Aircraft Leasing and Financing: Tools for Success in International Aircraft Acquisition and Management

that.

Foreword

When I started in aviation in the early 1980s, it was common for airlines either to own their aircraft or to lease them through a long-term finance lease with a purchase option. Today, almost 40 years later, and having spent most of my career in the financing and leasing of commercial aircraft, I have witnessed many changes in the aviation industry. When asked who owns the airplanes that the airlines fly, the response will most likely be, the airlines, of course. While it is true that airlines own a majority of their aircraft on average, what many people don’t realize is that more than 40% of the world’s fleet is leased—and that figure continues to rise. Commercial aircraft cost tens of millions of dollars each, sometimes in the hundreds of millions of dollars, resulting in the need to finance the purchase of an aircraft, whether it be by an airline for its own use or by a lessor to lease the aircraft to an airline.

Aircraft Leasing and Financing: Tools for Success in International Aircraft Acquisition and Management captures these changes in the aviation industry by providing a comprehensive overview of the commercial aircraft industry and explains in detail how both airlines and leasing companies finance the purchase of these capital intensive assets. This book will serve as an excellent text and reference for students planning for a career in aviation. In addition, experienced professionals will find herein the means to familiarize themselves with aspects of the industry that may be outside their area of expertise.

Various chapters cover why and how airlines select certain types and models of aircraft for their fleets and how to decide whether it’s better to lease or own the aircraft. Legal and regulatory issues, insurance, aircraft valuation, and taxation are also explained, all of which are critically important to the overall financing aspect of an aircraft. Chapters regarding leasing explain how lease rates and maintenance reserves are calculated and the mechanics behind engine leasing.

Over the years, the main sources of finance have shifted from banks to nonbank financing such as capital markets, private equity, export credit agencies, and others. In many cases, tax considerations can be the decisive factors when weighing whether to purchase or lease aircraft. Aircraft lessors have moved their main presence from the United States to hubs in Ireland, Singapore, and Hong Kong. New leasing companies are growing rapidly in China and Europe, and consolidation among lessors is becoming increasingly common. Aircraft Leasing and Financing provides a comprehensive overview of the evolution of many types of financing in use today, as well as the growth of cross-border leasing and the additional burdens imposed by the requirement for lessors to be aware of laws and regulations imposed in different jurisdictions.

Two professors from Embry-Riddle and a senior executive from the aircraft leasing industry—with input from experienced industry experts—have coauthored what serves as an excellent resource for everyone in the commercial aviation industry.

C. Jeffrey Knittel, Chairman and Chief Executive Officer of Airbus Americas, Inc., Herndon, VA, United States

Foreword

The commercial aviation industry is big business, generating over $700 billion of annual contribution to global GDP, making it larger than some G20 countries. Passenger demand continues to grow at more than 5% per annum, a trend that has been sustained, virtually unabated, for half a century. Some 500 airlines now carry more than 4 billion passengers every year on a fleet of 25,000 jet airliners and 4000 turboprop aircraft.

A total of 40,000 new commercial jet aircraft are expected to deliver over the next 20 years, 60% of which will be needed for airline growth requirements, with the balance replacing existing, aging fleets. These deliveries will require $6 trillion of financing, sourced through a combination of secured and unsecured bank debt, bonds, portfolio securitizations, and other capital markets products, equity investors, and cash flows from retained profits. Up to 50% of the total funding requirement will be channeled through operating lessors that already own and manage over 40% of the world fleet, valued at close to $300 billion.

For airlines, the selection of aircraft to operate their future networks is typically focused on performance capabilities and measured by payload, range, fuel burn, and other operating costs, as well as ownership cost. For operating lessors and other investors in aircraft, the analysis is quite different. Whilst the benefit accruing to the airline operators is a critical part of the analysis, the long-term value retention of these high-cost assets and their liquidity (how many airlines will continue to want to operate the aircraft and how many investors will continue to want to acquire them) are the most significant considerations and understanding these requires specialist skills and extensive industry experience gained over several industry cycles.

Sustainable success for an aircraft investor will be driven by two factors—securing the lowest possible acquisition prices for the assets and ensuring that sufficient liquidity is always available to finance those assets at the lowest possible blended cost of capital. Delivering these core elements and then selecting the right aircraft for long-term investment, knowing the right price to pay, protecting the asset’s value through its economic life, and achieving the desired sale price on exit are not determined by luck.

This book provides a step-by-step guide through all of the key considerations and processes required to undertake a successful aircraft acquisition and financing assignment as well as negotiating the subsequent lease agreement and dealing with the ongoing risk and portfolio management and asset value considerations that will be needed in order to achieve the expected economic returns from the initial investment. The global nature of the industry is also reflected in the book's coverage of issues such as taxation, accounting treatment, and cross-border transactions, which will become ever more relevant as emerging leasing jurisdictions such as Hong Kong and Singapore extend their influence.

The authors combine real-world aircraft leasing, financing, and investment experience with the knowledge of what is needed to deliver relevant information and knowledge to students in an academic environment as well as to current practitioners who wish to expand their existing knowledge of the sector. As such, it fills an important gap in the market and will be an invaluable text and reference source for a wide audience, adding to the range of tools available to prime future generations of aviation industry professionals and investors.

