Investing in aircraft assets is, on first principles, no different to making investments in any other asset class. In its simplest form, the mantra of “buy low, sell high” applies, although perhaps it should be modified to “buy well, sell better and manage assiduously in between”

By Dick Forsberg, Head of Strategy

Investing in aircraft assets is, on first principles, no different to making investments in any other asset class. In its simplest form, the mantra of “buy low, sell high” applies, although perhaps it should be modified to “buy well, sell better and manage assiduously in between”.

Everybody involved in the commercial aviation sector will be fully aware of its highly cyclical nature. The importance of this fundamental fact cannot be overstated when it comes to investing in aircraft – and within the broad definition of “investing” should be included any transaction that relies on the asset’s future value as security against a financing arrangement. Commercial lending banks are just as much taking asset risk on the provision of secured debt into an aircraft financing as an operating lessor taking that asset onto their books – although some banks only come to realise this when they are facing a loan default and possible (re)possession of the asset.

The industry cycle has been a core component of commercial aviation for at least 40 years – in other words since almost the dawn of the jet age. Over all of that period of time aircraft have been bought and sold at various stages of their economic lives, including at the end of their lives for part-out, with the aim of making some money from it along the way. Whilst the volume of trading does not come close to that seen in some other asset classes and the industry is far from transparent in the way that trades are reported, there is more than enough empirical evidence available to establish close correlations between i) the age of an aircraft and its value and ii) the proportion of the asset’s value that can be realised through a sale at each stage of the industry cycle. Understanding these relationships, along with the ability to manage the assets during the hold period, is critical to building a successful aircraft investment portfolio.

Exhibit 1. – The Industry Cycle

The industry cycle influences not only aircraft values, but also the relationship between supply (seats and aircraft) and demand (passengers), airline profitability, financial liquidity and aircraft trading activity. All are linked and the transition from one phase of the cycle to the next is at the heart of extracting value from aircraft investments (see Exhibit 1).

Before getting into the detail of how to better understand these key investment drivers, is it worth noting that there are multiple investment models, each requiring different skill sets, or at least different mixes of skills, to manage the portfolio and protect investor value. There are also different types of investor, from hands-on traders of metal (either whole aircraft or components) to arms-length passive financial institutions for whom an aircraft is nothing more than an opportunity to diversify a financial portfolio or manage a tax position. In between are a wide range of participants, from specialists to generalists, equity and debt providers, whose intimacy with aircraft operations, technology and value trends is diverse and frequently incomplete. Each investor category and each business model will have its own focus, requirements and priorities when it comes to building an aircraft portfolio. The criteria applied to the selection of assets for investment, as well as the timing and routes for realising the embedded value in the investments will depend on the business model adopted and the requirements and motivations of the investors, however the basic rules for selecting the right assets, paying the “right” acquisition price and realising the expected profit on disposal apply to all investors and all business models.

At its simplest level, the investment economics of an aircraft portfolio can be expressed as

Return = ¹∫ _n (Rent, Term, PV, FV, CoF)

In other words, transaction economics are a function of the purchase price, the sale price, the lease income stream, which is itself a function of the terms of the lease agreement, and the all-in financing costs. Whilst all of the elements of the investment proposition are important, if the wrong asset type is purchased, too high a price is paid or the investor has unrealistic expectations of future value performance, the expected returns will not be met.

Exhibit 2: Example of asset value movements through the cycle

Market to Base Value Ratio: 737-800

1997-2010 year of build

For most investors, aircraft investment will be a cycle play, buying when values are within a cyclic low range and aiming to sell as the cycle approaches a future peak (See Exhibit 2). For some, of course, their specialist ability to manage values as aircraft approach the end of their economic lives will dictate a different strategy, where technical management of component lives (especially engines) is the over-riding criterion.

Who invests in aircraft?
There are two broad categories of aircraft investors – the metal people and the money, or paper, people. The metal investors are those that first come to mind when thinking about aircraft as investments, but the latter are also an important component of the broader market, especially with respect to sustaining financing liquidity. These include the buyers of EETC paper in the US capital markets and investors in the public market lessors. Whilst the former rely mainly on the tranched structure of their investment vehicles to manage risk, the latter will apply the same judgement and investment decision tools as would be applied to any other stock market transaction.

Equity investors on the metal side can be classified as primary or secondary. Primary investors come in a variety of forms, but all are motivated by the strong risk-adjusted returns that can be made from owning commercial aircraft, if the appropriate management platform is in place and a suitable investment strategy applied. Aircraft have consistently generated stable risk-adjusted returns for investors throughout the economic cycles, outperforming many other asset classes (Exhibit 3).

