Jane’s Transport Finance
Despite the current market conditions, aircraft lessors are experiencing high demand for services. But are the good times just a short-term uptick or a longer-term phenomenon? Alison Tucker reports.
Business is booming for lessors as market conditions that are putting the squeeze on other sectors of the industry - high fuel costs, the credit crisis and the slowdown in the world economy - serve to push business their way.
High demand for leased assets at this stage of a cycle is unprecedented. Whether such a development represents a short-term phenomenon or a long-term trend is yet to be seen; but with only about 4,500 commercial aircraft on lease out of roughly 18,000 in operation, growing demand for new-technology aircraft coupled with strong order books means that lessors are in a good position to weather the current downturn in global aviation.
Since the scenario began to unfold late last year, airlines worldwide have been faced with the prospects of cancelling or delaying deliveries of new aircraft or sub-leasing aircraft to other carriers as cash flows come under pressure. Leasing aircraft has become an expedient solution to current airline woes, allowing carriers to expand aircraft fleets without putting more debt on balance sheets. It also enables airlines that cannot buy new aircraft because of prohibitive capital costs - or because they are far down the new order waiting list - to access modern, fuel-efficient aircraft in a more suitable timeframe.
A quick look at the order books of both Airbus and Boeing indicates that aircraft lessors are bullish on the operating lease market. Lessors control more than 15 per cent of the Airbus and Boeing order backlog, including many of the near-term delivery positions. As well as playing a dominant role in acquiring new aircraft directly from manufacturers, lessors are expanding their portfolios through sale/leaseback transactions and purchases of second-hand aircraft from carriers and other leasing companies in a bid to capitalise on growing demand.
According to Klaus Heinemann, chief executive officer (CEO) of Netherlands-based lessor Aercap Holdings, the long-term outlook for lessors is positive. “The proportion of the global fleet under operating lease has increased from 17 per cent in 1990 to 35 per cent currently. The industry believes that operating leases will continue to become more popular and that 40 per cent or more of the global fleet will be subject to operating leases over the course of the next 10 years,” he says.
Dublin-based lessor AWAS is similarly bullish about the prospects for aircraft lessors. “The number of leased aircraft in the global fleet grew by 17 per cent between 1992 and 2007. We expect similar growth to continue in the future, especially with airline credits weakening and financing liquidity tightening,” says Frank Pray, AWAS president and CEO. “The percentage of current Airbus and Boeing order backlog by lessors is still less than it has traditionally been and it is now more diversified with the two mega players International Lease Finance Corporation (ILFC) and GE Commercial Aviation Services (GECAS) being replaced by a strong group of sophisticated players. We consider this diversification good for Airbus and Boeing as well as for airlines.“
Economic growth in countries such as India, China and Russia, where a rise in disposable incomes is encouraging a greater amount of air travel, is also helping to increase demand for leased assets.
Cornerstone of demand
According to Steve Hannahs, CEO and group managing director of California-based less or Aviation Capital Group (ACG), this development in particular differentiates the present cycle from preceding ones and is a cornerstone of the strong demand that lessors are experiencing in the face of the industry downturn.
“This cycle is different,” says Hannahs. “There is globalisation in the airline business. Some airlines that didn’t exist in the 1980s are now acquiring aircraft. Among other countries, these airlines are domiciled in the Middle East, Russia, India and China. There has been a lot of catching up, meaning that countries other than the US and European countries have developed aviation infrastructure. There are also a lot more aircraft flying in European airspace.“
Hannahs notes that lessors have experienced a robust market over the past several years but predicts a slowdown of about 18 months in aircraft acquisitions, although this may affect airlines more so than lessors.
“A major difference in this cycle is that airlines, for the most part, are crummy credits. Lessors provide more certainty for aircraft financiers. With experience in remarketing aircraft and a wide customer base, lessors are in a better position to place aircraft in the event of a default. New technology aircraft will also entail the requirement for managing aircraft assets in terms of maintenance. Banks that own aircraft suffer from asset management shortfalls, which will also push business in the direction of lessors,” he says.