Dick Forsberg, Head of Strategy, Avolon, Dublin, Ireland

Chapter 1

Overview of the Aircraft-Leasing Industry and Market Environment

Abstract

This introductory chapter provides an overview of the airline industry, global and regional markets for commercial aircraft, and discusses the history and current state of the aircraft-leasing industry. We present the historical data and forecasts for revenue passenger miles, load factors, demand for commercial aircraft, and funding sources compiled from a variety of industry sources. We also include brief introduction to major topics discussed in the following chapters of the book.

Keywords

Airline industry; airline leasing industry; regional markets; revenue passenger miles; load factor

Chapter Outline

State of the Airline Industry 2

The Market for Commercial Aircraft 4

Forecast 5

Aircraft Financing 6

Aircraft-Leasing Industry 8

Regional Markets 10

North America 11

South America 11

Europe 12

Asia and Southwest Pacific 13

Africa and the Middle East 13

Current State of Aircraft Financing and Leasing Industry 14

Topics Discussed in the Book 15

Fleet Planning 15

Principles of Aircraft Leasing Versus Ownership 16

Aviation Legal and Regulatory Framework 16

Aviation Insurance 16

Aircraft Funding—Debt, Equity, and the Capital Markets 16

Airline Credit Analysis 17

Leasing Portfolio Management and Risk Management 17

Principles of Maintenance Reserve Development and Management 17

Transaction Cost Modeling 18

Lease Agreement and Negotiation 18

Aircraft Valuation and Appraisals 18

Taxation and Considerations for Cross-Border Transactions 19

Engine Leasing 19

References 19

State of the Airline Industry

Out of all the alternatives to travel, air transportation is one of the fastest and one of the most expensive ones. What we call the airline industry today can be traced back to 1925 when the Air Mail Act in the United States facilitated the development of commercial air transportation by allowing the postmaster to contract private airlines to deliver mail. The Air Commerce Act in 1926 provided the Secretary of Commerce with the power to establish airways, license pilots, certify aircraft, and issue and enforce air traffic regulations. The Civil Aeronautics Act of 1938 created the Civil Aeronautics Board, the regulatory body that among other functions was charged with determining airline routes and regulating passenger airfares. However, the two most significant events that led to the airline industry as we know it today were the development of the Boeing 707, the first widely produced commercial aircraft powered by a jet engine, in 1957 and the Airline Deregulation Act of 1978. Jet-powered aircraft became the primary mode of long-distance travel in the world. The deregulation started the era of innovation and free-market competition in the airline industry and made airline travel affordable.

While air transportation used to be accessible only to wealthy individuals after deregulation, more airlines joined the competition putting downward pressure on airfares. The low-cost business model, pioneered by Southwest Airlines, made air travel even less expensive. Middle class became the driving force of the industry. Economic growth in developing nations in Asia, the Middle East, and South America resulted in the emergence of the middle class, which propelled the global air transportation industry even further. Also, the air service liberalization, such as open-skies agreements increased competition, improved incentives for airline efficiency, and provided substantial benefits to consumers.

With a growing world population and historically low oil prices in recent years, the demand for air travel is increasing exponentially. As presented in Fig. 1.1, the number of airline passengers increased eightfold from 1980 to 2017 and almost doubled from 2007 to 2017 exceeding 4 billion passengers per year.

Figure 1.1 Total number of airline passengers. Compiled by authors using ICAO Data+.

One common statistic that is used in the airline industry is revenue passenger miles (RPMs) (or kilometers). For airlines, it is important to know how many revenue passengers they carried for a mile or kilometer, because each of those passengers generates revenue. This measure combines the distance flown by aircraft, their capacity, and load factor. As presented in Fig. 1.2, measuring global airline industry performance using RPMs also demonstrates a tremendous growth in the last 10 years with RPMs in 2017 more than double their 2007 levels. Fig. 1.3 shows that this growth in RPMs was not only fueled by just increased capacity but also by higher utilization of airline fleets globally. From 1980 to 2017, the airline average annual load factor went from about 60% to more than 80%.

Figure 1.2 Global annual RPMs. RPM, Revenue passenger miles. Compiled by authors using the Airline Monitor data.

Figure 1.3 Global airlines load factor. Compiled by authors using the Airline Monitor data.

Today, after decades of low (or negative) profitability, the airline industry is performing well. Airlines have learned how to control costs and capacity, optimize their networks, minimize distribution costs, generate significant amounts of ancillary revenues, and efficiently finance their fleets. For example, in baggage fees alone, American Airlines collected almost $1.2 billion in 2017, which was the highest amount among the US airlines. Delta Air Lines and United Airlines were in the second the third place with $900 and $800 million, respectively. The International Air Transport Association estimates $38.4 billion of net profit for the global airline industry (IATA, 2017).

The growth and success of the airline industry has translated into robust demand for commercial aircraft. Fig. 1.4 presents the total dollar value of aircraft delivered by major commercial aircraft manufacturers from 1958 to 2017. The graph shows an exponential increase after 1980 with the dollar value of deliveries reaching $110 billion in 2015.