Exhibit 3: Returns on aircraft and other asset classes 1983 – 2002

Equity investors from the private equity space have been prominent during the current (2009/10) cycle inflection, with additional support coming from institutional investors such as pension funds and insurance companies. Over the years, sovereign wealth funds and banks have also been significant participants (e.g. Temasek, Investment Corporation of Dubai, WestLB, Bank of China, RBS, Standard Chartered) and are likely to remain heavily engaged in the sector.

A small number of operating lessors have positioned themselves in the public markets, deepening the pool of investors through the IPO process and, due to the number of shareholders, becoming proxy investors themselves, with a considerable amount of freedom to make investment decisions within the organisation.

Whilst primary investors tend to be fully informed on the sector and closely associated with an asset management platform that supports their investment activities, secondary investors generally take an arm’s length approach and rely extensively on third party managers for industry knowledge, investment decisions and asset management. At the secondary level, investors can buy into managed asset backed securitisation (“ABS”) structures that offer passive participation in pools of leased assets that are blended to de-risk the portfolio and come with a recognised asset manager to support the income stream. Other variations on this theme include managed funds for high yield investors, typically with a high equity component and generating strong cash yields and lower IRR returns. There are also a number of financial and tax-based structures that cater for the specific needs of an investor group (e.g. JOLs, KG Funds). In short, the industry has always been innovative in developing asset based structures that are investor friendly and do not require first-hand industry expertise on the part of the investor.

Selecting the Right Assets
The first step towards building an aircraft investment portfolio is to ensure that the assets acquired will achieve the value growth required and expected by the investors. From Exhibit 4 it can be seen that all aircraft are not equal when it comes to value retention. This chart compares a selection of aircraft that could all be purchased new in 1999 and shows their retained market values after twelve years, represented as a percentage of their original acquisition costs. There is a large difference between the best and worst performers, with value retention ranging from almost 60% down to 15% – a gap that can never be closed by any means at ones disposal around the structuring or terms of the transaction.

Exhibit 4. Aircraft Value Retention 1999 – 2011

Whilst it is often possible to make a profitable investment in one of the weaker-performing assets at some point in its life-cycle, it is critical that investors should be able to make a determination of the likely value retention performance of their target aircraft at whatever point in the life-cycle they are choosing to invest – and also to ensure that they have the appropriate asset management skills and resources at their disposal, as these vary considerably through the life of the aircraft.

The wide variation in aircraft value retention goes beyond simple trading volatility, which is more related to how the market behaves at different points in the cycle – more of this later. The fundamental ability of an asset to retain more, rather than less, of its value over time is essentially a measure of its liquidity and the way to better understand the value retention capabilities of different aircraft types is to compare their relative liquidities. In order to do this, it is necessary to identify the key drivers that influence an aircraft’s attractiveness over its lifetime. It is important here to think about attractiveness to investors rather than to the airlines that operate the aircraft, although with several of the factors the interests of the two will coincide. The core drivers, of which no more than 12-15 should be included in the analysis, can be broken out into market-related and performance-related metrics. The former include such things as total sales (in service and future orders), customer base (number of airlines and geographic dispersion) and the level of lessor commitment, with negative factors including the level of manufacturer support (proportion of the fleet on the OEM’s balance sheet) and the number of aircraft in storage. Performance related factors include the level of technology, the stage of the aircraft’s production life-cycle, its operating economics and fuel burn, family membership, mission flexibility, potential for freighter conversion and the degree of cabin and specification standardisation ( the Boeing 787 represents an important step change in this regard relative to previous generations of widebodies).

Exhibit 5: Relative Liquidity Ratings

Having selected the appropriate factors, which should all be measurable today and capable of being forecast into the future, a system of scores and weights can be developed and applied so that a “perfect” investor aircraft would have a score of 100. In this way it is possible to build up a relative hierarchy of investment scores for each aircraft or aircraft/engine combination under consideration, allowing an investor to apply a cut-off threshold score, above which an investment in the asset type would be deemed acceptable (see Exhibit 5, which includes a target investment threshold of 55% – note that the specific aircraft types shown have been disguised). The criteria selected and the scores and weights applied will vary depending on the investor’s objectives and business model, but the output – a set of “relative liquidity scores” – will allow any investor to identify investment targets that meet their criteria on a consistent and objective basis. An ability to look ahead through projections of the core criteria adds a significant dimension to the power of this approach by identifying future inflection points that can be used to guide investment acquisition and disposition decisions within the portfolio. Thus, aircraft types with ratings that begin below the threshold but cross it over time are potentially attractive future acquisition targets, whilst those whose ratings are trending below the line are more likely to be disposal candidates.

