Lessors face uncertain 2009 as demand drops

By Niall O'Keeffe

Two factors are set to drive down aircraft lease rates in the wake of 2008's economic tumult. One is continuing cuts to interest rates, which have declined to 1.5% in the UK, 2.0% in the eurozone and near 0% in the US. The other, rather more troubling factor is softening demand. The strength of this factor is the unknown that will determine the health of the aircraft leasing sector in 2009.

Some are optimistic. "The major impacts - if there are reduced rates - will be from the lower interest rates, and then it depends on the oil environment as to the demand effect on those lease rates," says Robert Martin, chief executive of the Singapore-based lessor BOC Aviation. "If oil prices were to spike up again due to any event, then we would see the ­greater impact on older aircraft."

Frank Pray, chief executive of Dublin-based lessor AWAS, draws encouragement from the airline profitability forecast issued by IATA in December 2008, in which the ­association predicted overall ­industry losses in 2009 would be $2.5 billion, half the $5 billion loss forecast for 2008. He anticipates "continuing softness in lease rates but in line with what we've seen in 2008, and the softness largely focused on aircraft that are basically leaving fleets in terms of permanent retirements". The ­examples he cites are the Boeing 747-200/-300, MD-80, DC-10 and 727.

Lease rates vary not just by aircraft type but by the nature of the transaction, explains Bob Genise, chief executive of Dubai-based DAE Capital. "If you have to place aircraft in today's market you definitely will see a significant drop in lease rates, and that's probably on a magnitude of 20% in some cases, [but] if you are doing sales and leasebacks with airlines who need to get aircraft financed and who need some liquidity, it's the other way round. I think you'll be able to push lease ­factors and returns up on those types of ­transactions."

What is important to lessors is not lease rates in absolute terms but what AerCap chief executive Klaus Heinemann calls "net margin", or the aircraft's earnings contribution: lease rental minus direct interest cost. He points to the impact of the 300 basis point decline in London Interbank Rate (LIBOR) between the first and fourth quarters of 2008, which would bring a monthly interest saving of $100,000 on a $40 million ­aircraft.

"We find there is over 70% correlation between lease rate movements and interest rate movements," says Stephen Hannahs, chief executive of Aviation Capital Group. "Even though lease rates have come down, our yields haven't been compressed that much... because my corresponding borrowing costs - these are highly leveraged transactions - have also come down," he says.

According to Hannahs, lease rates on three- to five-year-old Airbus A320 and Boeing 737 Next Generation aircraft fell by 10-12% ­between mid-2007 and December 2008. "If a plane was leased 18 months ago at $400,000 a month, it's probably going to be $365,000/$370,000 [now]," he says. Even sharper falls have been observed on older narrowbodies. He estimates that the rates applying to 1990s-build 737s are down by 25-30%, while rates on classics built between 1983 and 1990 have plummeted by as much as 50%.

Trends in lease rates over 2009 will depend partly on rates of airline bankruptcy and/or lease default, which carry the potential to flood the market with unwanted aircraft.

The attractiveness of aircraft as an asset class ­derives from their mobility, allowing them to be redeployed from economically distressed areas to those that are booming. The problem in 2009 is the apparent non-existence of that second category. "Unlike prior down-cycles where you always had pockets of strength in the market, I think the pockets of strength are few and far between right now," says Genise. "Even small quantities of aircraft being put in the market because of bankruptcies increased the supply at a time when there is not a lot of demand."

IMMINENT BANKRUPTCIES

There appears to be a consensus among lessors that a spate of airline bankruptcies is imminent. However, the industry might not be as hard hit as in the post-9/11 recession. "The airlines - particularly the bigger airlines - learned from the previous downturn and got their costs into shape... and so going into this downturn they're in much better shape than they were before," says Martin. "But unfortunately they haven't had time to rebuild their balance sheets, and particularly the equity in their balance sheets, because they only had a small number of years of profitability in this cycle. There are two sides to it."

Pray echoes the point that important groundwork has been laid. "Many airlines have very proactively taken steps to prepare for an environment with much softer travel demand," he says. "I actually don't expect 2009 to be worse than 2008, unless of course the financial markets further deteriorate."