Figure 1.4 Annual value of aircraft delivered. Compiled by authors using the Airline Monitor data.

The Market for Commercial Aircraft

According to the Airline Monitor, as of December 2017, there were more than 28,307 aircraft delivered globally (Fig. 1.5). Boeing still has the major share with almost 50% of the world fleet (including the remaining McDonnell Douglas aircraft). A relative newcomer, Airbus is not too far behind manufacturing 35% of the total number of aircraft in the world. Based on Airline Monitor data, between 2002 and 2011, Airbus delivered more aircraft than Boeing. However, in 2012, Boeing reclaimed the lead back. Thus, in 2017, Boeing delivered 763 aircraft versus 718 deliveries for Airbus. It is remarkable that both manufacturers have considerably ramped their production capacity, but both still have astonishing backlogs that keep increasing every year. As of December 2017, Boeing has a backlog of approximately 5900 aircraft, while Airbus’s backlog is approaching 7300 aircraft. Even though Boeing has delivered more airplanes than Airbus in recent years, as reflected in the backlogs, Airbus is outperforming Boeing with new orders.

Figure 1.5 Commercial aircraft manufacturer market share as of December 31, 2017. Compiled by authors using the Airline Monitor data.

Forecast

The major factors that influence demand for new aircraft are the need for more fuel efficient aircraft when fuel costs are high, the replacement cycle of the aircraft and global economic growth that creates a requirement for more capacity, especially in emerging markets. On average, commercial jets have a useful economic life of 25 years, with widebody aircraft typically being on the longer end of the range and narrowbody aircraft being on the shorter end. However, the optimal economic life depends on many internal and external factors: interest rates, fuel prices, availability of new technology, and others. When airlines operate aircraft, they balance capital and direct operating costs. Capital costs include depreciation and amortization that are large for new aircraft and then decrease with aircraft age. Aircraft acquisition and financing costs or lease payments (for leased aircraft) contribute to the capital costs and are highly dependent on the level of interest rates. In a low-interest rate environment, capital costs tend to be relatively lower leading to shorter economic lives of capital assets. Direct operating costs include fuel, maintenance, crew, and insurance costs. When aircraft age, maintenance costs drive the direct operating costs up. Also, fuel costs are higher for older aircraft compared to modern new technology aircraft. Therefore, higher fuel prices and low-interest rates accelerate the aircraft replacement cycle, while high interest rates and low fuel prices tend to extend economic lives of commercial aircraft.

All major forecasts indicate significant growth in air traffic for the next 20 years with a reasonably high and constant load factor. Fig. 1.6 presents a forecast by the Airline Monitor, but both Airbus and Boeing project similar growth. Airbus predicts an average air traffic growth of 4.4% per year with 35,000 new passenger and freighter aircraft delivered by 2036 with an estimated value of US$5.3 trillion (Airbus, 2017). Airbus anticipates 60% of new aircraft will be delivered to meet the growing demand and 40% to replace existing fleets. Boeing expects an annual air traffic growth of 4.7% with which approximately 41,000 new deliveries at an estimated market value of US$6.1 trillion by 2036 (Boeing, 2017). The forecasts by Airbus and Boeing included passenger aircraft with 100 or more seat capacity. The Airline Monitor’s forecast presented in Figs. 1.7 and 1.8 considers all commercial passenger and cargo aircraft increasing the number of estimated aircraft deliveries to more than 56,000 units. Almost 90% of the in-service aircraft in 2040 would consist of aircraft delivered after 2017.

Figure 1.6 Historical data and forecast for RPMs and load factor. RPMs, Revenue passenger miles. Compiled by authors using the Airline Monitor data.

Figure 1.7 Historical data and forecast of aircraft deliveries. Compiled by authors using the Airline Monitor data.

Figure 1.8 Current and forecasted in-service aircraft and deliveries. Compiled by authors using the Airline Monitor data.

Aircraft Financing

With such a large number of aircraft to be delivered after 2017, airlines and leasing companies will need to finance more than $5 trillion worth of aircraft. Since we will discuss the sources of aircraft financing in details in Chapter 6, we only briefly mention them here. Three decades ago, cash and equity financing were the primary sources of aircraft funding. Now, the aircraft financing landscape is quite complex and includes bank and capital market debt, manufacturer and export credit agency financing, insurance, revolving credit, warehouse facility, and other sources of funding. Probably, the most significant development, however, is an increased share of leased aircraft in the airline fleets that currently is more than 40% of the global fleet and more than 50% of the new deliveries.

Fig. 1.9 presents the sources of funds for global aircraft and Boeing deliveries in 2017. Lessors accounted for approximately 51% of aircraft deliveries in 2017 with the majority of funding coming from bank debt and capital markets. Airlines used more bank debt than capital markets in 2017 because banks were offering very attractive financing deals to the airlines. However, for aircraft lessors, the capital markets were the primary source of financing with 65% of aircraft deliveries financed using secured or unsecured capital market debt. Between 2016 and 2017, the capital market financing increased from $63.2 to $65.4 billion with aircraft lessors accounting for 36.7% and 65% of this number, respectively (Boeing, 2018).

