Lessors seem to be Unshockable Jan/Feb 2023

The operating lease industry has come through the pandemic, successfully dealing with the threat of airline bankruptcies and lease defaults. Then all the leased aircraft in Russia were seized. Then interest rates, which represent by far their largest cost element, soared. This has all resulted in a situation where the leading lessors are claiming fundamental strong financial health with a very positive outlook.

In fact, the fall-out from Russia’s invasion of Ukraine has had a serious impact on the lessors’ profitability but they have responded by publishing two net income figures — the actual result and one adjusted for write-offs they have had to make on aircraft leased to Aeroflot and other Russian airlines.

The implication is that the Russian losses will eventually be recovered from the insurers; after all their assets were in effect stolen in Russia. Numerous legal cases have been launched mostly in the Irish courts and mostly against Lloyd’s of London insurers and re-insurers (see table of estimated impairments). Law firms are the only certain winners as it is not legally clear-cut as to whether the insurance policies do fully cover all the lessors’ costs as the leasing companies technically terminated the lease agreements, in line with Western government sanctions.

Three of the main lessors have recently released their financials for calendar 2022 (SMBC and BOC Aviation have yet to report for their full financial years).

• AerCap, having completed the “flawless integration” of GECAS, saw its revenues increase by over a third to $7bn but it reported a net loss of -$0.73bn, a margin of -10.4%, which it adjusted to a net profit of $2.18bn, 31.1%, by stripping out the Russian impairments. AerCap has already made a projection for 2023: $1.2bn net profit, $1.7bn after adjustments.

• Avolon increased its revenues by 9% in 2022, but achieved a slightly better than break-even result; with relatively little exposure in Russia its adjusted net profit came in at $0.25bn.

• Air Lease Corporation, the most efficient and profitable of the lessors in recent years, also reported a net loss for 2022: -$0.14bn compared to a profit of $.41bn the previous year; adjusting for Russian impairment (plus some other financial adjustments) ALC produced a pre-tax profit figure of $0.66bn for 2022.

The largely unanticipated invasion of Ukraine effectively terminated the leases of about 500 Western jets, of which about 100 were recovered, so roughly only about 4% of the global operating leased fleet was affected. Understandably, the lessors are not speculating about the next geo-political shock but Taiwan continues to look vulnerable. China is a major player in the aircraft leasing industry, with about 20%, 2,600 aircraft, of the global operating fleet owned by Chinese state banks, other Chinese-backed entities or in joint ventures with Japanese financial institutions. Of this fleet about 28% are leased to North American and European airlines. Could these 700-plus aircraft be weaponised in the event of a PRC/ROC conflict?

The interest rate impact

All the lessors seemed to prosper in the era of ultra-low interest rates that stretched from 2010 until early last year when sudden inflationary pressures, largely caused by the Russian invasion of Ukraine, caused an abrupt change of monetary policy by the Fed, the ECB and the Bank of England. One-year LIBOR shot up from 0.3% pa at the beginning of the year to 5.85% by the end, the same level as in the 2006-08 peak. (LIBOR — the key benchmark rate — will be replaced after June this year by SOFR (Secured Overnight Financing Rate)).

Interest rates may come down somewhat over the next 12 months but are very unlikely to revert to pre-2022 levels. For the lessors this means that lease rates have to be recalibrated with their new cost of capital.

Their composite cost of capital depends on the proportion of debt in floating or fixed rate debt, the maturity schedule of the debt and the lessor’s credit rating. The major lessors have predominantly fixed into historic low rates; ALC, for example had 91% of its debt at fixed rates at the end of 2022, giving it a composite cost of funding of 3.07%.

But raising new funds has become expensive. At the beginning of 2022 the top-tier lessors could raise five-year senior unsecured debt at an all-in rate of around 2-3% but that rate has more than doubled. For example, ALC achieved funding of $1.5bn in January 2022 for five-year unsecured notes at 2.20% and 2.875% but in November and December it was paying 5.85% on two five-year loans of $700m each.

The credit rating companies have maintained their investment grade ratings for the leading lessors — BBB or BBB- from Fitch, focusing on strong cashflow and liquidity. Avolon, for instance, generated $1.2bn in operating cashflow in 2022, more than in pre-pandemic 2019, and had total available liquidity of $5.6bn. AerCap claims to have $18bn of liquidity sources.

