How are rising interest rates affecting equipment finance?
07 July 2023
With interest rates in Europe and the US at their highest levels since the credit crunch and predicted to rise further, construction equipment buyers are facing a hike in funding costs. Lucy Barnard finds out how manufacturers and banks are cushioning the blow for rental firms
Lenders are warning that interest rate rises in the US and Europe are set to push up the cost of financing construction equipment to levels not seen since the credit crunch.
In June the European Central Bank raised its main refinancing rate to 4%, its highest level since 2008 and signalled that more increases could be on the way. And in the US, the Federal Reserve, which has spent the last ten months ramping up borrowing rates, said it expected to raise rates twice more before the end of the year.
For rental companies which mostly fund machinery purchases by taking out loans or long-term leases secured directly on pieces of equipment – a type of funding known in the trade as ‘asset finance,’ each central bank hike is likely to spell an increase in overheads.
According to the US-based Equipment Leasing & Finance Association (ELFA) leases and loans are used to finance around 80% of all equipment sales.
And, although banks and finance companies are free to set monthly payments at whatever level they choose, as the cost of their own borrowing increases, they inevitably try to pass this on to their customers.
For traditional hire purchase loans, one of the most popular ways of financing construction equipment, banks are currently quoting interest rates of around 8-9% a year, up from around 3-4% a year ago.
This means that initial interest payments alone on a typical $200,000 (€183,000) excavator bought through hire purchase, would have gone up from around $6,000 (€5,000) a year last year to $16,000 (€14,700) this year.
For rental companies which typically buy whole fleets of new equipment, the costs involved can spiral into the millions.
So far, most of the finance companies contacted by International Rental News reported that the number of loans which have fallen into arrears – a term referred to in the financial world as delinquencies – remains low. But lenders say this could rise quickly if economic conditions deteriorate.
“We are seeing a higher rate of delinquency in the US, and the impending recession and rising interest rates are not likely to help,” says Greg Stangl, head of regional sales North America for construction, transportation and industrial at DLL, the asset finance division of Dutch bank Rabobank. “When it comes to restructuring debt, there is likely to be a large difference in their payment which will greatly impact these companies.”
Confidence falls in equipment finance sector
In June the ELFA warned that the amount of money spent by customers acquiring new construction equipment through loans or on leases was expected to fall over the second half of 2023.
The organisation, which tracks sentiment across the equipment finance sector with a monthly survey of 25 members including Caterpillar, Volvo AB and Bank of America, said that although investment in construction machinery rose 8.5% in Q1 2023 and was 22% above its year ago level, confidence across the sector fell slightly, suggesting that the market “may have peaked.”
In Q1 2023, Cat Financial, the finance arm of Caterpillar, reported that the volume of new loans it had written fell 11% to $2.4 billion (€2.2 billion) compared with $2.7 billion (€2.4 billion) during the same period in 2022 while John Deere reported that net income at its Financial Services division fell 20% to US$185 million, due to “less favourable financing spreads, higher expenses and lower gains on operating lease dispositions.”
Yet, despite the increased costs associated with borrowing, banks say that current market conditions are keeping demand for asset finance high.
They say that supply chain issues experienced during the pandemic, which forced many manufacturers to reduce or delay shipments or to increase lead times for new machines, has left many large rental customers in need of updating their fleets.
And, with inflation rates in both the US and Europe remaining high, customers are keen to use asset finance to buy equipment before prices rise again.
“At times like this when interest rates are high, and inflation is high, asset finance is very attractive to businesses,” says Ian Isaac, managing director of Lombard, the asset finance arm of UK based NatWest Bank which also has a joint venture with UK-based manufacturer JCB called JCB Finance. “We’re seeing levels of demand outstripping what you would see as ordinary business investment level.”
“There’s been some unlocking of supply chains, so more assets are becoming available, and we see businesses saying ‘We need to get these assets before the prices go up. We’ve got an opportunity to beat our competition. We need to modernize.’”
“By taking out asset finance, businesses can buy stuff now that they might have waited for previously. And, with the cost of money likely to go up further, they think, ‘I’m buying now, getting the assets now and they’re earning money for me now, so why would I wait?’”
DLL’s Stangl, agrees. “While the supply chain presents challenges and delays, it is improving,” he says. “So, despite the rise in interest rates, there is still a huge demand for equipment financing.”
Captive finance programmes
So, how can firms get the best deal in a high interest rate, high inflationary environment?
“We’re definitely seeing rental companies wanting tighter terms now,” says Lombard’s Isaac. “Where they might not be able to raise their day rates fast enough, they are wanting to pay smaller deposits upfront for the equipment and borrow over longer periods just to make sure that they are cashflow positive.”
Manufacturers say that despite the rising cost of borrowing, they are working to keep costs to customers low through their specialized captive finance programmes.
“The higher interest rate will make the instalments more expensive to our customers, but captive finance companies can offer promotional rates to help absorb part of the steep increase,” says Oddone Incisa, president of financial services at CNH Industrial.
“This is funded through the many marketing levers than an OEM and a dealer have available to support customers in their buying decisions. The level of contribution has remained constant to support the business; not all of the increase in interest rates has been transferred to the customers.”