Understanding Aircraft Values
Having identified the aircraft types that meet the investment criteria and will therefore be core target assets for the investment portfolio, the next step is to understand how their values will perform through the phases of the industry cycle and over the longer term, starting with what is an appropriate acquisition price and extending over the life of the aircraft.

Exibit 6. Real Value as percentage of Real Original Value

Statistical regression analysis (measured by R2) has shown that some 2/3rds of an aircraft’s underlying value retention is directly correlated to nothing more complicated than the age of the asset (see Exhibit 6, which shows the distribution of values achieved on the sale of several thousand aircraft over the years, expressed as percentages of their original cost).

The clever stuff comes in figuring out what influences the remaining 1/3rd of value retention. At any point in the life of an asset, its value will be closely linked to its remaining economic life and, from an accounting standpoint, this can be benchmarked by calculating the Net Present Value of the cash flows over the remainder of the aircraft’s economic life, making appropriate assumptions around lease terms, lease rates, default probabilities, transition costs, etc.

Economic life is ultimately determined by the ability of an aircraft to generate profits for the airlines that operate it both in absolute terms and also relative to alternative aircraft types that might be available as competitors at the outset or introduced later in its life. As a broad rule of thumb, current generation 100+ seat commercial jets will have an economic life of around 25 years, although plenty will still be in commercial service beyond 30 years and life extension through cargo conversion is also possible for some aircraft. Whilst there is always plenty of debate, especially during low points in the industry cycle, around the appropriate assumptions for economic life (which directly impacts depreciation policies and aircraft values), there continues to be strong evidence, as shown in the survival curves in Exhibit 7, that economic life has not materially changed since the 1970s. Short-term cycle-driven events, such as the parting out of a small number of young in-production aircraft, should not be taken as a signal that the entire fleet has had its useful life curtailed.

Exibit 7. Jet Fleet Survival Curves 1965 – 1995 Build Years

It should also be noted that, whilst it is important to be able to account for an aircraft’s value at any point in its life, asset trading activity and value realisation is closely aligned to the different phases of the industry cycle. Over the past several decades, a pattern of value volatility has been established around the inflection points of the cycle, influenced by the liquidity of the asset in question, and it is this volatility that drives the whole cyclical aircraft investment model. Whilst the amplitude of this volatility will vary depending on the aircraft type and its relative liquidity, there is a consistent temporal correlation between value movements across all aircraft, which results in values rising and falling broadly in phase. This can clearly be seen in Exhibit 8, which contrasts the value movement of two quite different aircraft through the cycle.

Exhibit 8. Market to Base* Value Ratio

Constant five year old vintage aircraft

Before getting into aircraft values too deeply, it is worth setting out some definitions of the key terms that are used when describing an aircraft’s value. Several of these are defined by ISTAT (the International Society of Transport Aircraft Trading, which is the industry body representing the interests of aircraft owners, appraisers and traders) and they are set out in the box below.

Base Value is the most widely used term to describe an aircraft’s underlying, intrinsic value i.e. before any impact resulting from prevailing market conditions. It is frequently applied to a “standard” aircraft specification and configuration, particularly when quoted in a generic sense or presented in a broader table or list of values, rather than applied to a specific aircraft or serial number. Since Base Value pertains to a somewhat idealised aircraft and market combination it may not necessarily reflect the actual value of the aircraft in question, but is a nominal starting value to which adjustments may be applied to determine an actual value. It is also true to say that in real life an aircraft rarely sees base market conditions, as base market is a transitional state in the cycle between weaker and stronger conditions.

The Market Value of a specific aircraft will remain consistent with its Base Value in a stable market environment, but where a reasonable equilibrium between supply and demand does not exist, trading prices, and therefore Market Values, will vary from the Base Value of that aircraft. The extent to which Market Values vary relative to Base Values through the cycle will be determined by their attractiveness to airlines and to investors i.e. their relative liquidity. The qualities of the aircraft will dictate the level of volatility (the size of the Market Value movement above and below Base Value) attached to it. This is the arbitrage opportunity for aircraft investors and, whilst perhaps stating the obvious, it is absolutely critical to get it right.