As it stands, many lessors are reporting ­stable progress. Among them is Colm Barrington, chief executive of Dublin-based lessor Babcock & Brown Air (and chairman of Aer Lingus). "As of the end of November our B&B Air receivables situation was very good," he says. "People say, 'Do you have anybody on watch?' I think we've got everybody on watch right now! But the facts haven't lived up to the ­direst expectations."

John McMahon, chief executive of Shannon-based Genesis Lease, notes that "it wouldn't be unreasonable to expect some ­airlines to collapse" given economic trends, but adds: "The thing that drove the airlines out of business in 2008 was largely the huge increase in their cost base resulting from fuel... I don't think that anybody is operating under the assumption that low oil prices are with us for the long term, but clearly it does bring some huge advantages to the airlines in a difficult environment." Strikingly, many airlines have yet to lift oil surcharges imposed when the fuel price crisis was at its worst, just as dramatic currency shifts have yet to feed into new aircraft prices.

After the financial meltdown of late 2008, there are fears of a major shortfall in the ­financing available to meet airlines' and ­lessors' requirements in 2009. "Transactions will get done, but I don't think there's enough money out there to take care of all [the aircraft] on order for delivery in 2009," says Genise. "I don't think the manufacturers can fill that gap and the export agencies won't fill it either. They'll help, but there's been such a tremendous contraction in the banking and capital markets that it's going to be very difficult to get it done." He adds: "It wouldn't surprise me to see some airplanes ready for delivery with nobody ready to pay the bill."

Doom and gloom abounds, with the investment banking sector having almost vanished, the commercial banking sector doubling as a black hole for taxpayer money, and the credit markets in a state that Barrington characterises as "awful". In this context, it seems likely that many airlines and lessors will elect to defer deliveries of new aircraft. A consequence is that Airbus and Boeing may have to consider curtailing production in 2009, ­according to Heinemann.

By one estimate, 20% of the airframers' backlog is attributable to overbooking, which will quickly disappear as recession bites. If slots remain available, the airframers must face the choice of cutting production or ­financing deliveries themselves.

FINANCING ASSISTANCE

Airframer financing is a resource that lessors may need to tap, says Pray. "Should the financial markets further deteriorate I feel that lessors will need to introduce measures to secure their own survival, and in my mind that will include approaching Airbus and Boeing in terms of financing assistance for both aircraft deliveries and for pre-delivery payments."

It also appears probable that export-credit agencies will also become more active, particularly in light of the US Ex-Im Bank's professed willingness to broaden its traditional role to include provision of direct loans and support for pre-delivery payments and pre-owned aircraft financing. One would expect European ECAs such as Coface, Euler Hermes and ECGD to follow suit.

Just as Boeing, Airbus and the ECAs might be required to assist customers in need of financing, so might lessors be expected to deliver short-term solutions for viable lessees beset by cash-flow crises. These could take several forms, including short-term lease payment deferrals, unsecured loans to cover a seasonal downswing, or - where the situation is deemed terminal - aircraft repossessions.

However, lessors' capacity to help may be constrained by their own liquidity worries. "In today's market I don't feel that lessors are immune to the challenges that we see by the liquidity shortages that we see in the financial markets," says Pray. "This is evidenced by even some of the historically strongest players like ILFC and GECAS being under significant pressure today... I think the big difference in what we've seen [compared with] prior downturns is the liquidity crisis, which is affecting lessors as much as it is affecting airlines."

Pray stresses the need for caution and pragmatism in dealing with distressed lessees: "I get many letters every week in terms of requests for restructuring. We basically divide the pool of help into those we believe are good long-term bets and those where any support would basically be throwing money down the toilet. I also feel very strongly about the fact that we need to treat all of our customers as equals, because if we basically address cries for help from only some of our customers, we actually put them at a competitive advantage vis-à-vis other people we lease to."

