High debt costs eat into aircraft lessor returns

Some lessors may be making lower returns on new sale/leaseback deals than they were pre-Covid because of increased financing costs, according to Ishka research. Lenders indicate that like airlines, risk-adjusted margins on new secured financings for aircraft lessors have risen since the onset of the Covid-19 crisis. A higher cost of debt means that, despite lease rate factors increasing slightly on new sale/leasebacks, the actual returns aircraft lessors are generating are comparable, if not worse in some cases, than the pre-Covid-19 era when lessors faced more competition but enjoyed a benign financing environment.

One leasing source confirmed equity returns on new deals are now lower than pre-Covid due to the increased costs of debt.  Lenders state that limited recourse financings secured against aircraft, which are commonly used by smaller lessors and asset managers to fund new sale/leasebacks, have seen a notable margin hike.

Financiers indicate that margins for these types of deals can vary but many non-recourse aircraft secured loans are now being signed at 400bps over Libor with some lessors being quoted financing with margins of up to 500bps over Libor.

In contrast, top-tier airlines have been rumoured to command 0.7 lease rate factors (LRFs) on new sale/leasebacks in July and August 2020, a slight increase from the 0.5 and 0.6 LRFs that airlines were able to obtain on sale/leasebacks in 2019.  

As a result, asset managers and lessors that are signing deals today are seeing returns squeezed despite the higher risk prevalent in the aviation industry.

“A lessor’s costs in a P&L sense are depreciation, plus interest plus SGA (sales and general admin expenses). If you think they should be allocating 4% or 5% per annum on depreciation plus expenses, plus allowance for bad debt,[and] if you are borrowing money at 400 bp plus the costs of funds, so 500bp or 550bp, how are you making any money? The gap in there to make any P+L is absolutely waiver thin,” explains one European lender about current lessor’s returns on new deals.

Lenders wary of new warehouses

Lessors differ in how they choose to raise debt and their relative risk profile from a lender’s perspective. Both factors help dictate the ultimate cost of new debt. The largest lessors have historically issued either unsecured bonds or raised warehouse facilities to raise new debt for aircraft purchases. Some lessors still have access to the capital markets and can raise debt relatively cheaply because of a strong underlying rating.

Air Lease Corporation (ALC) is an example of an investment-grade aircraft lessor that has been able to issue unsecured bonds in the crisis. The California-based lessor priced a $700 million unsecured bond in August with an interest rate of 2.875% set to mature in 2026.

But lenders stated that all lessors are likely to have seen some increase in the cost of secured bank debt. A few bankers state that the top five lessors are still able to raise secured debt facilities with margins at or below 300bps for full recourse deals.

“If you opt for a lessor financing either you do or do not get recourse. The range starts somewhere in the 250s [basis points over Libor] for full recourse deals to the lessor and easily goes up to the 500bps for a non-recourse deal with widebody metal risk,” explains one European financier.

“It depends on the lessor, if it is a super straightforward full recourse deal for one of the top three lessors with one of the better names you might even find something being closed around the 300s or the 290s which is the best I see, but without the full recourse from one of the top five lessors it can easily go up into the 400s,” adds the financier. 

Financiers also added that new warehouse financing has largely “disappeared” since March as financiers are increasingly reluctant to fund new portfolios of aircraft.  This represents a step change in the financing landscape. For the last four years many aviation banks have aggressively chased lessors to offer them warehouse financings which lessors can use to acquire a portfolio of aircraft that could then be refinanced in the capital markets.

Banks often pursued these deals to win mandates for the follow-on capital market refinancing solutions including aircraft ABS or private placements, explains one source.

But lenders are candid that financiers are increasingly looking through lessor portfolios to assess the underlying airline credits. “Lessors portfolios, generally speaking, have sub-investment grade airlines. So, lessor portfolios have a higher airline risk than average. As a lender you will look through that and say, ‘hey we have some concerns and as a result need lower advance and higher margins’,” stresses Michael Dickey Morgan, EMD at Burnham Sterling, an aviation private-placement debt arranger.

Doing “better” deals in the new normal

The higher cost of debt has an impact on the returns that lessors are able to generate. Not all lessors are competing on new deals. Some lessors are waiting to see what happens and are postponing new deals until the fourth quarter as they hope to see returns improve. Other lessors are in “cash preservation mode,” according to financiers, as they seek to minimise outgoings to help deal with reduced rent collections.“Lessors are looking at their blended capital stack and saying, ‘we can live with this for a while, we have enough cash, we can worry about gains next year’. For the next 12-18 months they need to worry about cash flow liquidity, and deferring capex. At least until they get a sense of how the airlines come through the winter and where we are at with a vaccine,” reflects one financier.

Despite the significant hike in financing costs lessors are still doing deals. Some lessors are using equity to complete deals or hoping to refinance deals in 36 months after the current crisis abates. One asset manager that has been actively bidding on aircraft stated that a modest hike in  LRFs obscures why some of the recent sale/leasebacks represent “better” deals than before the crisis.

“Yes, LTVs have gone down but purchase prices have also gone down. Lessors doing deals would argue: ‘We are buying assets at much lower prices than we were before, we are doing deals with airlines that we are quite confident will stay in after, at rents that make sense for that airline even after Covid. Yes, returns are low, but we can push these up once the debt market is back.’ How much of that is wishful thinking? It has certainly allowed lessors to be active and their thesis for investment is that you need to be active throughout the crisis, high and lows. You are certainly doing deals now with airlines you simply wouldn’t be able to do in normal times,” explains one senior aircraft lessor executive.

“The returns are low but the risk is relatively low too, as the price of the aircraft and the valuation has baked in any potential downgrades etc for new deals. I am much more worried about deals done just before Covid-19 at the peak that are probably more at risk because they will have a much tougher time,” the lessor adds.

 

The Ishka View
 

The real surprise here is not that lenders are increasing the cost of debt to lessors. The risks to aviation after all in the Covid-19 era are real and apparent as countries impose travel bans and quarantines. So few banks are now actively offering secured aircraft deals that margins have inevitably risen.

But what might be surprising to some is that after an initial bump in new sale/leasebacks lease rates in March, top-tier airlines have seen a fairly negligible rise in lease rates as plenty of lessors continue to bid on deals. “There is still plenty of liquidity,” reflects one lessor. Some of this liquidity is likely to be historic but leasing sources state there are rumours of fresh investor mandates for new deals.

Lessors doing new sale/leaseback deals argue that relatively low headline lease rate factors obscure the improved terms, lower purchase prices and more stringent return conditions now common on most new deals. All these factors help boost returns in the long run. Crucially, these new deals are now also being done with better credits as practically all lenders and most lessors opt to work solely with top-tier airlines. Returns can be improved on new deals if lessors can successfully refinance in 36 months at much lower terms, but it does introduce a considerable refinancing risk.

In the meantime, the few lessors that are willing to do deals for second-tier airlines represent a vital source of liquidity as banks become increasingly selective on aviation credits (See Insight: Rising airline debt margins attract hedge fund interest).

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