By David Yu and William Loh
Feb. 13, 2024, © Leeham News: As we entered 2024, this is an interesting time for aircraft finance and leasing. As an industry and economy, we have come from historically low-interest rates (cost of funds) close to 0% to a federal funds rate of 5.5%.
The US Federal Reserve has indicated cutting rates going forward. The US economy is still ripping it on many measures and the threat of a hard landing has all but vanished, with inflation coming under control. That said, Wall Street consensus is a low 4% federal funds rate which would mean a lot more rate cutting. But this is not what the frothy economic indicator data suggests. Instead of immediate large cuts, we only see small and short cuts towards the end of the year.
This is not what some folks were hoping for when they entered into previous deals. They want to have the lowest rate possible, especially for those with debt coming to maturity and needing to be refinanced in 2024 (a significant number). Wherever interest rates end up, it will not be what investors have planned for, and too high a rate environment will all but ensure an increased pressure to sell.
Many leased aircraft deals currently yield in the 6-7% gross annual yield range and this created an imbalance scenario for profitable deals with a high cost of funding, including margin spread added. Those with private placement bond issuances (under Rule 144A of the Securities and Exchange Commission) at low rates will have an advantage with continued lower financing costs. One silver lining is that lease yields have increased more than 1% annualized as there is a capacity shortage of new and old aircraft available for lease.
Airlines are looking for additional lift capacity to sustain their growth in a post-COVID environment. Engine difficulties are taking down aircraft availability. The OEMs and their suppliers are under pressure and production rates are not as high as expected compared to pre-covid.
It will take some time for the supply/demand balance to return, especially now that Boeing has been restricted from raising its 737 MAX rates by the Federal Aviation Administration (FAA). After the MAX MCAS flight control system mess, this is beyond disappointing and will begin to reduce future value expectations (and credit committee approvals) if the many quality control issues are not corrected in the near term.
United has already removed the 737-10 MAX from some of its fleet plans. UAL has ordered 277 of the type with 200 options. At least MAX deliveries have started again into China.
The bad news that the FAA certification of the 737-7 and 737-10 will be delayed is related to an engine anti-ice problem that has somehow made it through on the 737-8 and 737-9. Due to composite parts used in the engine cowling, if pilots run the anti-ice system for five minutes in conditions with no icing present, these parts can overheat, disintegrate, and possibly even endanger the aircraft. Some pilots are using sticky notes and setting alarms not to forget to shut this off. Hopefully, this system can be automated as it is on the Boeing 777.
Currently, even end-of-life 20-year-old aircraft are finding homes with long lease terms at full rates for lessors who have them. This also shows that there is a lot of money still in the system, and these aircraft’s values will have risen as well, which over time may help make up for low lease rate factors when some deals were done. So, the imbalance will surely have to be corrected by rational players doing profitable deals (based on a reasonable analysis process).
There are very good signs then, especially for those players who have mostly sat out 2023 in deal-making. They will also want to deploy the significant amounts of dry powder that they have previously raised. This will create opportunities for nimble players focused on this market. We are looking forward to helping investors understand these deals using our risk management system. Best of luck hunting as there will be interesting deals to be done.
David Yu is an investor turned full-time finance professor at New York University Stern and Shanghai, where he teaches and focuses on cross-border investing and financing along with a specialty in real assets and aviation. He is also Chairman of Asia Aviation Valuation Advisors (AAVA) and China Aviation Valuation Advisors (CAVA) and the only Senior ISTAT Certified Appraiser based in North Asia. He is the author of “Aircraft Valuation: Airplane Investments As An Asset Class” and his research website is www.davidyuda.com. He is also a fellow of the Applied Economics Institute at Johns Hopkins University.
William Loh has three decades of multi-cycle aviation and risk management experience advising senior managers regarding the future prospects for high-profile investments and transactions. He has founded IAA (www.intlaviation.com) in 1999. His career includes working as a corporate planning analyst for one of the first LCCs (Florida Express) in Orlando, developing yield management models for Lufthansa in Frankfurt, and eight years as Deutsche Bank’s subject matter expert in Frankfurt and London. He has created an innovative aircraft future value/lease rate forecasting simulation model, as well as a lease IRR/NPV pricing model. His understanding of aviation has been enhanced by ASEL and glider pilot ratings, as well as over 200 hours in airliner, fighter, and helicopter flight simulators. Loh has a Bachelor of Science degree in Applied Mathematics from the University of Florida and is a qualified U.K. registered securities representative.