Lessors in the
post-pandemic world Apr/May 2021

Resilience was the key word for the CEOs of the operating lessors, as they recounted how their companies have been impacted by the Covid-19 shock, through airline bankruptcies, lease defaults and deferrals and sharp falls in asset values. One might have expected these tribulations to have depressed the lessors’ market values, but investors appear to have regained full confidence in the aircraft operating business.

Share prices of quoted lessors have rebounded from the lows of the early months of the pandemic and, in the cases of AerCap and ALC, have touched five-year highs while BOC Aviation claimed early this year to have achieved the highest market capitalisation in the global aircraft leasing industry (see charts). Confidence in the sector goes beyond the post-pandemic euphoria that has driven airline share prices; there is a feeling that the restructuring of the aviation industry will boost the leasing sector.

The restructuring involves an increased role for the lessors as capital providers and ownership of the majority of the global fleet. Also there may be M&A activity within the sector, led by the AerCap/GECAS merger (see following article for more detailed review) and Carlyle’s purchase of Fly Leasing, the 84 aircraft portfolio quoted on the NYSE, partly owned and managed by BBAM.

Breaking even?

However, some financial reality: looking at the sample of results for 2020 (see table), lessors’ revenues were down just 11% on 2019 but profits disappeared, with 2019’s net margin of 26.6% turning into a loss of 1.7%. While this was a much better performance than that of the airlines, the full impact on the lessors from Covid-19 may not be fully reflected in the accounts for another one or two years. Like banks, the significance of leasing company accounts may lie not on the figures on the pages but in the assumptions behind them.

All the lessors have reported that most of their airline clients have requested some form of lease payment relief, and this has been granted through deferrals and/or lease extensions. Lessors generally account for payment deferrals by treating them as a loan from the lessor to the airline, placing the unpaid rentals on the balance sheet as an asset which is amortised as the airline resumes payment of the arrears. The rental deferrals plus accumulated interest are recorded as revenue for the period in which they are due, and so the P&L account is not damaged in the short-run, and will not be as long as the deferred rentals are paid by the airlines.

The good news is that the lessors generally have reported that deferrals have been kept under control. Airlines have greatly reduced their request for deferrals and most arrears seem to be being paid back when due. This has alleviated a major worry of last year — that there would be a cascade of defaults — and largely reflects the state aid that has been pumped into the airline industry.

Still, there are the problem cases, identified when the lessor switches from accrual accounting to cash accounting. Cash accounting is employed when the airline cannot be relied on to make contracted payments and the security deposits have been drawn down, or when the airline is put into Chapter 11 or some other form of bankruptcy restructuring. In the first quarter of this year the percentages of fleet net book value that had been switched to cash accounting were, for example, 15% at AerCap, 10% at Avolon and 7% at Air Lease Corp (ALC). This is one of the ratios that the credit rating agencies monitor closely.

The upside to this situation is that if the airline recovers financially or makes a successful exit from bankruptcy protection the lessor may receive cash lump sums that go straight into revenue with no costs attached. The downside is that cash accounting may presage impairment charges on the value of the affected aircraft.

Impairment charges can have a major impact on the reported results of the lessors. For instance, Avolon’s net loss of $(36.6)m last year included impairment charges of $106.2m. Fly Leasing’s net loss of $(67.4)m was largely the result of impairment charges of $115m, including a remarkable $106m on two 7-year-old A330-300s. These charges warn of impending problems but are not current cash costs. Taking an optimistic view, there is always the possibility than the impairment loss will not materialise in full and part of the loss can be written back into future P&Ls, if the market for second-hand aircraft turns up.

The reality, however, is that the leasing industry is nervous about asset values — no one can be sure of the current let alone future values of commercial aircraft because of the unprecedented global supply/demand imbalance caused by the pandemic. During the last 20 years when leasing companies have grown strongly, aircraft values have been robust and predictable, proving remarkable resilient even in the Great Financial Crisis ten years ago.

To assess values, lessors and investors have to rely on the appraisal companies, specifically on estimates of actual market values as opposed to the fair market values (which are supposed to represent underlying values assuming a balanced market between buyers and sellers, a concept that doesn’t work in 2021). The most realistic appraisers, such as AVAC, indicate a 20% fall in in new technology narrowbody values from pre-Covid levels, a 25%-plus fall for older narrowbodies, a 30% decline for new technology widebodies, and around 50% for older widebodies.

The nightmare is that there has been a permanent impairment in values, which means that balance sheets will have to fixed through write-downs. This has adverse implications for expected income from aircraft sales and, in some cases, for loan to value ratios.

As for current lease rates, the indications are for a steeper decline in rates than for asset values — for example, by 25-30% for new technology narrowbodies — but much depends on the circumstances of individual transactions.