Figure 1.9 Source of funding for aircraft deliveries in 2017. 2018 Boeing Finance Market Outlook.

Aircraft-Leasing Industry

Forty years ago, the aircraft-leasing industry was virtually nonexistent and accounted for less than 2% of the global aircraft fleets. This percentage remained small until the early 1990s, which was around 15%, then it jumped to 25% in 2000, and finally over 40% in 2017 (Kaplan, 2017).

Fig. 1.10 depicts the progression in the number of aircraft leased in 10-year increments. There were only 17 aircraft leased in 1970 and 100 in 1980.

Figure 1.10 Number of leased aircraft. Compiled by authors using CAPA and Ascend data.

As of December 2017, there were more than 50 lessors with aircraft portfolio values $1 billion or more. Table 1.1 presents the top 20 lessors based on portfolio values. These 20 lessors have combined portfolio values of more than $220 billion and 7208 aircraft. Even more impressive, the top three lessors manage almost 3000 aircraft with a combined fleet value of $76.7 billion! The aircraft-leasing industry has been going through consolidation with mergers and acquisitions. Thus, AerCap acquired International Lease Finance Corporation in December 2013. Avolon had a strong organic growth from 2010 to 2016, and then it merged with Hong Kong Aviation Capital in 2016 and acquired CIT Aerospace in 2017. AWAS sold 40 aircraft to Macquarie in 2015 ahead of its acquisition by DAE Capital in 2017. The industry consolidation will likely continue as larger lessors are better positioned to take advantage of their low cost of capital and the attractive deals available in the strong market (Wood, 2018).

Table 1.1

From Flight Global.

Fig. 1.11 presents lessors’ fleets by operating regions as of June 2018. Asia and the Southwest Pacific region are ahead of the rest of the world regarding the number of leased aircraft and their value, followed by Europe and North America. A higher value of leased aircraft operating in Asia and the Southwest Pacific implies that lessors deploy more new and more expensive, such as widebody, aircraft in this region compared to Europe and North America.

Figure 1.11 Lessor fleets by operating regions as of June 2018. Compiled by authors using CAPA data.

Regional Markets

While world air traffic has been growing and forecasted to continue its growth at about 4.5% in the future, the regional growth is disparate. Fueled by an emerging middle class, traffic growth in the Asia/Pacific region is outperforming developed markets of North America and Europe. As presented in Fig. 1.12, the Asia/Pacific region will represent about 50% of world traffic by 2040. Also, in the same year of 2040, Africa and the Middle East will reach the traffic level of North America.

Figure 1.12 Historical data and forecast of RPMs by region. RPMs, Revenue passenger miles. Compiled by authors using the Airline Monitor and ICAO data.

North America

Based on the International Monetary Fund 2017 data, North America included three countries that ranked the 1st, 10th, and 15th based on their GDPs: United States, Canada, and Mexico. The North American air transportation industry went through consolidation and is very mature. North America accounts for about 30% of the world commercial fleet and will require a large number of replacements over the next 20 years. Boeing expects an annual air traffic growth of 3%, with the fleet growth of 1.8%, including 8640 aircraft deliveries with a market value of US$1.04 trillion (Boeing, 2017). Airbus forecasts a bit slower annual air traffic growth or 2% for 2018–36 (Airbus, 2017). Fig. 1.13 presents historical data and forecast for North American fleets and market share. While the number of aircraft in North America will steadily increase, higher growth in Asia/Pacific and Africa/Middle East regions will reduce North American fleet market share to under 20% by 2040.

Figure 1.13 North American fleet and market share. Compiled by authors using the Airline Monitor and ICAO data.

South America

South American countries have faced economic difficulties, but the economic reforms in the region are expected to stimulate the markets, especially in Brazil and Argentina that are the two largest countries in South America. In its market outlook, Boeing expects an annual air traffic growth of 6.1% in Latin America that includes Central and South American region. This growth will result in a 4.4% annual increase in the number of aircraft in the region, with more than 3000 deliveries valued at $350 billion (Boeing, 2017). Similarly, Airbus projects 2720 new aircraft deliveries in Latin America in the next 20 years (Airbus, 2017) (Fig. 1.14).

Figure 1.14 South American fleet and market share. Compiled by authors using the Airline Monitor and ICAO data.

Europe

With more than 50 countries and over 200 different languages, Europe is very diverse in terms of the strength of local economies, cultures, and transportation preferences. Despite being a mature industry and the presence of competition from the well-developed railway system, European air transport industry continues to grow. Over the next 20 years, Boeing projects 3.7% annual growth in traffic and 2.7% in fleets with 7530 aircraft deliveries valued at more than $1.1 trillion (Boeing, 2017). Airbus also expects 7175 commercial aircraft deliveries to European airlines by 2037 (Airbus, 2017) (Fig. 1.15).

Figure 1.15 European fleet and market share. Compiled by authors using the Airline Monitor and ICAO data.

