Commercial Passenger Jets Chart Source: IBA

Top 10 Lessors And Mid-Life Aircraft Market Trends

There’s a robust market for mid-life aircraft but aligning record-keeping, lease returns and higher maintenance reserves is another story.

Printed headline: A New Lease on Life

Big orders tend to dominate aviation headlines, as do glitzy launches of new aircraft lines. The past five years have seen plenty of both, which together suggest a frenzy of interest in new aircraft, as certain airlines and lessors push hard to rejuvenate their fleets.

Certainly, backlogs have crept up for years, reaching a “new normal” of 6-10 years of aircraft production, according to analysis by Deloitte. In the decade prior to 2008, in contrast, Boeing and Airbus typically had 2-5 years of order fulfillment on their books.

After years of growth, however, the market for new aircraft seems to have peaked. In 2016, Boeing recorded more deliveries than orders for the first time in seven years. Last year, Airbus did add a few dozen units to its production schedule, but that trend is expected to decline in 2017.

Still, backlogs are near record highs, implying that demand for new equipment has never been greater. This is certainly true in China, where airlines almost exclusively seek new aircraft, but the global picture is more muddled. The U.S., for instance, encompasses a wide variance in equipment procurement strategies, from Spirit Airlines, with an average fleet age of five years, to Delta Air Lines, with an average of 17. 

Consultancy IBA Group, puts the average age of the global fleet at 11 years—almost the mid-point of most aircraft’s economic lives. Also worth noting is that the global fleet of roughly 25,000 aircraft is split between 5,000 or so airlines, which means that most only operate a handful of aircraft. Such airlines—the majority—are too small to have the resources or credit ratings to acquire new aircraft, and so they must get by with older equipment.

Then there are oil prices, which fell by more than half in 2014 and have hovered around $50 per barrel for the past two years. This removed a major impetus to buy or lease new, more fuel-efficient aircraft. And although cheap finance has kept the market buoyant, expectations that oil will stay down are feeding through.

“Lower fuel prices mean deferrals of new-generation aircraft,” says Jonathan McDonald, head analyst for commercial and aging aircraft at IBA. “Airbus is prepared for deferrals of A320neos and Virgin Australia is now deferring the [Boeing] 737 MAX because in the current fuel environment they can’t justify the higher unit costs of those aircraft and are happy to plod on with what they’ve got,” he says.

All of the factors noted add up to a robust market for midlife aircraft. Indeed, analysis by IBA shows that the average age of the commercial fleet has climbed steadily, from 8.9 years in 2006 to 11 years in 2016 (see graph). This is partly because technology insertion packages and other modifications have allowed older aircraft and engines to operate more efficiently and reliably for longer.

It is also worth noting that rock-bottom interest rates have made it cheaper to rent both new and old aircraft.

Sourcing MidLife Aircraft

Lessors often define a midlife aircraft as one entering its second lease, which typically occurs after an initial lease term of 8-12 years. Second leases can be renewals by the existing operator, but midlife aircraft also are sought to meet short-term capacity requirements or to satisfy specific fleet strategies.

In other circumstances, older aircraft embark on a first lease after a period of ownership by an airline—often to satisfy short-term capital requirements. In March 2017, for instance, Kenya Airways sold to, and leased back from an undisclosed lessor, one 14- and one 15-year-old Boeing 737-700. Airlines with weaker credit ratings obviously will struggle to rent or buy new.

AerCap delivered this Airbus A350-900 to Air Caraibes on Feb. 28. Credit: Air Caraibes

Sale-leasebacks are a key source of new and midlife aircraft for lessors, although availability will vary. Dublin-based Aergen Aviation Finance focuses on midlife narrowbodies for its portfolio, but its recent acquisitions have been from other lessors rather than airlines, as Managing Director Cameron Burr says: “Airlines in North America are making money hand over fist and don’t need any cash from sale-leasebacks, so the primary source [of midlife aircraft] right now are the GECASes, Aercaps and ACGs [Aviation Capital Group] of this world.”

The companies mentioned by Burr are among the top 10 lessors in the world, with portfolios ranging from hundreds to more than 1,000 aircraft (see table, page 28). Aergen, a relative newcomer, hopes to take its fleet from 22 to 100 aircraft within three years. Meanwhile, the top 10 lessors will focus almost exclusively on new aircraft as they take delivery of long order streams. In many cases, this will mean offloading older assets onto lessors such as Aergen and Apollo Aviation.

“When you have 1,000 airplanes, you don’t want to worry about a 12-year-old airplane. New airplanes don’t have the same complexities, so [big lessors] would rather send the older stuff to people like us and move on,” Burr says.

That said, there’s no fire-sale of older assets. Big lessors know that demand for midlife narrowbodies such as the A320ceo and 737-800 remains strong, so they will sometimes package less attractive models into a deal.

“They put seven narrowbodies up for sale but insist that you take two widebodies with them. Our objective has never been widebodies, but that’s where the market is headed,” says Burr.

How Second Leases Differ

Lessors that sell aircraft to other lessors often do so partway through a second-lease term. These usually last about six years—much shorter than the initial lease—but by their end, the receiving lessor will have an asset that is at or very close to maturity—the third and final stage of an aircraft’s life cycle. At this point, the owner will decide if it is worth more to part out the asset or lease it again. Much will depend on the condition of the engines, which represent about 80% of the value of a mature aircraft.