“There is a lot of demand for aircraft and financiers are knocking on our doors. ACG has the backing of a strong corporate parent (financial services company Pacific Life). This is a relationship-driven industry and you want to be able to access capital in the down-times,” continues Hannahs.
By contrast, John McMahon, CEO of Genesis Lease, does not believe the current cycle is necessarily different from those before. “I’m not sure this aviation cycle is different - except that it is happening a couple of years earlier than expected,” he says.
“In previous cycles, there has been a run-up in aircraft orders leading to a peak in good economic times and subsequent deliveries take place in an economic downturn often accompanied by an external shock, such as the oil crisis of 1973; the US recession/savings and loan crisis in 1981/82; the first Gulf war in 1991; the terrorist attacks of 9/11; and, more recently, the credit and oil price crisis. There will be difficulties and casualties ahead but commercial aviation will restructure to accommodate the operating environment and will continue to be a key part of global infrastructure,” he says.
Large order books
The confidence of lessors in a continuing buoyant market is evident in several big-ticket orders placed with manufacturers.
In early January, Dubai Aerospace (DAE) confirmed a USD10.9 billion order for 100 Boeing aircraft comprising narrowbody and widebody models, following up a November 2007 letter of intent (LOI).
DAE entered the aircraft leasing arena in November 2007 with the simultaneous announcement of the acquisition of eight A330-200 aircraft from Emirates under a sale/lease-back scheme and the acquisition from GECAS of 20 aircraft, comprising
B-737s and A320s. DAE also penned a memorandum of understanding (MOU) in November 2007 with Airbus for 100 aircraft, including narrowbody and widebody versions. There are rumours that DAE may place another order within 18 months for about 50 A330 and B-777 aircraft.
In January 2008, AWAS completed an order for 100 new aircraft from Airbus. T his deal, valued at USD6.9 billion at list prices, will see AWAS take ownership of 75 new A320-family aircraft and have options for an additional 25 aircraft. In March, AWAS finalised an agreement to purchase six A330-300s from Airbus for Singapore Airlines (SIA) in a deal valued at USD2.1 billion. Financing was committed by two syndicates led by DVB Bank and KfW Ipex-Bank and HSH Nordbank.
BOC Aviation is likewise thinking big. The lessor plans to triple the size of its fleet to 300 aircraft over the next five years, taking advantage of sale/leaseback opportunities that would allow it to acquire aircraft without being captive to the long lead times for new orders precipitated by bulging manufacturer order books.
“We have a strategy of forward-placing aircraft,” says Robert Martin, BOC Aviation’s managing director and CEO. “Today, all except 16 of our 73 aircraft on order have been placed. The next new aircraft available for lease is in March 2010 and thereafter in 2011. With airline orders doubling between 2007 and 2010, many airlines are looking to do sale/leaseback deals as carriers require capital to expand fleet size. Leasing allows airlines to refleet without purchasing aircraft outright, which frees up cash on balance sheets for working capital.
“Demand from airlines for leased aircraft definitely exists. In the previous year we saw more than 10 competitors for one sale/leaseback deal but now there is only a handful. This year we are looking to expand our fleet via sale/leaseback transactions and have achieved success, notably concluding three B-777-300ER sale/leaseback deals with Air Canada. We also closed a narrowbody sale/leaseback with a Brazilian carrier last month.“
Aercap’s Heinemann is somewhat circumspect about the large orders penned. “There is a certain risk of over-ordering on the side of leasing companies and airlines,” he says. “If this problem arises, it is a risk that will need to be taken into account from as late as 2012 onwards since new aircraft delivery slots for the next four years have already gone,” he says.
An inevitable development of growing demand for leased aircraft is increased competition within the sector as new entrants pitch themselves against established lessors in an effort to capitalise on burgeoning demand in high-growth regions.