Norwegian has been an interesting case. The airline went into bankruptcy protection (examinership under Irish law) last year which exposed its 787 lessors in particular. AerCap and BOC Aviation became majority owners of the distressed carrier, which then in January abandoned its long-haul operations to concentrate solely on intra-Europe, in the process returning 37 787s to Boeing or leasing companies. Former executives of Norwegian then set up Norse Atlantic Airways, a Norway-based transatlantic LHLCC with a planned fleet of 787s, scheduled to start up in late 2021 or early 2022. Nine of these 787s are to be leased from AerCap under an agreement signed in April.

Terms of the lease agreement are of course confidential, but Norse’s investment message is that it will be able to achieve much lower costs than Norwegian largely because of the new leases rates, about 50% lower. AerCap is understandably reluctant to elaborate but commented that new leases typically have a variable element in the first year; in other words, a power by the hour agreement.

Rebalancing the aircraft market

The lessors have a major role to play in rebalancing the aircraft market and restoring solidity to values. According to Steven Udvar-Házy, chairman of ALC and industry guru, there is a surplus of about 4,000 jets that should be retired now, which could bring the market back into balance by 2023, hopefully. (Ed Greenslet of Airline Monitor in his 2021 global forecast comes up with a similar figure for the surplus, 4,400 units though sees a slower return to equilibrium). Udvar-Házy also observes that many of these aircraft would have been taken out of service pre-Covid if market conditions hadn’t been so buoyant.

Assuming that Covid-19 has somewhat reduced the commercial life expectancies of 737 Classics and early NGs, the early A320 family, 757s, 767s, 747s, A330s, A340s and A380s, the “killing zone” might now be taken as over 15 years. Lessors have a fleet of about 1,700 units of 15-plus years so conceivably could themselves almost halve the surplus by retiring theses jets as they come off lease; whether they would have the financial incentive to do so, rather than sell on, is another matter.

Most lessors have modern fleets — ALC itself and the Chinese lessors have less than 5% of their fleet numbers in the scrapable category — but some lessors are exposed, notably ALC’s merging rivals, AerCap with 30%, and GECAS with nearly 50%. The truly elderly lessors are Boeing Capital Corp, lessor of last resort for the OEM with 90% over 15 years old, and two mid to late life specialists — Carlyle, pre the Fly Leasing purchase, with 65% of its fleet in this category and Castlelake with 43%. AerCap/GECAS plus these three specialists account for about three quarters of the lessors’ scrapable fleet.

The lessors could also have a substantial degree over the delivery side of the aircraft market, particularly with regard to Boeing.

Even following the spate of MAX cancellations last year, over 300 aircraft, the lessors have over 700 737MAXes on firm order, which equates to over three years of production for Boeing at recovery rates. The MAX situation had an obvious negative impact on lessors, which have had to deal with parked aircraft and been unable to complete deals with airlines. On the other hand, the MAX situation alleviated some of the Covid-19 pressure as lessors were able to cancel or defer delivery without the normal financial penalties, because Boeing was unable to fulfil its contract by delivering within 12 months of the scheduled date. They still have this option for much of their backlog. There are production issues with the 787 as well, where lessors hold 100 delivery slots, equivalent to over a year of production.

At Airbus the lessors have taken a controlling share of the A320/21 neo orderbook — 1,300 units, 22% of the total backlog or two and half years of production. This is the aircraft type that appears to be most suited to the post-Covid world, for both short- and long-haul.

Financial power

Indeed, the direct order totals underestimate the control of the lessors because the pandemic has altered the relative financial power of leasing companies relative to most airlines.

Firstly, airlines with liquidity problems, or with excessive debt, are opting to defer their own delivery positions and take capacity from the lessors in the interim, greatly reducing cashflow stress. Three-month security deposits on leased aircraft absorb a fraction of the capital required for PDPs.

The leading lessors say that they are in effect offering a fleet management product, finding solutions for both the airline and the OEM. For example, ALC concluded a complex transaction with Alaska Airlines last year which involved providing operating leases for 13 new 737-9s while buying 10 ex-Virgin America A320s from Alaska, which the lessor is currently placing with airlines such as Qanot Sharq Air, a start-up in Uzbekistan.

Secondly, as a result of the Covid pandemic, sale and leaseback transactions have become a critical source of funding for the airline industry. And as the airline industry emerges from the pandemic it will be necessary to repay state loans (which have escalating interest rates) or swap them for commercial loans. In such circumstances the state-aided airline, ie almost all the flag-carriers and Legacy network types, will have little choice but to use their unencumbered assets to raise cash through sale and leaseback.

