Circularity and object financing in leasing

By 2030, in other words, already in the relatively short term, land use and construction in the Netherlands must be sustainable and circular. Circular construction entails a different way of looking at ownership. The way of financing circular construction also requires a different approach. In this blog, Heleen Wessel-Krijger explains what to look out for.

Unit of building

Now, the financing of a property still takes place on the basis of the unit of the building. As security for this, the financier receives a security right based on the unit of the collateral. That security right is usually a mortgage lien on the building and subsoil.

With fully circular construction, current engineering thinking is that as many, if not all, parts of a building are recycled and made to last for many hundreds of years. The parts, such as walls, facades, roof tiles, window frames, doors, LED lighting, kitchens, boiler, etc., should be reusable. Preferably in the same size and shape because reworking creates nitrogen emissions and material loss. Moreover, for as much as possible, the parts should be equipped with smart devices. These enable the producer to provide the parts with timely maintenance and keep them up to date. Legally, parts are not considered a unit in circular construction.

Fully circular construction

In fully circular construction, the building user does not acquire legal ownership of the building components. The land user rents or leases the building components from the manufacturer or supplier, who retains ownership of the components. The land user enters into rental, lease and/or use contracts for those components. Those contracts must be coordinated with the producers and suppliers both during and after construction as much as possible. The life span, technical interchangeability, maintenance and replacement of the parts play an important role in this.

Financing circular materials through leasing

When not a unit but specific items are financed, it is called object financing. This is a different form than financing a business as a whole as in capital financing or mortgage financing of a building as a unit. The best-known form of object financing is leasing. In leasing, things are financed by the producer/supplier/lessor giving an object in use to the lessee for a certain period of time. The lessee/user pays a fee for the use.

Financial and operational lease

In general, leasing is distinguished between financial and operational lease. These are economic terms that have no legal definition in Dutch law, but have similarities with rent and installment plan. Leasing practice is mostly contract law where the agreement sets out the arrangements between the parties.

Financial leasing involves an agreement of the use of an asset. The risk of a change in value of the underlying asset lies to a large extent with the lessee/user. It is usually the intention of the parties that ownership of the leased asset passes to the lessee/user at the end of the lease term. For this reason, financial leasing is sometimes compared to installment plan. Financial lease is therefore less obvious in circular construction than operational lease.

Operating lease generally means an agreement regarding the use of the good where the risk of a change in value of the leased good remains with the lessor/producer/supplier. With operational leasing, ownership remains with the lessor/financier/producer. Operational leasing is therefore similar to renting.

Risk in technical obsolescence

To promote circular construction and to ensure operational leasing, it is further important to place the risk of technical obsolescence on the lessor/producer/supplier. The lease terms under operating lease are not equal to the value of the object. Furthermore, the leased object is on the balance sheet of the lessor and not of the lessee/user. With leasing, whether operational or financial, the lease/use can be accompanied by an option to buy (sale-and-lease back). This is obviously not preferable in circular construction, because then the incentive of reuse is missing.

With operational leasing, the lessor/producer/supplier retains ownership of the asset, which means that the economic incentive to extend the useful life and reuse materials remains with the producer/supplier. He feels responsible for optimal circularity and knows better than anyone else what the product needs in terms of maintenance and replacement of parts. The user is not only relieved, but also has certainty of costs because they often remain the same during the lease period.

Leasing reusable parts of a building can therefore contribute significantly to circular construction. In leasing contracts, it is important to compare as much as possible with operational leasing. It is also preferable that manufacturers and suppliers of all parts join forces and contract together, so that the building user can enter into agreements for their use in a relatively simple manner.

Do you need advice on drafting such contracts? Heleen Wessel-Krijger is ready to answer your questions regarding object financing in leasing.