During the age of low interest rates, leases have always looked like an attractive way to get an expensive car or truck at a cheaper payment than through outright financing. That has changed. It may come as a surprise to those who haven’t bought a new car recently, but the leasing trend got so hot that eventually luxury auto companies like BMW leased over 70% of their overall purchases pre-COVID.
BMW isn’t unique in this statistic - in fact, lease penetration has been on an uptrend for at least the last ten years and was expected to continue in that direction. But today, in a supply-crunched world where used car prices are up over 40% year over year, the tables have turned on leasing. People who signed a three year lease in 2019 or early 2020, right before the pandemic, are discovering their lease buyouts are extremely attractive; sometimes netting $10,000 or more in equity, while at the same time, a replacement lease is much more expensive than they expected.
At the moment, many are deciding to buy out their perfectly good lease car rather than redo their cyclical three-year turn-in for a similar new car that is now likely selling for well over sticker. That puts substantial downward pressure on lease sales which are vital to OEMs at a time when manufacturers really can’t afford to raise incentives. Sales volumes are already way down due to ongoing production constraints from the semiconductor shortage and Ukraine invasion, making additional spend on customer acquisition somewhat redundant as there aren’t enough vehicles on the market to satisfy existing demand. It makes more sense for OEMs to increase their incentive spend when there is excess inventory - which is certainly no longer the case.
Historically, leases have been heavily subsidized with capitalized cost reductions paid for by the OEM. Customers see this on their contract as a near zero money factor, zero down payment, no first month payment, or cash discounts on the purchase price. These discounts are worth it to help the OEMs in various ways, particularly to maintain customer loyalty. Improved customer retention has allowed leasing/finance companies more control of the resale market by reselling vehicles in their own dealer network as Certified Pre-Owned, which tend to be priced at least 5% more than the same vehicle sold at an unaffiliated dealer without CPO status. The franchised dealer pays a fee to the OEM for the certification, and the customer receives extended warranty benefits and a comprehensive service checkup for the extra price. All of this helped the OEM’s keep residuals strong and by extension, monthly payments low, especially when compared to traditional financing.
Today, however, it is the dealers profiting off sky-high high prices, not the manufacturers. Automakers commit to their invoice pricing (the price at which dealers buy the cars) for an entire vehicle model year, and although those prices could be subject to revision, that hardly ever happens because it confuses customers and makes corporate budgeting and marketing extremely complicated. So when dealers raise prices to exorbitant levels seen over the last six-plus months, the OEM subsidies can’t keep up. There’s a limit to how much cash the manufacturers can throw on the hood because their profit is capped.
Lease deals are looking worse and worse compared to traditional financing, and because of typically high lease penetration, this has serious ramifications for payment shoppers who once could afford a new car lease but may now have to look pre-owned. In the US, where everyone outside of a major metro needs a car, the used market tends to be more resilient than new, but they are heavily correlated with supply and price.
For typical used car buyers, whose average vehicle age is pushing 13 years, their vehicles are essential for work and family obligations, and they have no choice but to replace them when they die or become uneconomical. Recent new car buyers, on the other hand, have long warranties, surprising equity (for now), and little risk being forced into a surprise purchase and can afford to wait until prices normalize and more favorable market conditions return.
All of this adds up to a pretty negative outlook for OEMs for the short and medium term. With six rate hikes scheduled for 2022, prices may start to cool slightly, especially if production ramps up, but higher interest rates could make consumers balk in the F&I office. Although no one expects these inflated prices to last forever, they are likely to continue throughout 2022, at least.
For those invested in major OEMs, it will be worth keeping an eye on their captive finance company’s loan portfolios over the next year or more. A substantial portion of automaker profit is derived from financing arms, which in turn rely on leases. Those books have just begun to see the full effect of the inflated resale prices, and some OEMs are even taking drastic measures restricting customers lease buy-out options to retain profits on turn-in. This could give some short term boosts to their P&L, as they clearly stand to benefit from cars taken back with much higher market value than expected, but this relies on customers continuing their typical lease cycle. This cycle looks temporarily broken, however, and these prices just incentivize more owners to buy out their lease instead.
There is considerable risk ahead for OEMs as prices deter new car buyers for some time. Three years ago, nobody expected used cars to be a high-performing asset class. Now, for the first time owners may have some equity, but find themselves with nowhere to put it.