Residual values – understanding the risks and rewards

July 2002

One of the most complex and controversial issues relating to vehicle leasing concerns residual values (RVs) says a spokesman for the Southern African Vehicle Rental and Leasing Association (SAVRALA).

Very often, leasing customers are not entirely clear on the definition of RVs, how they are calculated and, in practice, “how they work.” For instance, a common expectation is that at the end of the lease period, they automatically have a right to buy the vehicle in question at the predetermined price. Unless negotiated, this is not the case.

By definition, a residual value is the Rand value – or a percentage of the initial or prevailing retail price – ascribed to a specific vehicle for a specific period of usage taking into account the distance to be travelled during that time. Quite simply, the RV placed on a vehicle today is an estimate of what it will be worth in the future.

Residual values are one of three major risk elements assumed by a full maintenance leasing (FML) company, the other two being credit and maintenance risks. In basic terms, the client contracts with an FML company to assume this risk either partially or fully.

Corporates often want to avoid the RV risk, but want their drivers to be able to purchase “their” vehicles at the end of the lease period at the contract residual value. As one leading FML company puts it: “This is like having your cake and eating it. Most FML contracts do not give the lessee the right to purchase the vehicle, unless at market value, and do not specify residual values”.

If the customer wants the driver to have the option to purchase the vehicle at the end of the lease period at a predetermined value, this must be agreed at the outset at an amount typically a few percent more than the FML company’s standard RV. In this case, at the end of the contact, if the market value of the vehicle is greater than the option price, the driver will probably buy, and, if it is less, the driver will return the vehicle to the FML company with no downside.

Some of the factors that play a role in determining how some of the larger leasing companies attach a residual value to a specific vehicle include:

  • using statistical modeling and forecasting inflation and expected market conditions,
  • the current market value of used vehicles as determined by the Mead and McGrouther guide,
  • “hands-on” experience of their customer base and specific usage patterns,
  • historical experience and statistics obtained through wholesale operations and retail outlets, ie. the actual market values achieved on resale,
  • SAVRALA’s quarterly statistics which serve as an indicator of current forecast RVs on selected vehicle models by the industry.

Based on these factors and also as dictated by changing market trends and current models, residual values are continuously reassessed and reworked to ensure that the forecasts are as accurate as possible.

Leasing companies may be more conservative when determining RVs on some imported vehicles as there is concern that they depreciate at a greater rate and retain a lesser value at the end of the lease period.

Motor manufacturers can play a significant role in assuring higher RVs by releasing limited numbers of popular new models and not flooding the market. This serves to stimulate used vehicle prices. Excessive discounting is detrimental to the used vehicle market and car manufacturers can help to improve RVs by not resorting to discount tactics purely to improve market share.

The complexity of residual value forecasting cannot be fully covered in a few paragraphs and these pointers serve to shed some light on the definition of RVs and how they are determined. When going into a partnership with a leasing company, it is important to remember that those affiliated to SAVRALA are bound by a Code and Charters set out to establish standards of good practice within the vehicle rental, leasing and fleet management industries. They are intended to ensure that customers who obtain rental or leasing facilities from association members receive the highest levels of service, honesty and integrity in all of their dealings.