A report by the International Air Transport Association (IATA) indicates that by 2011 the market share of air traffic should shift decisively towards Asia from the US and Europe, with regional travel within Asia representing about 27 per cent of all passenger traffic. “Strong growth in developing economies, particularly China and India, will continue to boost the global economy while high energy prices continue to support strong growth in the former Soviet Union and the Middle East,” the report notes. China in particular is witnessing a slew of leasing startups.
In 2007, Industrial and Commercial Bank of China (ICBC) established a leasing company that invests in big-ticket assets, including aircraft and ships. The leasing company was solely funded by ICBC with registered capital on CNY2 billion (USD292 million). China Merchants Bank was also green-lighted by the country’s regulator in 2007 to establish a big-ticket leasing business, also with CNY2 billion in registered capital.
China Development Bank recently entered the aircraft leasing market through the acquisition of a 95 per cent stake in Shenzhen Financial Leasing Co. Other shareholders include HNA (Hainan Airlines) Group and Xi’an Aircraft Industry (Group) Co Ltd. Registered capital of the new company is CNY7.48 billion. Other banks in China also plan forays into the aircraft finance sector.
Beijing-based aircraft lessor Dragon Aviation Leasing was formed in October 2006. It is a venture of China Aviation Supplies Import & Export Group Corporation (CASGC), which holds 50 per cent of Dragon Aviation Leasing and is contributing a key position in the Chinese aviation market; Aercap Holdings, which holds a 25 per cent share in the company and will manage the aircraft; and French bank Calyon, one of the key institutions in the aviation financing market, and which also has a 25 per cent stake in Dragon Aviation Leasing.
Dragon Aviation Leasing will initially focus on narrowbody aircraft with a geographical focus on the People’s Republic of China market where, according to estimates by airframe manufacturers, the Chinese domestic aviation market will require up to 2,600 additional aircraft during the next 20 years. The new venture expects to build a portfolio of USD1 billion worth of aircraft in the next several years.
The Middle East, with its vast reserves of oil money, has the potential to become a major centre for aircraft leasing. While the few leasing companies domiciled in the region benefit from generous and supportive governments and very deep sources of equity, there is some doubt as to whether there is sufficient impetus from bankers in the region to get into aircraft finance, bearing in mind the Middle East’s preference for real estate and the bond markets. Nonetheless, there has been some movement in this direction - particularly as the region hosts a large number of equity investors.
Aircraft lessor Falak Investments was set up in 2007 as a joint venture between Bahrain-based United International Bank and Muzun Partner Ltd, a company related to Switzerland-based lessor Novus Aviation. Novus Aviation is a familiar name in the aircraft finance market. Almost 10 years ago, Novus Aviation established the Muzun International Aviation Fund (MIAF), which has subsequently been completely sold out.
Falak Investments was established with 11 aircraft, valued at about USD400 million. The company plans to expand aircraft leasing activities and recently signed a letter of intent (LOI) with Royal Bank of Scotland (RBS) to acquire five additional aircraft, including A320-family, B-737NG, B-747-400 and ERJ-145 aircraft. Novus Aviation is the asset and aircraft lease manager of Falak Investments.
Further afield, Australian banking group Investec entered the aircraft leasing business this year with the launch of Investec Global Aircraft Fund and AUD73 million (USD68 million) in initial capital. Seed investors include three large industry superannuation funds - Auscoals Superannuation Seafarers Retirement Fund (SRF) and the Stevedoring Employees Retirement Fund (SERF).
Existing lessors are not treating the new entrants lightly. “We believe the se startups are to be taken seriously as they have determined financial backing and the aim to build global franchises over time,” says Heinemann.
While some banks and lessors have formed joint enterprises in regions where strongest demand is expected, Pray does not believe that being domiciled outside the developing regions of Asia and the Middle East will have much bearing on business growth. “Larger lessors work on a global basis anyway. At the current time, 31 per cent of AWAS business is in the Middle East and Asia, with our Asia exposure growing significantly over the next 24 months. Airlines in this region will seek out the best possible solutions. Where the lessor is based, we think, is irrelevant,” says Pray.
