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Model 3 Leasing Won't Solve Tesla's Problems

By Adam Levine-Weinberg – Updated Apr 10, 2019 at 11:17AM

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Tesla could start offering a lease option for the Model 3 within the next few months. However, it might not boost sales as much as some bulls expect.

Tesla (TSLA 0.50%) is preparing to extend its leasing program to the Model 3, according to Electrek. An internal Tesla document indicated that leasing could begin within two weeks, although the company later clarified that it would take longer to get the program off the ground -- perhaps a few months.

The availability of leases for Tesla's most affordable vehicle could unlock incremental demand. However, Tesla won't be able to offer attractive lease options -- unless it uses aggressive assumptions about the vehicles' residual values. And if it goes the latter route, Tesla could open itself up to huge losses in the future if Model 3 resale prices come in lower than planned.

A silver Tesla Model 3 on a road

Tesla could start offering Model 3 leases in the next few months. Image source: Tesla.

Tapping a new pool of demand

Tesla has offered leases for its Model S and Model X vehicles for years. They aren't cheap. For a Model S with a $94,000 list price, Tesla is currently offering a three-year, 36,000-mile lease in California for $8,424 down, including the first month's payment, plus $1,539 per month. That works out to more than $62,000 over three years.

Despite the massive expense of leasing a Tesla, leasing accounts for a little over 20% of Model S and Model X volume. CFO Deepak Ahuja recently acknowledged that most people leasing Teslas have a small business and choose the lease option because it has tax benefits for them.

Nevertheless, management believes that offering leases for the Model 3 will boost demand. That's important, because Tesla has been struggling to sell as many Model 3s as it is building -- though the wait time for California customers is down to one week or less. Yet the size of that demand boost, and the financial risk it entails, will depend on how aggressively Tesla prices the leases.

Check out the latest Tesla earnings call transcript.

Can Tesla rely on high residual values?

Whether it leases a vehicle directly to a customer or through a leasing partner, Tesla assumes the risk that the vehicle will depreciate more than expected over the lease term. Customers who decline the option to buy their vehicle at the end of the lease term can return it with no further obligations. Tesla then has to resell the car, and pay the cost of getting it ready for resale.

In recent years, Tesla has had no trouble reselling Model S vehicles coming off lease for more than their assumed residual value. Bulls see this as proof that there's not much risk involved in Tesla's leasing program.

A silver Tesla Model S on a road

Tesla Model S residual values have been strong for the past several years. Image source: Tesla.

However, residual values could plunge in the coming years. First, Tesla has only had to resell off-lease vehicles in a strong market up until now. A recession could put significant pressure on pricing. Second, in recent years, Tesla has had a waiting list for new vehicles, making used Teslas more desirable. With production surging and wait times falling, that's already changing.

Third, the electric-vehicle market is about to become way more competitive, as virtually every major brand is readying electric models. The Tesla brand will almost certainly retain its cachet, but price-sensitive buyers -- i.e., the people most likely to consider used vehicles -- are also likely to check out other brands in the hope of getting a good deal. Fourth, and most importantly, Tesla has already cut Model 3 prices -- twice. With more competition hitting the market every year, the electric-vehicle tax credit phasing out, and production costs falling, Model 3 prices will likely continue to decline. Clearly, that will pressure resale values, too.

Pricing will probably have to be quite high

Together, these factors may force Tesla to charge an arm and a leg for Model 3 leases relative to the cost of buying the car outright.

For example, the cheapest Model 3 available today costs $42,900 -- or $44,100 after destination and document fees. But if a comparable new Model 3 could sell for $35,000 a few years from now, Tesla may have to assume that a Model 3 leased in mid-2019 will depreciate by 50% over three years. That could lead to pricing along the lines of $7,000 down, including the first month's payment, plus $650 per month after all taxes, fees, and interest -- putting the total cost at nearly $30,000 for three years: hardly affordable.

Even with these onerous terms, Model 3 leases might still appeal to some small-business owners. However, the incremental demand pool would be relatively small compared with Tesla's ambitious plans to raise production.

Of course, Tesla could try to juice sales by reducing the lease payment and betting on a higher residual value. If so, investors should watch out, as the company could be setting itself up for huge losses when those vehicles are returned a few years down the road.

Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.

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