer profitability lies in the hands of collateral data insight. In the above example, Vehicle 1 depreciates by $6,000 from 36-month residual to 72-month residual. On the other hand, Vehicle 2 depreciates by only $5,400 from 36-month residual to 72-month residual. A difference of $1,200 in three-year depreciation could lower the used lease monthly payment by over $35 for a 36-month lease. The automotive market in 2016 is expected to again reach sales in the mid-17 million mark, however, a slight uptick from sales levels in The majority of industry observers believe there is not much more room for growth in the coming years. This, coupled with the rising number of used vehicles coming back into the market either through trade or lease returns, means that depreciation will also continue to grow, impacting the forecast of vehicle residuals in the coming years. As a result, residual forecasting will remain key to the balance of any healthy used lease opportunity. Automotive professionals would be wise to rely on collateral data in order to identify the right vehicle candidates in a lease program, how to make sense of their used lease potential, and how to plan for returns and re-lease environments. September

8 Summary Leasing remains an attractive opportunity for manufacturers and dealers to offer beneficial monthly payments on cars and trucks for consumers looking to get the best deals possible. Over the past several years, this environment, combined with highly available credit and stable retention values, has fueled lease deals on virtually every type of car and truck, in addition to the historically lease-friendly luxury types. This record-breaking volume now represents a flood of leases being returned to the market, and the industry has turned to new strategies to keep this inventory moving. One strategy in particular is used leasing, and several manufacturers and lenders have begun to leverage a used lease program. In order to be successful, particularly as the market plateaus with accelerating vehicle depreciation, the industry will need to rely on collateral data in order to take advantage of precise residual forecasting on used vehicles. In doing so, manufactures, lenders, and dealers will have a better handle on identifying the right vehicles for used lease opportunities, with better visibility into risk potential and profit opportunities. Evaluate the following criteria to good used leasing vehicles: 1. Look for vehicles with relatively lower level of incentives/subvention on new offers 2. Review the collateral data to find vehicles with relatively lower depreciation after three years of age 3. Review the data on cents per mile depreciation differences between new and used to determine mileage charge differences in higher mileage cases 4. Find Lower Certified Pre-Owned costs to find used vehicles with lower capitalized cost Black Book collateral data is made possible through access to vehicle insight that is timely, independent, and accurate. Black Book s suite of values includes wholesale, trade-in, and retail values that are updated on a daily basis. Black Book offers the industry s most innovative portfolio management technology, which lets lenders evaluate different vehicle options to see how each would impact a portfolio in real time. Black Book s data can also help with loss forecasting, which includes historical trending and depreciation curves to measure the impending risk of downward or upward movement in specific vehicles and vehicle segments. Collateral data from Black Book is made available with detailed analytics provided in a variety of file formats, through online portals, and on desktop or mobile platforms. For more information, please visit BlackBook.com/Lender-Solutions or call Appendix 1. i-magazine.com/channel/dps-office/news/story/2016/04/1-8-million-vehicles-to-come-off-lease-by-end-of-2016-study-says.aspx 2. autonews.com/article/ /retail04/ /too-many-used-cars-lease-them 3. usatoday.com/story/money/personalfinance/2016/04/24/refinancing-your-car-loan-worth/ / 4. autoremarketing.com/subprime/why-used-car-leasing-makes-sense-ally-%e2%80%94-and-industry 5. wsj.com/articles/hot-on-the-lot-leasing-a-used-car How to Grow a Profitable Used Leasing Portfolio

9 Black Book Lender Solutions Contact Information: (855) Jared Kalfus Senior Vice President, Sales (855) Automotive Valuation and Analytics Anil Goyal Senior Vice President, Operations Alex Yurchenko, Ph. D Principal Data Scientist September

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