Eastern Railroad Discussion > Lease of new locomotives

Do railroads contract into operating leases (RR does not own equipment and keeps it off their books and charges as operating expense) or as a captial/financing lease (RR owns equpment and sets up purchase like a loan charging interest expense)?

Or does GE, for example, set up any kind of lease they want?


How about other equipment?

There are many examples of both (and others), and how the locomotive is painted means nothing.

wabash2800 Wrote:
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> Do railroads contract into operating leases (RR
> does not own equipment and keeps it off their
> books and charges as operating expense) or as a
> captial/financing leaase (RR owns equpment and
> sets up purchase like a loan charging interest
> expense)?

This has evolved as accounting and tax rules have changed.

Back in the 1970s and 1980s, tax laws allowed leasing companies to gain tax benefits when they leased equipment. The railroads did not have access to those benefits if they purchased or financed the locomotives themselves. The leasing companies could therefore buy the locomotives and lease them to the railroads for less than what the railroads could finance them on their own.

Those in the business field will remember such things as the 15% investment tax credit (ITC); accelerated cost recovery (ACR), which permitted quick depreciation of purchases, and various leasing incentives that were offered under Reaganomics to spur the economy. There were also the equipment trusts, which preceded Reagan, but which also gave an incentive to acquire locomotives through financial institutions rather than for the railroads to own them outright.

At first, the railroads were allowed to consider such leases as off balance sheet if they were for no more than 75 percent of the estimated locomotive life, and there was no prior agreement on a sale price of the locomotive to the railroad at the end of the lease term. In other words, the leasing company had to be taking some risk in making the lease, and it couldn't look simply like a loan to the railroad. Thus the 15 year lease became very popular, and such leases were not considered as debt when a railroad was evaluated by the accountants and analysts.

As time passed, the railroads had to report such arrangements in the footnotes of their annual reports as long-term obligations. The analysts began considering such obligations as the equivalent of debt, so the attraction of off balance sheet reporting became diluted.

Most railroads still go for leases, since they get the indirect tax benefits that only lessors can get. However, EMD and UP worked up a very short term lease (5 years) for their SD-70 purchase that allowed it to be reported as a simple operating expense. This arrangement was unusual, since EMD was taking the risk that UP would refuse to extend the lease beyond five years, and they would be stuck with a bunch of locomotives they would have to lease or sell to others, perhaps at a significant loss. With the strong economy, that hasn't turned out to be a problem.

Thanks Run8. I am an accountant so understand the workings of leases. I was just wondering what was most prevalent in the RR industry. I had the impression over the years that the railroads were in debt real deep.

wabash2800 Wrote:
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> Thanks Run8. I am an accountant so understand the
> workings of leases. I was just wondering what was
> most prevalent in the RR industry. I had the
> impression over the years that the railroads were
> in debt real deep.


There's no predominant type of lease. Some are operating, some are capital. Depends on the railroad's planning horizon, and what kind of negotiating pressure each side applies.

For example, when the UP started the SD70M buying binge, the initial leases were for five years---clearly operating leases. While some were aghast (such as Extra 2200 South) that UP wouldn't outright purchase that many locomotives and took the lease as a sign of the company's financial weakness, what UP was doing was exploiting its understanding of the industry. Specifically, UP knew that there were only six Class 1s and that if the lessor didn't like the terms UP offered for the second lease, there wasn't another road that could take 1,000 locomotives. So, someone had someone else over a barrel. If, at the end of a second or third least period, UP sees that there are better locomotives available---and Lord knows EMD and GE would be thrilled to sell UP another 1,000 brand new lokies---or better financing terms on different power, it can walk away and leave the leasing company that owns the SD70Ms hanging.

KCS is doing capital leases on the Retro Belle acquisitions. They think they need these lokies for 15 years and they think they won't change their minds about their functionality in the interim.

So, the financing is chosen to fit a motive power need/philosophy and a financial office need/philosophy.

As to deep debt, no, it really isn't that bad any more. Most rails keep the debt/book capital around 40%. Only KCS among the Class 1s is higher, reflecting the size of the purchases of TFM shares they've made over the years. The Big 6 are all investment grade, KCS is a B or B+ (can't remember which).

BobE

Thanks Bob.