Ronan Doyle
The debate continues over residual values...
…or more correctly, the debate begins. The rule of thumb of a 25 year life to a 15% residual has remained reasonably unchallenged and unchanged for a number of economic cycles. Recently, however, there has been a marked divergence in the value ascribed to new versus second hand aircraft, evidenced principally by the growth in part-out operators. This gap has brought into focus the assumptions over residual values.
Increased levels of production of existing aircraft and promises of the efficiencies to be delivered by the next generation are a factor. Lower ownership costs will push operators to seek out the most efficient models to operate or face the commercial and economic consequences on their attractiveness to customers and ultimately their profitability. Equally relevant, however is the increasing likelihood that the strong position held by the big two manufacturers will come under threat as others target the most attractive categories. With more choice and competition comes the inevitable impact on pricing and value.
Not only does it reduce the income earning capacity of the asset, changes to expected lives will stretch into maintenance reserving, tenor of financing structures and ultimately the capacity to generate income from asset disposals. The skillset of the typical operating lessor will require re-thinking as an increased premium will be placed on being able to determine the ‘right time’ in the cycle to buy and sell aircraft as well as the ability to accurately assess and monitor the maintenance status of their fleet.
It’s only a matter of time before the debate over impairment around the senior management table will start with ‘when’, rather than ‘if’.
The funding profile will change too
Until now, aircraft leasing, has been largely funded through the banking system. The new Basel III capital rules will fundamentally alter this relationship. When banks have less capital to lend they tend to become more concerned about exposure limits and credit quality.
Basel III rewards a focus on investment grade customers. This may be at variance with the typical profile of heavy users of aircraft lease finance. While recent developments in relation to the rating of lessors may help in this regard, equally, lease finance is likely to become more expensive under Basel III, because the Liquidity and Funding Ratios for banks will require longer dated (and hence more expensive) funding so as to match the typically longer maturities of lease finance books.
For aircraft lessors, this is likely to be a further catalyst to the recent signs of an emerging ‘self originated’ debt finance model whereby the traditional banking groups are replaced by bilateral facilities with investors and non-bank lenders.
And the way in which it will be measured is still being agreed
The third game changer for the industry relates to the anticipated changes to the accounting rules. The traditional structure of operating (off Balance Sheet) vs finance (on Balance Sheet) leases is under challenge. With some exceptions, principally for short term leases, all such arrangements will be on Balance Sheet for the lessee. This brings considerable challenges for the lessor community as their decisions will need to be conscious of the accounting being followed by their lessee customers.
As with all changes, the detail of the proposals will be key in driving the commercial impacts for the lessor community. Equally, first mover advantage for lessors in terms of assessing the impacts on existing and future assets and lease contracts should yield dividends going forward.