Toyota's cheap-lease gamble

LOS ANGELES -- Eager to regain market share in the price-sensitive compact segment, Toyota is cutting customer lease payments on the redesigned 2014 Corolla by setting residual values much higher than in the past, according to dealers and lease trackers.

It's a risky move. Toyota and its finance captive are counting on lease-end values to be well above those of competing cars that have long enjoyed stronger residuals than the Corolla.

Boosting the residual forecast means reducing the principal carried on the lease, thus lowering monthly payments. That's a key factor as Toyota angles to become No. 1 again in the compact sedan segment. The Corolla was the compact king for nine years in a row before being overtaken by the Honda Civic in 2012.

The 2012 Civic was a miss with critics but a hit with car buyers after Honda increased incentives. This year the re-engineered Civic's incentives are almost zero, but the Civic still led Corolla through July, 191,120 units to 183,435.

With the Corolla's launch this month, Toyota has lease incentives right out of the gate. Three-year leases from Toyota Financial Services on most trim levels will be assigned a residual value of 63 percent for a 15,000-miles-per-year lease. For the Corolla S, the residual is 65 percent. For a lease of 12,000 miles per year, Toyota will add 2 percentage points on all trim levels.

ALG, a research company that monitors and projects vehicle values, says Toyota is at least 3 percentage points too optimistic, even in a best-case scenario. If Toyota really misses the mark and residuals hold at their historic rates, Toyota Financial Services could be on the hook for big losses three years from now.

Vince Bray, a spokesman for Toyota Financial Services, said the captive isn't taking undue risks. He said increasing residuals is a cheaper incentive than cash on the hood and better for preserving brand value.

Bob Carter, senior vice president of automotive operations for Toyota Motor Sales U.S.A., said: "We don't monkey around with 'buying up' residuals. That's not to say we aren't aggressive."

Toyota Financial Services carries the paper for a customer's lease. If a car returns from the lease after 36 months, goes to auction, and used-car dealers don't want to pay Toyota's projected resale values, Toyota Financial is on the hook for the difference.

If Toyota has set the 2014 Corolla residuals 3 percentage points higher than the vehicle's auction value in three years -- as ALG estimates in its best-case scenario -- the company suffers a $600 loss on a $20,000 Corolla.

Those losses could add up. Toyota wants to sell 330,000 Corollas next year. An estimated 76,000 will be sold by Southeast Toyota Distributors, whose customers Toyota Financial Services does not finance. Of the remaining 254,000 Corollas, 25 percent are projected to be leases, and Toyota Financial Services has 98 percent penetration of dealers' lease business. That means about 62,000 Toyota Financial leases, which is more than $37 million in exposure if Toyota is 3 percentage points too confident.

Bray said Toyota and ALG use different math to determine residual values. But even when ALG used Toyota's formula to forecast Corolla values, its best-case scenario still shows the car coming in several percentage points lower than Toyota.

Both Toyota and ALG are adding up to 6 percentage points for the 2014 model's residuals, predicting that the new design and features will be more appealing to consumers.

When the Corolla's rivals were redesigned, they all got a bump in residual value, according to ALG data: 12 percentage points for the Ford Focus, 13 for the Chevrolet Cruze and 15 for the Hyundai Elantra.

But Eric Lyman, ALG's vice president of partner development, said those three vehicles were "game-changers for their respective brands in the compact segment." He doesn't see the Corolla triggering the same surge in consumer demand.

ALG's forecasts of future residual values generally are used by automakers and finance companies to set lease terms. Industrywide, the 2010 model year's lease returns came back this year with a sales-weighted residual of 51.75 percent, according to ALG. In 2010, ALG's forecast was 51.87 percent -- off by just one-tenth of a point, despite a turbulent market in the interim.

Toyota declined to give specifics about the accuracy of its forecasts, but Bray said, "TFS has the most extensive firsthand information on residual value performance and return rates for our vehicles. TFS also employs comprehensive remarketing activities designed to maximize proceeds and minimize disposition costs on used vehicles."

For the last few years, nearly two-thirds of Toyota's leased vehicles have been purchased at lease-end by the customer or by a dealer as a trade-in, reducing Toyota's exposure, according to Toyota Securities and Exchange Commission filings.

That's because those lease deals were done after the market plunged in fall 2008. With the market now strong, demand for lightly used cars is higher than the supply, forcing up prices. Dealers and customers are happy to buy out an end-of-lease vehicle with a residual value that may even have equity.

But ALG already is forecasting a reversal of that trend and an industrywide drop in residuals by 4 points by 2016, Lyman said.

Toyota does run some incentives for off-lease vehicles on a case-by-case basis, such as a guaranteed buy-back if a dealer can't sell the vehicle, Bray said.

Black Book, another used-car valuator, is seeing some softening in the compact segment with gasoline prices holding well below $5 a gallon and mid-sized cars getting much improved fuel economy. Historically, compact vehicles have averaged 15 to 18 percent depreciation per year, which would make the projected residuals for the 2014 Corolla residuals too optimistic.

"Any time you bump up residuals you're going to have some exposure, and [the Corolla] is in a fairly crowded segment," said Jeff Bunch, Black Book vice president of lender solutions. "It could be a risky situation. You have to ask if it warrants the amount the amount of new-car sales you get for it."