Asia and Southwest Pacific

The Asia-Pacific region has been and will continue to be the most dynamic region in the world. The economic expansion in India and China leads to the rapid development of a middle class that is the primary driver of air traffic growth. Through 2036, Boeing expects an annual air traffic growth of 5.7% in the region, with 4.8% annual growth in fleets and 16,050 deliveries of new commercial aircraft valued at $2.5 trillion (Boeing, 2017). Airbus has a similar forecast of 15,895 deliveries in the Asia-Pacific region by 2037 (Airbus, 2017) (Fig. 1.16).

Figure 1.16 Asia and Pacific fleet and market share. Compiled by authors using the Airline Monitor and ICAO data.

Africa and the Middle East

Africa is a large and diverse continent with an abundance of natural resources such as metals, oil, and minerals. While the continent has many tourist and business destinations, the air transport industry still has room to grow before it reaches maturity similar to North America or Europe. For Africa, Boeing expects an annual air traffic growth of 5.9% and fleet growth of 4.1% with 1220 aircraft deliveries valued at $180 billion over the next 20 years (Boeing, 2017). Airbus forecasts 1154 deliveries over the same period (Airbus, 2017).

The Middle East is known for its petroleum resources and its location between Asia, Africa, and Europe that offers convenient connections among these regions. For this region, Boeing projects an annual air traffic growth of 5.6% and fleet growth of 5.1% with 3350 aircraft deliveries valued at $730 billion over the next 20 years (Boeing, 2017). Similarly, Airbus forecasts 2879 deliveries in the region for the same period (Airbus, 2017) (Fig. 1.17).

Figure 1.17 Africa and Middle East fleet and market share. Compiled by authors using the Airline Monitor and ICAO data.

Current State of Aircraft Financing and Leasing Industry

Even though world GDP has been growing at a suboptimal rate, airline traffic, measured by RPMs, continues to grow at almost 8% annually indicating the robustness of the industry (Wood, 2018). Robust growth of RPMs supports adding capacity through new aircraft deliveries to airlines and lessors. Improved airline profits, availability of liquidity in global financial markets, and historically low oil prices help to create a favorable environment for the aircraft-leasing industry. The fact that the recent airline bankruptcies in Europe (Alitalia, Airberlin, and Monarch) did not have a severe adverse effect on the industry also demonstrates the resilience. Most of the affected aircraft were quickly remarketed and released to other airlines. While air transportation is a cyclical industry, the current growth phase of the cycle seems more prolonged than in the past and does not show signs of slowing down, and the industry remains attractive for investors. New capital has flooded the industry in recent years, which compressed the lease rates and resulting margins. Compressed margins may serve as a leading indicator of the approaching end of the expansion phase, but the majority of industry players expect the expansion to continue through 2018 and 2019 (Wood, 2018).

Several areas of concern are increasing fuel prices and interest rates, intense competition among airlines, and the relative strength of the US dollar (for those airlines that have large portions of revenues denominated in foreign currencies). Also, geopolitical developments, such as the departure of the United Kingdom from the European Union, and economic sanctions of Russia, Iran, and North Korea may also impact the future of the industry.

Attracted by potential returns, new investors, such as banks, private equity firms, and hedge funds, are still entering the industry through mergers and acquisitions, which is the fastest way to obtain technical and marketing expertise in the aircraft-leasing industry. There are no signs that the industry consolidation will stop any time soon, as the low cost of capital (that is correlated with the credit rating of the lessors) is a prerequisite for acceptable returns in the low margin environment. Industry insiders blame the new entrants and enhanced competition for compressed lease rate factors, especially in the sale-leaseback market for new aircraft. In some instances, the lease rate factor in the sale-leaseback market for new narrowbody aircraft have reached the low .50 seconds, which are not sustainable for lessors in the longer term.

Capital markets currently dominate aircraft lessor financing with both unsecured issues and aircraft asset-based securities (ABS). While bank financing is also available, Basel III and upcoming Basel IV are limiting traditional balance sheet financing, and most of the bank deals are in the structured finance space. The demand for funding has led to the emergence of new capital sources, such as Aircraft Finance Insurance Consortium (that will be further discussed in Chapter 6), crowdfunding as a source of equity, and others. More new sources of capital will definitely appear in the near future to finance large fleets projected to be produced by aircraft manufacturers.

Topics Discussed in the Book

This book presents a collection of topics and insights that are essential for professionals working in the aircraft-leasing and financing industry as it has grown into one of the most distinctive and important industries in the world. While facts and discussions included in the book are known to seasoned aircraft financing specialists, young professionals entering the industry or professionals moving into the aircraft financing and leasing field from different industries will find that the book will accelerate their learning and help in understanding a wide variety of topics that make this industry unique.

Fleet Planning

We start with aircraft selection strategy basics in Chapter 2 which discusses how airlines and aircraft-leasing companies select aircraft to include in their fleets and how aircraft manufacturers decide which aircraft to manufacture. The aircraft selection decisions are crucial for these companies as they involve hugely capital intensive assets that are at the core of their businesses. Also, the aircraft selection decisions are complex and influenced by multiple variables, including global economic conditions, company strategies, technological innovations, air transport market developments, decision-maker influence, and others. Fleet planning involves multiple functions of an airline or lessor: financial—acquisition, ownership, and financing costs; operational—flight and cabin crew training, passenger experience, etc.; engineering—technical crew training, maintenance intervals, engine commonality, investment in tooling, projected dispatch reliability, etc.; strategic planning—how the aircraft fits in an airline network or lessor portfolio; and strategic vision—how the potential market, technological, and macroeconomic developments change the outlook for this aircraft.