Lessors have seen one source of funding virtually disappear. Asset Based Securities — packages of aircraft leases offered to investors — are no longer viable as the lease rates still reflect low interest rates.

Still, lease rates have to follow interest rates, which they will do with lags depending on the expiry profile of the lease portfolio. None of the lessors has been willing to put a timescale on their lag period. Typically, five-year operating leases have fixed rentals with escalation clauses relating to specific inflation measures. The new higher lease rates apply just for new agreements and are negotiated between lessor and lessee with regard to rolling over existing leases and signing new leases.

As a theoretical example: a year ago an airline might expect to lease a new A320neo at around $300,000 a month but to fully cover the increase in the lessor’s interest costs that rate would have to be increased by 33% to about $400,000 (based on a three point interest rate increase and 80% debt financing). At the end of last year IBA, the aircraft appraiser and consultancy, noted that it was observing 14% to 20% increases in lease rates for new-technology narrowbodies compared to the previous year.

Some investors in leasing companies are worried that airlines will not be able to absorb this type of cost increase. To allay these concerns, AerCap produced a pie chart during its results presentation showing that aircraft rentals and ownership costs accounted for only 5% of airlines’ total costs in 2022. This argument, which used to be frequently deployed by airports, is questionable. Airlines tend to focus of what percentage of the operating or net result the cost item accounts for. And some major leasing clients have much higher exposure: for example, at Wizzair, an airline with almost all its fleet under operating leases, rentals and depreciation accounted for 24% of total costs in 2022.

Lessors and OEMs

Have the lessors been prescient or lucky or both? In 2021 they seemed to be facing a very problematic situation with grounded airlines demanding deferrals on their lease payments or threatening to go out of business, defaulting on the leases. In the event, the pandemic fall-out turned out to be controllable thanks mainly to the state support afforded to the airlines filtering through to the lessors. Of the 30 top lessees identified in the May 2021 issue of Aviation Strategy, many looked financially vulnerable at that time but only three have had major defaults — the Russian carriers Aeroflot and S7, and Hainan Airways — and none of those was as a direct result of the pandemic. The latest results presentations scarcely referred to deferrals and defaults.

In the current market, with rising interest and lease rates, one might expect asset values to come under pressure. But this does not appear to be the case; rather, new and second-hand prices held firm throughout 2022 and are predicted by IBA to increase markedly this year, both for narrowbodies and for widebodies.

The fundamental reason is the tight supply/demand balance for new aircraft caused by production shortfalls at the OEMs — see article. AerCap focused on the effect of supply constraints in its results presentation. It estimated that during the period 2019-2022 1,800 fewer narrowbodies were delivered than was planned, which equated to 11% of the 2019 fleet. For widebodies, the production delays hit in 2020-22 when 720 fewer aircraft were delivered than planned; this was equivalent to 15% of the 2019 fleet. AerCap expects the supply constraints “to persist for some time”.

ALC too is sceptical about the OEMs’ production targets, and reckons that restricted supply combined with post-pandemic demand recovery, particularly when China fully re-opens, probably means that the airline industry will be able to achieve strong growth in traffic and in yields, a favourable environment for pushing up lease rates.

On the other hand, the balance sheets of many airlines have been weakened by the state-backed debt taken on during the pandemic, which also has a positive implication for the lessors, in that airlines will prioritise paying down debt from their improving cashflow rather using it for capex, which means more demand for operating leases. Demand for new aircraft is coming from some new sources — notably Air India’s mega-order and perhaps an upcoming order from Saudi Arabia. The lessors with their formidable orderbooks — see table — are in a much better position to fulfil early delivery slots than the OEMs.

The long-anticipated point where leasing companies own over half the global commercial fleet has been bypassed. Lessors have accounted for 60% of new deliveries over the past three years, with the result that the lessors’ global fleet, according to Avolon’s estimates, increased by 1,850 units to 12,950 between 2019 and 2022 while the airlines’ owned fleet fell by 350 aircraft to 12,750. So operating lessors now control about 50.4% of the total. Increasingly, lessors are not only the main supplier of aircraft but also the main driving force determining the demand for technological and ESG innovation at the OEMs.