For now, let’s rewind to the beginning of the second lease. Aside from length, there are other notable differences from the lease contract of a new aircraft. Price is the most obvious: A midlife Airbus A330 costs 5-6 times less than a new model, and the rental rate will reflect that. However, there is not a direct correlation, as aircraft tend to depreciate faster than their lease rates. As a result, lease factors—the overall lease payment as a percentage of an aircraft’s value—are usually higher for older aircraft.

Source: IBA

Although the lessee of a midlife aircraft will benefit from lower rents, he or she also will pay higher maintenance reserves. These are monthly payments into various pots to cover scheduled maintenance for engines, engine life-limited parts, landing gears, airframes and APUs. Because overhaul intervals for older equipment tend to shorten, but the volume and hence cost of work per event is often greater, reserves are higher than for new items.

Maintenance reserves cannot normally be transferred from one item to another, and if, say, an engine performance restoration costs more than the amount in the engine pot, the lessee often is obliged to make up the shortfall. If an aircraft meets its lease-return conditions, the lessor is usually entitled to any money remaining in the maintenance reserves. Other arrangements are possible, however, especially if a lessor wants to part-out an asset.

“What’s more common for midlife aircraft is that the lessor will negotiate with the lessee to buy out the return conditions, as the lessor may value the cash more than the condition,” says Mike Yeomans, head analyst for commercial aircraft and leasing at IBA.

Alternatively, when an asset is due to be leased again, a lessor usually will demand that the aircraft is returned in the same condition in which the lessee received it. Thus, if a new aircraft is leased, the lessor expects to receive it back as close to economic full-life as possible. For a returning A320, for example, this might equate to the market value of a 12-year-old A320 in perfect condition.

“The general rule is that the standard returned should equate to the standard delivered. Hence the first set of lease-return conditions sets the tone for the delivery and redelivery conditions throughout the life of the underlying asset,” says Diarmuid Healy, head of technical asset management for lessor SMBC Aviation Capital.

If an aircraft does not meet its redelivery conditions, often the lessor will refuse to take it back, and may charge a premium for late delivery. Airlines are advised to start preparing for redelivery two years before the end of a lease term, as it is easy to underestimate the work required to meet minimum return conditions. Poor maintenance planning can have expensive repercussions: For narrowbody aircraft, IBA estimates that, on average, operators spend $1.65 million more than necessary to meet minimum lease-return conditions, while that figure jumps to $3.9 million for widebodies.

The Paper Trail

Lease-return conditions encompass four sets of requirements governing the certification, physical status, performance and records of the asset. For lessors of older equipment, the documentary requirement is often the most crucial, even if an aircraft’s outward condition appears impeccable.

This is because most of the value in a midlife or older aircraft is tied to its parts, and engine components in particular. Part of Aergen’s business case, for instance, rests on its ownership of Avioserv, which supplies narrowbody engine components to the aftermarket.

“Every purchase is looked at with two sets of eyes: Aergen from the leasing side, and Avioserv from the teardown perspective,” says Burr. “If engines are missing six months of maintenance history, when the plane comes off lease, those engines will have zero value, so records for the older stuff are paramount.”

SMBC Aviation Capital delivered this Boeing 787 to Avianca, the fourth of a four-aircraft sale and leaseback deal. Credit: Avianca

 

Nonetheless, tracing back-to-birth records is time-consuming, as evidenced by British Airways’ efforts to phase out its aging Boeing 737-400 fleet at London Gatwick Airport. The airline eventually sourced 10 used A320s as replacements, but starting in mid-2013 it took well over two years of thumbing through paperwork to do so.

One might expect the standard of record-keeping to reflect the stature of an aircraft’s owner, but this is not always the case: Small airlines with limited technical departments can still keep optimal records, while owners and operators of massive fleets are sometimes more slapdash.

“One of the largest leasing companies in the world has such poor record- keeping that people will shy away from them,” notes Burr.

Complications

The global passenger fleet includes 26,714 aircraft (Airbus counts 18,019, but does not include aircraft smaller than 100 seats), according to IBA, of which 48% are leased (see charts, page 33). Whether that share (closer to 40% in other estimates) grows much further is open to discussion, but it is obvious that the portfolios of most big lessors will expand significantly.

Combine this fact with MRO and parts-price inflation, and it is clear that more maintenance reserves will be paid—substantially more, according to IBA, which estimates that the maintenance reserves market will more than double, to $50 billion per annum, within 10 years.

This expansion is set to intensify one of the fiercest debates in leasing: the conflict between maintenance reserves and OEM engine maintenance agreements. Most widebody engine sales are now packaged with the latter, but complications can arise if an airline wants to sell and lease back its new aircraft-engine combination.

Demand for leased midlife aircraft may shift the current balance between leasing and owning.

 
Essentially, this is because the operator is concerned with the condition of the asset, while the lessor assumes residual value risk. The airline signs up to a full-service, price-per-flight-hour deal with the manufacturer to ensure predictable maintenance costs, but the lessor wants compensation for any cycles burned off the engine, potentially making an airline pay twice for maintenance. 

“There are no perfect solutions, and the bespoke nature of each operator’s individual maintenance agreement can be a challenge, particularly since the majority of the maintenance risk is tied up in the engines,” says Healy.

“Agreeing [on] compensation and workscope levels are the key areas of focus, and this can be challenging and time-consuming where the maintenance agreement does not align with the lease contract,” Healy adds.

Reaching alignment between competing interests becomes more complicated as equipment ages. As stated, lessors want higher reserves, but airlines may favor full-service support contracts to cover the increased likelihood of unscheduled events, for which they would bear the cost under a maintenance reserve deal.

This is another reason, then, why midlife aircraft leasing requires specific knowledge, experience and resources. 

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