While agreeing with Pray that the global reach of a lessor is more important than where the company is based, both Martin and McMahon see a degree of benefit to having a local presence in different regional markets. “While lessors generally have a global rather than regional focus, being in the heart of activity does provide some advantage,” says BOC Aviation’s Martin.
For McMahon, “aircraft leasing is a truly global business and a properly diversified portfolio needs to reflect this. Each lessor can contend that he has some advantages in his home market and to a certain extent this may be true, but those benefits can become disadvantages if there is too much exposure to a single market. On the other hand, a global lessor can certainly benefit from local presence in various markets. In this respect, Genesis is fortunate that the company’s relationship with GECAS provides market access through 27 offices worldwide,” he says.
Although Asia and the Middle East will provide the largest potential for lessors, the US, which accounts for 36 per cent of the world’s commercial aircraft, is also expected to boost demand for leased assets as legacy carriers park old-technology aircraft in favour of leasing more fuel-efficient models.
According to McMahon, the US, in the short-to-medium term, is likely to represent more of a replacement market than a growth market. “This market is still huge in scope because there are so many aircraft that need to be replaced. I would expect US airlines to have a new focus on the benefits of operating leasing as they re-fleet. The US represents around 12 per cent of the Genesis portfolio and there is scope for that figure to grow,” he says.
Aercap sees potential in the US market “in the medium term, though certainly not in the short-term". True to strategy, BOC Aviation’s Martin sees the potential for a number of sale/leaseback deals in the region. “US carriers have had excess capacity for a long time and have been trimming their fleets to adjust to market demand. We can work with them to place out the excess capacity via sub-leases or sales,” says Martin.
AWAS, says Pray, sees limited opportunity in the US. “Currently we have nearly 20 per cent of our20fleet placed in North America. Due to the ageing US fleet, we do expect that US carriers will need to seek out newer aircraft in the near future and with our forward order pipeline of new aircraft, we are well placed to meet this demand. However, at this point in time, we achieve better risk-adjusted returns in other parts of the world so our exposure to the US is likely not going to increase,” says Pray.
Lessors have benefited from production delays with regard to the B-787 and, to a lesser extent, the A350 aircraft. Delays in manufacturing the B-787 have resulted in increased demand for B-767-300ER leases, boosting that aircraft’s lease rentals and values.
The B-787 is now expected to be available in late 2009 and the A350 in 2013. Although these aircraft are designed to replace B-767 and A330 aircraft, lessors perceive little threat to business when the new Boeing and Airbus models do enter the market.
“We don’t expect the arrival of the B-787s and A350s to impact our business since these big aircraft will be in a completely different category in terms of monthly lease rentals compared with the B-767,” says Heinemann.
Pray makes a similar point. “There is a significant capital cost differential between current production and new production technology aircraft that will keep current production aircraft such as the A330 and B-767-300ER very much in play. The main focus is on operating economics: the B-767-300ER still has lower total trip cost than either the A350 or the B-787 and the current production A330-300 has lower seat mile cost than both the A350 and B-787 models. In essence, we see demand in this sector continuing even when new technology aircraft come to market,” says Pray.
According to BOC Aviation’s Martin, demand for the B-777-200ER has also benefited from delays to the B-787. Focusing on narrowbody A320 and B-737NG aircraft and, to a lesser extent, the B-777-300ER, Martin foresees little impact on BOC Aviation’s business when the B-787 and A350 come online.
Lessors are also watching the new breed of regional jets from Russia, China and Bombardier’s C-Series with interest, but the aircraft will need to prove their mettle and marketability before lessors will invest in them. Heinemann voices the majority view, saying: “We will only consider the possibility of ordering any of these new aircraft once they have been launched and established a sufficient market base.“
© 2008 Jane’s Information Group