Chapter 2 provides fleet-planning perspectives from an airline, lessor, and manufacturer point of view that are related but may have different goals and measures of success. Understanding the wants and needs of all industry players will lead to a greater understanding of effective aircraft selection decision-making.

Principles of Aircraft Leasing Versus Ownership

Chapter 3 discusses lessees’ and lessors’ decision-making process. Specifically, we focus on leasing or purchasing aircraft as a lessee’s financing decision that involves a selection of the lowest cost alternative to use the aircraft. However, leasing also provides flexibility for an airline in its fleet decisions, access to current aircraft technology, and helps transferring aircraft residual value risk to the lessor. From a lessor’s perspective, leasing an aircraft is a capital budgeting or investment decision when the lessor is assessing whether the income stream from the lease would generate an adequate return on their investment. Chapter 3 numerically demonstrates how to calculate a Net Advantage to Leasing and a range of lease payments that would satisfy both the lessee and the lessor, as well as the process associated with evaluating the criteria involved in the lease versus buy decisions.

Aviation Legal and Regulatory Framework

Aircraft financing and leasing is an industry governed by unique rules and regulations. The mobile nature of aircraft assets creates complicated multijurisdictional issues. Moreover, high equipment value and interchangeable components lead to increased legal, political, and collateral risk. Chapter 4 addresses legal and regulatory matters specific to aircraft financing. Particular topics include applicable governing law, conventions and treaties (Chicago, Warsaw, Montreal, Geneva, Cape Town), aircraft registration and ownership, recordation of interest in aircraft, Section 1110 of the US Bankruptcy code, liens, regulatory considerations, jurisdictional review, lessor and operator liability, and multilateral agreements.

Aviation Insurance

Insurance is a risk-management technique that reflects the need to protect property interests in the event of property damage. It involves a contractual agreement between an individual or entity seeking protection and an insurance company that is providing protection. As part of this agreement, the insurer charges the premium in exchange for the promise to cover losses that may result from an accident. Airlines, leasing companies, and other aircraft owners (e.g., aircraft investors) all seek protection against the risks associated with operating aircraft. Insurance is a critical sector of the aviation industry. Before writing an insurance policy, the underwriter carefully evaluates each risk, and it is this process that determines the premium. Chapter 5 will help with understanding the types of coverage, factors that affect the premium, and the legal regulations of the airline business and the overall process of drafting an effective insurance policy.

Aircraft Funding—Debt, Equity, and the Capital Markets

In Chapter 6, we discuss how airlines and leasing companies raise funds to finance their fleets. Chapter 6 focuses on various aspects of equity and debt financing, as well as on national and international organizations that facilitate aircraft financing for airlines and leasing companies. It also provides a brief overview of the pecking-order theory of capital structure, describes major debt instruments used in fleet financing by airlines and leasing companies, reviews the role of rating and export credit agencies, and discusses significant innovations in aircraft financing. Special considerations are given to enhanced equipment trust certificates, ABS, and predelivery payments financing.

Airline Credit Analysis

In leasing, risk underwriting is the process of assessing risks faced by a lessor in order to decide whether or not to originate a lease. The risks are not limited to creditworthiness. The process also involves a thorough analysis of the lessee’s ability and willingness to meet the lease requirements. In Chapter 7, we discuss how lessors conduct airline credit analysis. Specific topics include assessing airline business models, strategy, and ownership structures; airline ability to generate revenues and its sources (business travel mix, cargo, etc.); airline yield and load factor; airline cost structure; key industry-specific credit/leverage metrics and coverage ratios; cash balance and sources of potential liquidity; debt and lease maturity profiles; availability of funding for aircraft; balance sheet strength; and airline risk-management practices.

Leasing Portfolio Management and Risk Management

Purchasing the right aircraft at the right price, managing them well, and selling (or disposing) them at the right price are essential for a leasing company’s success. A small mistake at any stage (purchasing, managing, or disposing of aircraft) may reduce a leasing transaction return to an unsustainable level. Risk management and portfolio management discussed in Chapter 8 are critical for a leasing company’s survival. We start with a brief overview of aircraft acquisition channels and risks inherent with the business of leasing aircraft. While risk and portfolio management are overlapping concepts, we present them in two different subsections: understanding and mitigating risks on asset and liability sides and then managing lessors’ portfolios by diversifying their exposure to substantial individual risks. We describe major risks faced by aircraft-leasing companies and the techniques used to mitigate them. Interest rate risk management is discussed at length as it is critical for lessors that manage the spreads between the cost of funds and return on assets.

Principles of Maintenance Reserve Development and Management

Chapter 9 provides an overview of aircraft technical conditions and maintenance reserves and their application in the world of aircraft leasing. Since regular and proper maintenance is crucial for safe aircraft operation and maximum value preservation, leasing companies expect the airlines to maintain assets according to manufacturer’s recommendations and regulatory requirements. Charging airlines a maintenance reserve is one way to ensure that maintenance costs are accounted for even if an airline defaults on its lease. The chapter describes major maintenance events, determining proper maintenance reserve rates, reserve rate escalation, and other related topics. The chapter contains examples of relevant documents as well as a mini case to practice maintenance reserve rate calculations and maintenance reserve cash flow forecasting.