Early in January, it was reported that insurance company AIG had appointed Moelis & Co to advise on the sale of its leasing unit ILFC, which according to Flight's ACAS ­database has a portfolio of more than 1,000 aircraft. AIG is under US government control following a $150 billion bailout last year. Allco Finance is also reported to be seeking a buyer for its aviation division, after falling into receivership in November 2008, while there has been speculation about the futures of portfolios held by RBS and CIT. Against this backdrop it seems highly probable that large lease portfolios will change hands over the course of 2009 (though addition of new capacity seems a remote prospect).

"There are two things that normally cause lessors to change hands or consolidate," says Martin. "The first thing is where you have a parent company that decides that they need to sell - generally for reasons outside our industry, where the core business has got into problems and they decide the leasing company is non-core. We've seen that time and time again in previous downturns, and I think we're going to see that this time around. The second thing, which is more severe this time around than previous downturns, is basically people's ability to access liquidity, in particular if they were relying on a lot of short-term debt and short-term paper to finance themselves."

Consolidation could take the form both of small companies combining and of big players being broken up. "I don't think there are the debt volumes out there to support large-scale consolidation," says Martin. "Debt is really the driver. There's plenty of equity out there there are plenty of private-equity companies looking to get into this business."

LESSOR VIABILITY

Amid increased scrutiny of ownership structures, concerns have been raised about the future viability of publicly quoted lessors, but McMahon makes a pertinent point in rebuttal. "If the rest of the market had gone on its merry way and so on and this was unique to aircraft leasing companies it would be a genuine question that needs answering, but it applies across the board... Any business that requires financing, where financing is an integral part of the business, has been impacted dramatically in the course of the last 12 months."

In addition to the challenge of financing themselves, some US lessors may see their tax payments increase if the new administration follows through on plans to end tax breaks for companies that export jobs.

By broad consensus, North America is a regional market that will gain in importance to aircraft lessors in 2009. "I'm reasonably optimistic about the domestic US market," says Heinemann. "If one assumes - which most analysts do - that the domestic US aviation performance might improve in 2009, there might be opportunities stemming from assisting the airlines in shifting some of the fleet structure into more modern equipment." Pray characterises both the US and Canada as "promising fields for development", while Martin reports that North America has been driving growth in BOC Aviation's sale and leaseback activity. According to IATA's latest forecast, North America's airline industry will be the only one to turn a profit in 2009. It will, IATA predicts, reverse a loss of $3.9 billon in 2008 to post a profit of $300 million.

In contrast, cool winds are blowing in one of the emergent economic superpowers. "There are certain markets that will not be as strong in 2009 as they have in the past, and India is the immediate one that jumps to attention," says Barrington, adding that B&B Air has lately found Eastern Europe to be a "very active" market, as airlines look to replace ageing Russian aircraft. China, too, remains an active market, though growth has slowed.

Barrington sounds a note of caution about the US market's potential. "The conditions available for lessors in that market are just not good enough," he says. "US airlines have problems paying security deposits, maintenance accruals, giving you decent return conditions, etc, and until those conditions change we're only taking selected opportunities in that market."

Beyond the ebbs and flows of demand, access to financing will remain a critical issue for lessors. Hannahs suggests that, following various national governments' costly bailouts of haemorrhaging credit institutions, a return to more 1970s-style banking might be imminent. "You're going to have significantly more oversight and regulation by all governments," he predicts. "It'll be a much sounder, more conservative financial system imposed upon everybody in the world, because this is a ­global effort.

"It's good news for the financial system, but the bad news is that many smaller start-up companies that were able to start in the last 25 years of relatively relaxed financial markets might not have the ability to start today, because capital will not be as easy to obtain."

In the 1970s, recalls Hannahs, aircraft ­financiers typically capped loan-to-value at 75% and dictated that loans be fully ­amortised over a 10- to 12-year period. "Guess what? That limited the ability of airlines to sell ­airplanes," he says. "I'm not suggesting we're going to go back to that, but it's going to be more restrictive than it has been... It's going to put more of a burden on some of the bigger lessors to pick up the demands of the industry to finance, because the airline industry's not going to go away. People aren't going to stop flying. It's just that the financing mix is going to change."

© Reed Business Information 2009