Used car price fluctuate. Leasing allows you to profit from the fluctuation, as long as you buy the right lease.

Used Car Prices are the Key to Leasing

Buying is a gamble. Leasing gives you options.

This is the final installment of a 3-part series on motor vehicle leasing. The first installment is:

The single most important factor in deciding the question of whether to buy or lease your next new car is the Residual Value specified in the lease contract.

At the end of your lease, you will have the option to purchase the car at the Residual Value, and because this is specified at the beginning of the lease term, rather than at the end, the leasing company (who still owns the car during your lease period) is the one who takes all the risk of price volatility in the used car markets.

For example, suppose you lease your next vehicle at a time when used car prices are very high, but at the end of your lease, these prices have dropped, and the market value of the car is now below the Residual Value. Then, you simply decline to purchase the car, and the leasing company is stuck with a loss. However, if the market value is higher than the Residual Value, then you may purchase the vehicle at the previously specified Residual Value and you enjoy the windfall in the form of equity in your used car.

Manheim is probably the best-known used car auction company in the United states, and they’re kind enough to publish monthly data on the prices paid for 3yr old cars at their auctions.

The data shows that used car prices can be volatile. During the Great Recession of 2007–2008, prices plunged, as auction markets were inundated with cars repossessed from bankrupt homeowners, and fewer buyers could qualify for car loans. In an effort to spur demand, the 2009 Cash For Clunkers program spent $5 billion to junk inefficient used cars and encourage drivers to purchase new. Markets recovered, but it wasn’t enough to save General Motors from bankruptcy.

By January 2011, used car prices climbed higher than their pre-recession levels and in an effort to encourage more new vehicle sales, auto manufacturers and their subsidiary leasing companies reduced their estimates of price depreciation by increasing the Residual Values they offered in new car leases. (Remember that a high residual value means greater risk for the leasing company, and less risk for the consumer). But the increases in used car prices spurred by Cash For Clunkers failed to continue when the program expired, and the leases written in 2012–2013 started to become a big financial drag on these leasing companies by 2015–2016, when the leases expired and consumers didn’t want to purchase at the inflated residual values.

The leasing companies were in big trouble.

As it turns out, one of the biggest sellers of used cars are the major rental car companies, like Hertz and Avis. They buy lots of new cars, and they get special pricing from the auto manufacturers. Then, after renting the cars out for a couple of years, they sell the used rental cars to consumers, or at auction.

When the leasing companies increased their residual values in response the recovery in used car prices, the rental car companies also changed their depreciation models and assumed that used car prices would resume an upward trajectory. It was an attractive gamble, given that it temporarily made the profits at the used car companies look better than they really were.

But used car prices drifted down, instead of up, and the rental car companies were stuck with such big losses that Hertz fired their CEO in Dec 2016. The CEO of Ford, despite booking record profits in 2015, was fired for similar reasons in May 2017.

And then a funny thing happened to used car prices. They spiked higher.

What happened was that the 2017 Atlantic Hurricane season was so bad, it destroyed at least a million cars (mostly in Texas and Florida). These consumers were flush with payments from their insurance companies, and they needed to replace their vehicles… fast. The increased demand drove both new and used car prices higher, and they’ve pretty much stayed high since.

The question for those consumers wondering whether they should buy or lease a car now is, “What kind of Residual Value is the leasing company offering me?” because your monthly lease payments will be calculated by the depreciation (difference between the Agreed upon Value of the Vehicle and the Residual Value) and the rent paid for the car, which will depend on interest rates (called a Money Factor, in leasing parlance) and the credit score of the consumer.

Depreciation is by far the biggest expense in car leasing.

Fortunately, the Manheim company gives us some data on depreciation, too. The graph below shows used car prices expressed as a percentage of the value of the vehicle when it was new.

The data is a little more difficult to interpret because it’s a combination of the Manheim auction data and the Federal Reserve Bank of St. Louis consumer price index data, which is adjusted for quality features that only became common on new cars recently: like back-up cameras, and semi-autonomous cruise control. The Fed data is adjusted for these, while the Manheim data is not.

Still, what Manheim does is very instructive. They divide their auction data by the Fed data from 3.5 years ago. That is, they’re trying to make a guess at what the residual value will be. It’s the same thing that the leasing companies do when they offer you a lease contract — i.e., make a guess at what the car will be worth at auction years later.

We can see that residual values have for sure been drifting up since 1995, but that they peaked at just over 50% in 2012. Since then, leasing has been a riskier prospect for the auto companies and a better deal for consumers.

When you’re looking at whether your lease contract is a good deal, divide the Residual Value by Agreed Upon Value of the Vehicle and multiply by 100 to express the ratio as a percentage. In the example I showed in my previous article, the Subaru Impreza lease contract was offering a Residual Value that is 65% of the Agreed Upon Value of the Vehicle.

Compare that total to the Manheim graph above, and you’ll see that the depreciation of the average 3.5-year-old used car sold at auction today is about 47%. In other words, the leasing company is gambling that the new Subaru Impreza will hold it’s value way better than the average 3-year-old used car.

Maybe it will. Maybe it won’t.

When you lease, you don’t have to worry about that, because the leasing company takes all the downside price risk, and you keep all the upside.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.