Car leasing is back with a vengeanceJuly 22, 2013: 10:37 AM ET
And that's a very good sign for the automakers.
By Doron Levin
FORTUNE -- The Newport Beach, Calif. periodontist who trades regularly among the latest Mercedes, BMW, and Lexus sedans is typical of a client that prefers to lease, rather than to buy, vehicles. Now her assistant, who keeps his Honda Civic for a long stretch, is leasing as well.
The recovering U.S. auto market has been characterized, in part, by a rising percentage of customers who are leasing cars, notably non-luxury buyers. Last year the percentage of those leasing reached 22%; this year it could break through 25%, according to Edmunds.com. Low interest rates and strong pricing for used cars are two factors behind the trend.
"Luxury brands have for a long time relied on leasing to maximize their sales volumes. Now mainstream brands are riding that wave, drawing buyers with the promise of lower monthly payments through leasing," says Jessica Caldwell, an analyst for Edmunds.com.
Many younger buyers have been attracted by lease deals because they can more easily understand a monthly payment and the simplicity of returning a vehicle after a set period of time -- as opposed to a fixed price that is complicated by a down payment and several financing options. Many also like the option of buying the car at a set price at the end of the lease period.
But those holding the lease (often the automakers themselves) may get burned if the so-called residual value of the car -- the projected price at the end of the lease period -- doesn't live up to expectations due to a soft market for used vehicles. Sometimes automaker lending arms create low monthly payments and unrealistically high residuals to disguise what actually is a financial incentive to buy.
Monthly payments for lease vehicles are usually lower than payments for purchased vehicles that are financed with a loan. But (as Edmunds.com points out) if a motorist decides to drive a car for six years or more, the purchase of a slightly used vehicle is more cost-efficient than new or leased vehicles.
Larry Dominique, president of ALG, a company that tracks residual values and lease rates, said, "We have seen automakers that traditionally didn't lease, such as Hyundai and Kia, are embracing the practice due to increased residual values." Rising quality and tight availability of Korean brands has raised transaction prices of new vehicles, making used vehicle prices stronger as well.
A vehicle lease is an agreement whereby a third-party financial institution owns the car, the user of the vehicle agreeing to pay a monthly rate and return the vehicle after a specific period of time, with no more than a set number of miles on the odometer. The agreement usually contains a financial penalty for exceeding the mileage limit.
ALG is bullish on the continued increase in the strength of residual values, which comes from rising demand for vehicles. Used-car supply is tight, Dominique said, "which is causing an unnaturally high value on used cars. We don't expect the supply of used cars to return to where it was in 2007 [when the car market tanked] until 2017."
A big disadvantage of a vehicle lease, getting stuck for a long time with a vehicle you don't like, has an up-to-date digital remedy. For a fee, Swapalease.com matches motorists who want to get out of their lease with those who might be interested in assuming them.
The auto companies have too fresh a memory of the last collapse to tempt a new one with residual values that wildly unrealistic. Still the threat of a new bubble is never too distant, which is why lower and lower monthly payments may trigger alarm bells.