Transaction Cost Modeling

In Chapter 10, we discuss the critical variables in an aircraft lease transaction and how to model the lease cash flows. Some of the key factors that affect a lease transaction include the purchase price, rent (lease rates), maintenance reserves, residual values, and transaction costs. All of these factors will impact the lessor’s return calculations. Modeling a lease transaction, therefore, involves taking into account the above cash flows to determine the purchase price that the lessor should pay in order to get a fair and adequate return on their investment using capital budgeting tools such as net present value and internal rate of return. Case studies and examples are used to show how to model the different factors and stress test the model and identify the key drivers that drive the returns for a lessor.

Lease Agreement and Negotiation

Chapter 11 focuses on the lease negotiation and the key elements of a lease contract. From a lessor’s perspective, a lease serves two primary purposes: First, to structure an economic return and second, to manage asset and credit risk. The key elements contained in a lease include the acquisition price in the case of a sale and leaseback, lease term, lease rental, technical specification of the aircraft being delivered, technical return conditions and details on how deviations from these conditions will be compensated, security deposits, maintenance reserves, other risk mitigants and covenants, restrictions on quiet enjoyment, which may include limitations on subleasing or operation in restricted jurisdictions, provisions for maintaining airworthiness and cost sharing, both during and after the end of the lease and restrictions on changes to aircraft specification, and the use of parts manufacturer approval parts. Lease negotiations are both an art and a science. For a lessor, the aircraft acquisition price and the lease rate are the elements of science, as both these factors are linked to financing costs and the return requirements for the business. While the art aspects of a lease negotiation depend on the individual lessor, lessee, and particular transaction, generally, the negotiations are structured around the risk mitigants (maintenance reserves, security deposits, and return conditions) as areas that may require compromise. The extent of the compromise from a lessor’s perspective typically depends on factors such as lessee’s track record of performance under previous leases, additional protection that the lessee can provide, or if the lessee is located in a country which is a signatory to the Cape Town Convention.

Aircraft Valuation and Appraisals

An appraisal, in essence, is an opinion of value derived based on a systematic process. Determining the value of an aircraft is important for different stakeholders such as leasing companies, financial institutions, aircraft brokers, airlines/operators, insurers and manufacturers. The valuation process is a systematic procedure used by appraisers to provide answers to a client’s question about value and value-related issues. In this process, it is essential to identify the client and other intended users, the use of the appraisal opinion and conclusion, and the type and definition of value required as of a particular date. Two major organizations provide guidelines to appraise aircraft. These are the International Society of Transport Aircraft Trading (ISTAT) and the American Society of Appraisers (ASA). While ISTAT has focused on commercial aircraft appraisals, ASA has focused mainly on business and general aviation appraisals. In Chapter 12, we address the main elements of the appraisal process and discuss the different approaches to value and various publications and sources providing aircraft values. We also include two case studies to outline the process of appraising a business and a commercial aircraft.

Taxation and Considerations for Cross-Border Transactions

Leasing transactions typically have multiple tax implications for both lessors and lessees. Since the transaction’s economics to a considerable degree are based on tax benefits, tax considerations are critical for lease structures, particularly for cross-border transactions. Chapter 13 provides an overview of different taxes applicable to lease transactions for both domestic and cross-border leases. We start with general concepts of aircraft lease-related taxes and then look at the country and regional markets and associated considerations for cross-border transactions in those markets. Over the past few decades, the popularity of leasing transactions has been growing steadily partially due to the tax advantages that come with leasing, especially for operating leases, as opposed to conventional financing for asset acquisition. Recent changes in the accounting treatment that require firms to show operating leases on their balance sheet may lead to a reexamination of the continued benefits of operating leases compared to other sources of financing. Further, diversity among countries’ tax laws may amplify these tax advantages, creating opportunities for new leasing structures to maximize the allocation of the available tax allowances.

Engine Leasing

Chapter 14 provides an overview of the leading engine OEMs and their products in the narrowbody and widebody aircraft market. Topics include engine maintenance, engine leasing, and aftermarket service programs. Initially, an engine might be worth 30% of the total aircraft value. However, with the correct maintenance, the same engine could retain 70% of its value, whereas the airframe is likely to depreciate by 80%–90% over a 20-year utilization. This is why airlines and lessors are so focused on engine maintenance. Since the aircraft is the critical tool which airlines use to generate profit, they must have access to spare engines either by purchasing the spare engine from an OEM or by leasing from an engine lessor or through hourly agreements that provide access to a spare engine pool to cover the engine shop visit period. There are also aftermarket service programs available from the OEMs to help airlines maximize engine value and maintain a more accurate forecast of future-maintenance events and expenses.

References

1. Airbus. (2017). Global market forecast 2017–2036. Retrieved from Aircraft Market: <http://www.airbus.com/aircraft/market/global-market-forecast.html>.