Fundamentally, the cost of capital for leasing companies tends to be lower than that of most airlines. The graph shows the trend for LIBOR one-year rates and also two examples of trends for debt in the crisis. ALC, probably the most efficient lessor, was able last year to raise $850m of unsecured funds at just over 3% pa; this year it succeeded in selling $750m of unsecured three-year notes at a remarkable 0.7% pa. American Airlines, the weakest of the US Legacies, was forced to price its $2.5bn junk bond issue at 12% pa last year; this year it succeeded in raising $2.5bn at 4.2% on loans backed by its frequent flyer programme, which is a reminder to lessors that airlines have other assets than aircraft to monetise.

Will core rates such as LIBOR remain at historically low levels? The trillions of dollars, euros and renminbi being poured by governments into economies to support the post-pandemic recovery will probably translate into some increase inflation and hence interest rates. But the basic finances of the leasing model still look sound: a good quality lessor can raise funds at 3-4%pa but could achieve a return on assets in today’s market of 7.5% (based on an estimated current price of $47.5m for a new A320neo and $300,000/month lease rate),

The lessees’ perspective

The point where leasing companies own over half the global commercial fleet must be close (if difficult to measure exactly because of volatility of the aircraft market). In 2020 something like 55% of Airbus’s deliveries went to lessors. This raises the question of where the limit to the separation of ownership and operation lies. Some commentators worry about whether dominance by the lessors would stifle innovation in developing new types, as lessors prefer ubiquitous standard-configuration aircraft that can be easily moved between airlines.

The graph gives a perspective on the lessees. The top 30 airlines account for about 42% of the operating lessors’ fleet capacity while over 400 airlines account for the remainder. It is notable how broad the lessors’ coverage is: those 30 airlines are located throughout the world, they include US Legacies (American is the biggest lessee), European network carriers, Asian flag-carriers, super-connectors and leading LCCs. There are a few exceptions: Ryanair doesn’t like operating lessors (though Wizzair has 100% of its fleet on operating lease) and Lufthansa has not yet entered this group.

When the pandemic struck lessors made the argument to their investors and financiers that they did not depend on airline profitability: if airlines were state-owned or being supported by governments, that support funding will flow through to the lessors. That has undoubtedly been the case. Only some Latin American carriers — LATAM is the most important — have gone through Chapter11 bankruptcy restructurings, which have cut off rental payments.

As discussed above the state-aided airlines will have to rely on sale/leaseback for funding as they emerge from the protection of state aid. But the lessors will have to play a major role in supporting successful transitions, and this may mean constraints on lease rate increases.

China leasing enhanced

The pandemic has probably enhanced China’s position in the operating leasing world. The first to experience Covid-19, China was also the first to recover. Chinese domestic flights (not passengers) were reported to be up 15% in the first quarter of 2021 compared to 2019.

The state-owned lessors have ungrounded almost all their fleets and their financial statements scarcely mentioned deferrals. BOC Aviation, the leading Asian lessor, reported a net profit margin of 25% and retained it’s A- investment grade credit rating. Its fleet is placed globally but two thirds of its lessees by value are based In the Belt and Road Initiative (BRI) countries. This is China’s 21^st century project to re-create the Silk Road across Asia and into the rest of the world. China’s infrastructure spending on transport, power generation and manufacturing within the BRI project is estimated to be around $100bn a year.

There is, however, also the filing for bankruptcy of various entities within the Hainan Group (see Aviation Strategy, January 2021). Shenzhen-based Bohai Leasing, which is 46% owned by HNA, in turn owns 70% of Avolon, which insists that it will not be affected by any changes of ownership that will emerge from the bankruptcy process. Avolon also has 11% of its fleet leased out to Hainan Airlines, which worries the credit agencies. Domhnal Slattery, CEO of Avolon, has a positive, probably accurate, view of Chinese aviation: “[HNA] airlines are integral to a fully functioning Chinese air transport sector … the airlines [will] ultimately be in a much stronger credit position following this reorganisation process”.

Geopolitics

Finally, we have updated our snapshot of the effective control and ownership in the following pie charts which divide the mainstream lessors’ fleets and firm orderbooks by geo-political zones (specialist lessors like Boeing Capital and Nordic Air are excluded). The analysis is based on aircraft numbers rather than value, which admittedly would be a better measurement.

Chinese state banks alone control 17% of the capacity with a further 15% owned by other Chinese-backed entities or in joint ownership with giant Japanese financial institutions — 32% in total. They have larger presence in the orderbook — 17% and 22%, or 39% in total.

US/European lessors control about 38% of the operating fleet and 39% of the orderbook. And within these totals the merged AerCap/GECAS entity will have 28% and 23%.

Given that geopolitics will prevent M&A activity between the US and the Chinese blocs of the aircraft leasing business, the AerCap/GECAS merger looks as if it could be a preemptive move, leaving minor targets for other lessors within the Western leasing world.