A common additional requirement when valuing an asset is a Maintenance-Adjusted Value. The majority of leases written today, at least for young aircraft, include return conditions that relate to a zero time maintenance condition aircraft, rather than the historically more traditional half-life status. This requires the lessee to return the condition of the aircraft at redelivery to “as new” status, either by performing restoration work or by paying a pre-agreed adjustment fee that reflects the difference between the actual status of the aircraft and zero time. Either way, the lessor/investor gets back an aircraft that is, in monetary terms, in the same technical condition as the day it was delivered. This is an important element of the overall investment proposition and a key element of the transaction economics. However, as the ISTAT definitions state, the standard appraised value relates to a half-life asset, so a separate valuation of the aircraft in zero-time condition must also be obtained, to reflect the expected condition of the aircraft at redelivery by adding back the value of the extra life.
So, how can investors find out what an aircraft is worth in Base, Current and Future Market Value terms? Most stakeholders in the industry rely heavily on professional aircraft appraisers, of which there are many, offering a wide range of resources and capabilities, each catering to a different mix of customers and markets. At one end of the spectrum lie the largest appraisal companies, often selling a range of advisory services, with global coverage, substantial analytical resources and heavily invested in intellectual capital. At the other end of the scale are a number of small “Mom and Pop shops” that rely heavily on their contacts and networking to supplement their analysis, but usually have extensive industry experience. In the middle are a number of mid-sized organisations, often with a more technical focus and capability and well-suited to preparing more customised sets of values than their larger peers will typically be asked to provide. In each case, it is important to remember that, as customers, investors are buying opinions, not black and white facts. Whatever the level of modelling and analysis that the appraisers bring to bear on the task, their output will always be a blend of art and science. The assumptions that they build into their forecasts and their individual views of markets, technical developments, manufacturers capabilities, etc, will result in a set of value opinions that will differ from those provided by their competitors.

Exhibit 9. 777-300 ER Base Value Forecasts

Whilst the variations are usually quite narrow for Base Values of commodity in-production single aisle aircraft, the divergence may be substantial for widebodies or for less liquid aircraft (see Exhibit 9) and increases with the forecast horizon. Hence, it is critically important for investors to understand the capabilities and characteristics of each appraiser and also what their target customer base may be (several specialise in US capital markets transactions, for example, which have different requirements from those of aircraft traders and produce different outputs). Having selected an appraiser that matches their requirements, an investor should take the time to understand as fully as possible the core assumptions and considerations that are going into the appraiser’s analysis to ensure that they do not hold diametrically different views to their own.

In some cases, the appraiser may be able to incorporate bespoke assumptions into their analysis. In most cases, however, and certainly when it comes to downloading valuations from the automated on-line valuation services that are now offered by several of the larger appraisal firms, it may not be possible to obtain anything other than a set of values based on standard assumptions. This lack of controllability over such a key component of the investment mix leads to the conclusion that smart investors should have their own in-house valuation capability to augment the services available from external appraisers. This is still rare amongst aircraft investors and leasing platforms as it requires not only a very specialised skill-set, but also considerable investment in time and money to develop a robust set of tools that essentially replicate what the professional valuation firms are providing. However, for those that are willing to make that investment, the benefits are significant. Firstly, the dependence on third party assumptions, which are often opaque, is removed; secondly, with the ability to input one’s own assumptions comes the capability to run alternative scenarios (for example, assuming a slower economic recovery, significantly higher fuel prices, the launch of a new replacement aircraft, etc), which helps to build out a volatility picture; thirdly, it brings the ability to benchmark and validate what the external appraisers are saying about asset values. However, the appraisers cannot be ignored and exert considerable influence – remember that the world at large, including lessees, lessors, lenders, aircraft buyers and sellers all have sight of the appraisers’ output and most of them will be relying upon it.

Acquiring the assets
The window of opportunity to acquire assets at attractive discounts to their long-run base values commences as the cycle moves into its weakest phase and lasts until a point in the recovery when the level of discount available no longer supports the return criteria for investors. Rather than attempting to identify the exact nadir in the cycle and cluster purchases narrowly around that point, most investors’ buy phase will span 3 – 4 years, including the early stages of the upturn, during which they will be able to continue to acquire aircraft at an acceptable discount to base values.

Acquisitions may be sourced through three broad channels: firstly, through the purchase and leaseback of aircraft delivering to airlines as part of their own direct orders with the manufacturers, or of aircraft already delivered and on the airline’s balance sheet; secondly, through the purchase of aircraft or portfolios of aircraft from other lessors and investors; and thirdly, by way of direct orders placed with the manufacturers. Whilst the sale and leaseback channel most commonly sources the core of investor portfolios, portfolio acquisitions are attractive as a way of getting earning assets onto the books quickly or through particular circumstances pertaining to the vendor which offer an attractive acquisition opportunity. Portfolios or bilateral purchases will also be an important source of assets for investors in used aircraft. Direct orders may not be appropriate for all business models, but can provide a strategic benefit by ensuring that a pipeline of aircraft is available for placement into airlines throughout the cycle, even at times when sale and leaseback pricing has become relatively unattractive, and provides an additional product for a lessor to offer. Direct orders should ideally be placed during the weaker phase of the cycle, when competitive pricing is more likely to be available, resulting in a delivery stream of well-priced aircraft peaking towards the top of the cycle when the placement of new assets is highly sought after by the airlines and supports strong lease rates.