Rene Koops, general manager for development and marketing at Hitachi Construction Machinery (Europe) agrees. “Captive finance companies have a unique advantage over other lenders,” he says.
“They are affiliated with the manufacturer of the equipment which gives them a better understanding of the product and its value. This knowledge allows them to offer more competitive rates and terms making them a more attractive option for borrowers.”
Brian Layman, vice president for construction equipment financial services at Volvo Financial Services North America argues that captives promote specific machine models through a variety of tools including discounted interest rates or bundling together finance with other services such as maintenance or insurance.
“Interest rates are a key consideration for new construction equipment purchases, but there are ways to offset those higher rates,” he says. “These include bundling your finance offer, using cash reserves or taking advantage of special offers.”
“Bundled offers are generally available from captive finance companies. Many times, the bundled offers are put together by combining resources of the different business units,” he adds. “Large banks don’t have these types of relationships with manufacturers and therefore can’t structure meaningful bundles built for specific types of equipment used on specific kinds of jobsites.”
For large rental companies, which have the financial clout to negotiate upfront discounts directly with manufacturers, banks are offering more sophisticated packages which bundle together many different leases and loans.
“We’re generally funding multiple assets and multiple asset types all at the same time as part of rental companies’ orders with manufacturers,” says Lombard’s Isaac.
“They do a draw down every quarter of the assets they have received as part of their order. We bundle that all together and put it in a specific agreement whenever the customer needs to finance those assets and pay for them.”
Bankers also point to the growing popularity of asset-based lending (ABL). This is a revolving credit facility tied to the value of all a business’ assets. For plant hire companies these will include fleet, but they can also include real estate as well as trade receivables and other inventory.
According to Oregon-based Allied Market Research, the global asset-based lending market was estimated at $561.5bn in 2021 and is expected to hit $1,721.38bn by 2031.
Finance companies also report some customers looking to increase loan terms to keep payments low or choosing to lease rather than loan equipment.
“Customers are reviewing the entire financing package and looking to get a repayment that makes the most sense for their business. We work to meet their goals by having discussions about what structures best fit their business,” says DLL’s Stangl.
“Oftentimes, in order to keep costs reduced, customers are interested in longer term leases to match their projects and lessen their monthly payment.”
Volvo’s Layman says that although the company has yet to see “a serious uptick in the lease portfolio,” the stability in payments of leasing “can help customers budget more effectively and reduce the impact of rising interest rates.”
Flexible lease models
Of course, switching to a lease deal is unlikely to suit all customers. Many rental firms have traditionally avoided taking out operating leases on construction equipment because the residual value of the machine at the end of the lease lies with the finance house or manufacturer which removes a significant earnings opportunity for the renter.
However, bankers say that this type of finance is growing in popularity for the sorts of machines for which there is not yet an established second-hand market.
“For emerging asset classes or asset classes where products are powered by electricity or hydrogen where that firm has less knowledge of future values in that category, that’s an area where we could see those firms saying we’re not prepared to take that risk so how do we lay off that risk to our finance partner?” says Isaac.
And, with fintech companies looking for ways to disrupt financial markets and telematics data becoming more mainstream, manufacturers and finance companies are starting to introduce new digital-driven flexible lease models such as ‘lease by the hour’ models, customers could be given more options to reduce monthly costs further in future.
Newcomers to the market include Rotterdam-based heavy equipment fintech leasing specialist Beequip which uses AI models to assess the value of the exact machine being leased and Australian fintech coaXion which is currently piloting a variable payment model based on how much and how a machine is used.
So far, most finance companies say that competition from fintechs in the heavy equipment asset finance sector has yet to take off, but lenders see change on the horizon.
“We don’t see major fintech disruption yet in construction asset finance but that doesn’t mean the sector isn’t ripe for disruption,” says Isaac. “It’s no longer a question of choosing between a day rent or a three-year lease. We see pay-by-the-hour and everything-as-a-service as an emerging area in this market.
“But if you look at other markets such as van or car hire, nearly all of these mobility-as-a-service models are being driven by rental companies which are experts in constructing smart propositions for their end users. Mostly we expect to see lenders innovate in the way that they fund those businesses rather than the lenders trying to disintermediate that value chain.”
Construction equipment finance terms
Hire purchase – a loan secured directly against the value of a piece of equipment. Customers usually pay a deposit and pay off the value of the machine in monthly instalments. Once the loan is paid off the customer takes ownership.
Operating lease – a contract that allows customers to use a piece of equipment in return for regular payments over a particular length of time (usually around three to five years) and where the value of th residual value risk assumed by the lender qualifies for off balance sheet treatment by the customer. The machine owner – the finance company or manufacturer continues to own the machine during the lease term and takes it back when the lease ends.
Finance lease - a lease which transfers most of the risks and rewards of owning the machine to the company leasing it. Usually, at the end of the lease term, the lessee will be able to choose whether to return the asset to the lender for resale, sell it to a third party or extend the lease.
Residual Value or Fair Market Value Leases – a lease where customers agree to pay monthly instalments roughly equating to the predicted depreciation in value of assets.
Asset-based lending - a revolving credit facility tied to the value of all a business’ assets but where the residual value risk does not qualify for off balance sheet treatment.