Aircraft leasing: the mechanics of renting planes
The number of people travelling by air has continued to increase, despite the recent slowdown in the global economy and other seemingly negative outside influences. According to the International Air Transport Association, the air travel industry has a long-term annual growth rate of 5.5%. Boeing, the plane manufacturer, expects air traffic growth of more than 4.5% per year over the next 20 years. It also predicts that the global fleet size will double. Rising incomes and a growing middle class in emerging markets will likely continue to be the biggest drivers of growth.
While these figures bode well for airlines, buying planes is an expensive business. One of the biggest sources of airline financing used to be bank debt, often from European commercial banks. But funding from this source began to dry up in the aftermath of the financial crisis. Global economic uncertainty and the European sovereign debt crises caused some banks to leave the market completely. This type of financing became even less common after banks began to reduce the amount of debt on their balance sheets, partly as a result of new regulations.
Leasing companies take on two risks. The first is that the airline will remain creditworthy. The second is that the second-hand value of the plane will meet expectations.
Other kinds of aircraft financing, such as the operating lease structure, therefore became more popular. Under this kind of agreement an airline rents a plane for an agreed period of time from a leasing company. The leasing company that owns the aircraft (the lessor) has sole claim to it. Meanwhile, the airline (lessee) pays for the right to use it. If market conditions are favourable when the lease expires, the airline can try to negotiate a new lease. If they are not, it can return the aircraft. Leasing companies take on two risks. The first is that the airline will remain creditworthy. The second is that the second-hand value of the plane will meet expectations.
The reward for taking on this risk is that the total amount paid to borrow the aircraft is more than the cost of buying it outright. The practice is increasing in popularity – according to the CAPA - Centre for Aviation Fleet Database, leasing currently accounts for half of the world’s commercial aircraft fleet.
How do aircraft become investable assets?
Leasing companies tend to purchase aircraft directly from manufacturers like Boeing and Airbus. Being important clients of these companies, some of the larger lessors can negotiate attractive discounts. They use both equity and debt (a 60% to 75% loan-to-value ratio is common) to finance their purchases.
Often, lessors raise equity capital by setting up funds to attract external investors. In the UK, the first aircraft leasing fund launched in 2010. Currently, there are five funds listed on the London Stock Exchange (LSE) with a combined market capitalisation of £1.5 billion1 . These funds invest in twin-aisle planes and lease them to a variety of airlines including Emirates, Etihad, Norwegian Air and Thai Airways.
Lessors use payments from the airline to pay off their debt, pay fund costs and pay a yield to the equity provider. The LSE-listed funds aim to pay annual dividends of around 8% to 9%. In addition, there’s the potential for additional capital return when they sell the planes at the end of their leases.
Effectively, the investment case depends on two things: the continued creditworthiness of the lessee and the second-hand value of aircraft. The majority of the LSE-listed funds invest in the A380, a twin-aisle aircraft that is not widely available and has only recently entered the secondary market. Lower returns tend to be available (or higher debt is required to achieve the same returns) on more commonplace planes, given that there is greater certainty over their second-hand values.
Until late 2017, an A380 had never come off lease and the plane’s fate on the secondary market was the source of much speculation. Five leases have now ended and the aircraft have been returned to their owners. Some were stripped for parts and had their engines leased out. Hi-Fly, a Portuguese leasing company, hired another. In turn, Hi-Fly has rented it to Thomas Cook Airlines and Norwegian Air for short periods. This has been widely viewed as a positive step towards establishing a solid secondary market for the A380 in future.
Airbus recently announced that it intends to stop production of the A380 in 2021. Emirates, a major customer, cancelled a number of orders as it struggled to fill the aircraft on some routes. Commentators are speculating as to the effect this will have on the LSE-listed funds. Some believe this could depress residual values, with others arguing that there is a greater chance Emirates will re-lease its A380s in order to maintain fleet capacity.
Aircraft leasing has become increasingly competitive. Leasing companies are paying higher prices for aircraft and airlines are negotiating better lease terms. As a result, it is becoming harder to maintain returns at the same level. To counter this, some leasing companies are looking to acquire older planes to lease to counterparties with lower credit quality.
In our view, investing in aircraft leasing at the correct time in the cycle can improve the risk-adjusted return of a diversified portfolio. Nevertheless, it is important to continue to monitor the deals being entered into by leasing companies, the health of the secondary market for twin-aisle aircraft and the continued creditworthiness of airlines.
1 Market capitalisation as at 21/01/19. Source: Bloomberg.