2. Boeing. (2017). Current market outlook. Retrieved from Commercial Market: <https://www.boeing.com/commercial/market/current-market-outlook-2017/>.

3. Boeing. (2018). Current aircraft finance market outlook 2018. Retrieved from Boeing Capital Corporation: <https://www.boeing.com/resources/boeingdotcom/company/capital/pdf/2018_cafmo.pdf>.

4. IATA. (2017, December). Strong airline profitability continues in 2018. Retrieved from IATA pressroom: <http://www.iata.org/pressroom/pr/Pages/2017-12-05-01.aspx>.

5. Kaplan, T. (2017, March). Mid-life aircraft trading patterns and the impact of lessors. (Flight Global) Retrieved from FlightAscend Consultancy: <https://www.flightglobal.com/asset/16191>.

6. Wood, T. (2018, January). Lessors. Retrieved from KPMG in Ireland: <https://home.kpmg.com/ie/en/home/insights/2018/01/lessors.html>.

Chapter 2

Principles of Aircraft Selection

Abstract

The main focus of this chapter is to provide an overview of how an airline or lessor selects an aircraft for their fleet and how a manufacturer decides what aircraft to produce. Each of these industries are extremely capital intensive and have different goals and success measures. This creates a dynamic and competitive market where aircraft selection decisions have the potential to either propel or bankrupt a firm. Understanding the wants and needs of airlines, lessors, and manufactures will lead to a greater understanding of effective aircraft selection decision-making.

Keywords

Aircraft selection; mission; availability; aircraft values; fleet planning; residual value; liquidity

Chapter Outline

Fleet Planning 22

Organization Structure 22

Aircraft Categories 25

Operating Weights and Payload Capability 29

Revenue and Cost Components 31

Additional Considerations 32

Aircraft Values 34

The Lessor’s Perspective on Aircraft Selection 36

Market Analysis 36

Aircraft Placement 37

Value Retention and Liquidity 38

Production Stages 38

Lease Rate Factor 39

Current Trends 41

Airline's Perspective on Aircraft Selection 41

Mission Capability 41

Fleet Composition 42

Availability 44

Economics 45

Financing 47

Manufacturer's Perspective on Aircraft Selection 47

Competition and Future of Commercial Aircraft Manufacturing 49

Primary Market 52

Customer Needs and Preferences 52

Macroeconomic Influences 53

Engine Manufacturers 55

Transparency of Aircraft Values 55

Summary 57

Appendix 2A: Mini Case Study A 57

Aircraft Selection (Airline) 57

Appendix 2B: Mini Case Study B 59

Aircraft Selection (Lessor) 59

Acknowledgments 62

References 62

Fleet Planning

When considering the selection of an aircraft, whether it be by a lessee or a lessor, there are many factors that go into the choice of the proper aircraft. These factors may include global economic forces, company strategy, and decision-maker influence. It is essential that all of these elements flow together in order to maintain a successful business moving forward. Fleet planning is a continuous exercise that normally looks at least 15 years into the future (Clark, 2007). Because the future can be very uncertain, in particular with respect to commercial aviation, it is very important to choose the right aircraft at the right time.

Aircraft selection is incredibly risky because the wrong decisions can mean the downfall of a firm. The wrong fleet, in the best case, can greatly impede the profitability of an airline or lessor, and in the worst case, it can lead to bankruptcy. Aircraft are high-cost assets and airlines, and lessors around the world collectively hold billions of dollars’ worth of aircraft on their balance sheets. As aircraft usually comprise the largest part of a firm’s balance sheet, the strategy behind what type of aircraft to buy or lease, the number of units, and the negotiated price per unit can be a politicized event. It is important to note, however, that due to the politically sensitive nature and size of an aircraft order, sometimes the best decision for fleet strategy is not taken because of economic or other factors. For instance, due to political reasons a state-owned airline may be pressured by its government to purchase a Boeing aircraft versus a Airbus aircraft despite Airbus aircraft being the better solution to its fleet needs. In this chapter, our focus is on other factors that are important in the aircraft-selection process, but political pressure should be recognized as a wildcard influence in the fleet decision-making process.

Organization Structure

Where should fleet planning fit in a corporate environment?

Fleet planning brings together multiple functions of an airline or lessor to decide on the best aircraft and quantities to acquire. Each function must work together in order to find the most appropriate option (Clark, 2007). The key functions are listed in the following sections.

Financial

How much does the aircraft cost? What is the total cost of ownership? Just like any major asset purchase, the purchase price can heavily influence the decision to acquire an aircraft. Boeing and Airbus list prices for new aircraft coming off the production line are shown in Tables 2.1 and 2.2. List prices, however, are often not the final prices paid by either an airline or a lessor. Depending on bulk order sizes, strategic importance to the manufacturer, and customer relationships, operators and financiers can receive discounts of over 50%.

Table 2.1

Data from Boeing and Airbus website.

Table 2.2

Boeing (2017).

In addition to price, the cost of ownership influences the decision to purchase an aircraft greatly. Aspects such as maintenance, financing, insurance, crew costs, fuel burn, and many other costs and expenses will be discussed in the following chapter outlining an aircraft’s overall cost of