Many lessees enter into lease transactions they believe to be competitive based on faulty rate assumptions. Most lease rate calculations do not take provisional rent into account. The provisional rent is the trapdoor that allows landlords to receive increases in the price of the lease. It is unpredictable and the amount can be arbitrary. By understanding how provisional rent can affect your lease, you can close this trapdoor and enjoy the lease price you thought you negotiated.

What is provisional income?

Provisional 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 commencement date of the lease. Most leases begin the first of the month following equipment acceptance. In a lease with monthly payments, the provisional rent is calculated as follows: multiply the number of days in the provisional period by the amount of the monthly payment and divide the product by 30. In the extreme case, the provisional rent can add almost a full periodic rent payment. In these cases, it drastically raises the effective rental rate.

The impact of interim rent in the extreme case can be seen in the following example: Suppose you accept a 36-month lease for equipment costing $100,000. Assume also that the monthly payment is $3,113 per month, paid on the first day of each month. Suppose the lease allows you to own the equipment for $1 at the end of the lease. Therefore, your effective lease rate is 8%.

Now suppose that the interim lease period is 29 days. For simplicity, we will 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 a higher return for the landlord.

The purpose of provisional income

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 tenants point out that the tenants have use of the equipment during the interim period.

Problems with the provisional rent

There are two flaws in the reasoning offered by these landlords. First, the provisional rent is exorbitant as it is based on the periodic lease payment rather than the tenant’s loan rate. Since each lease payment has a principal return component, the periodic payment is not an appropriate standard to use in provisional rent calculations. A calculation based on the renter’s loan rate is probably a fairer measure.

The second flaw in this reasoning is that the lessors have often not paid for the equipment during 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 leasing rates, while lessors can sneak additional yield through a trapdoor in the lease. Provisional rent can turn a competitive lease into a relatively high-rate transaction.

Solutions

Smart renters look for ways to limit or eliminate provisional rent. They try to make sure they get the lease they negotiated for. Here are five strategies to mitigate the impact of provisional income:

1. Eliminate provisional income. Try to negotiate a lease that excludes temporary rent. One way to eliminate provisional rent is to have the provisional 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 rate or your loan rate. This method will eliminate the principal return component that affects most provisional income calculations.

3. Limit or fix the amount of provisional rent. If you can’t remove the provisional 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 vendor to schedule equipment delivery and acceptance toward the end of the month. End-of-month acceptances would ensure a reduction in the provisional rent since the intermediate periods would be short.

5. Sale-leaseback at the end of the month. As a final strategy, if the lessor allows it, you can schedule a sale and leaseback of the newly purchased equipment at the end of the month. This strategy would also guarantee a short interim period.

It is important to understand the impact of the provisional rent on your lease. Instead of assuming you will receive the quoted lease rate, review the lease carefully. If your lease includes a temporary rent, plan to negotiate this feature. Use one of the strategies above to reduce this potentially expensive aspect of your lease. Even if you can’t remove the provisional rent hatch, you may be able to seal it.