Taking care of asset value
Having selected their target aircraft and made prudent investments at the right point in the cycle, investors will have their eyes on some point in the future when they can expect to harvest the embedded value of these aircraft as their market values rise with the cycle recovery.
However, in order to ensure that the aircraft they sell still retain all of the value they expect, it will be essential to manage the aircraft assiduously from a technical and risk perspective.

Technical asset management begins even before the asset is acquired, as there is potentially significant value to be lost or gained around the detailed specification of the aircraft. Beyond the core characteristics of the aircraft (weight, engine type, engine thrust) are a wide range of option items that may be selected by a purchaser, either for inclusion in a new build aircraft or added/removed at a later date . These will include options that enhance performance (such as auxiliary fuel tanks, winglets), address operational requirements (TCAS, crew rest modules, air-stairs, cargo loading systems) or enhance the on-board product (in flight entertainment systems, galley layouts, over-sized overhead bins). Some may be required for regulatory purposes and most will have both a cost (to install/acquire) and a value, which should be considered in the context of whether the item is a long-term enhancement for the majority of possible future operators of the aircraft. Some of the items are high cost, but may not be high value and a detailed specification review by technical experts will ensure that the investment price paid reflects the value of the selected specification.

Technical input into the drafting of a lease contract is also highly value-added, as this is where the return conditions are defined, as well as the level of any maintenance reserves that will be paid during the term of the lease. Having the “right” return conditions can have a material impact on the overall financial performance of the investment, running potentially into millions of dollars. Maintenance reserves protect the lessor/investor from the full cost having to put an aircraft into its return condition in the event of a default and it is important that the correct rate is set to reflect the actual or proposed operation of the aircraft by the lessee.

Finally, from a technical perspective, regular inspections of the aircraft throughout its time on lease, as well as at lease expiry, plus the ability to audit, approve and monitor the maintenance provider that is taking care of the asset all protect and enhance the value of the asset and the investment made, as does close technical involvement and support during the redelivery process itself.
In the same way, a rigorous approach to credit risk management will also help to protect the asset and the income stream from the investment, by providing on-going oversight of the aircraft operator and an early warning of any deterioration in business performance that might suggest that a default may occur. At this point, the involvement of “work-out“ specialists, including commercial, financial and technical experts, will quickly be able to determine whether it makes sense to work with the airline as they seek to resolve their problems or whether a termination of the lease should be pursued. It is always better to be decisive in these circumstances, as delay and uncertainty invariably make the situation worse (i.e. the level of unpaid receivables keeps on rising). As has often been said, “hope is not a strategy” and the investment is far better protected by having the ability to move fast and decisively to mitigate any losses.

Realising profits
For most investors, returns will be realised principally from the arbitrage between the prices at which aircraft are acquired and their market value on disposal. Where a dedicated leasing/asset management platform is established to support the investment, there may be additional value in the platform itself as a “machine” capable of acquiring, managing and disposing of aircraft assets efficiently and profitably based on the skills and experience of the team and the network of relationships it will have with industry stakeholders.

In any investment, the exit strategy is best determined at the outset. There are several options available for aircraft metal investors, all of which are time sensitive – as noted at the start of this chapter, this is essentially a cycle play. In the majority of cases, each, or at least most, of the options will be brought into play as the recovery cycle develops. This will occur on a sequential basis as the channels will open up at different points in time in the cycle.

If only to enhance investor confidence, it will be important to demonstrate the liquidity of the invested assets as early as possible in the recovery cycle and a small number of assets may be selected for sale whilst the cycle is still at a relatively low point and opportunities for acquisitions still exist. As the cycle improves, additional distribution channels, including larger bilateral sales, ABS structures and managed funds, will become available.

Assets targeted for sale should not simply be those yielding the largest profits; indeed this is often a poor strategy as it reduces the quality and earning potential of the remaining portfolio. Asset sales in support of an overall portfolio strategy can help to reduce concentrations, improve yields and otherwise manage asset and counterparty risk exposures.

Pursuing a systematic program of asset disposals through the up-cycle by a combination of “retail” sales of individual aircraft or small clusters of aircraft to smaller investors and more structured “wholesale” disposals (e.g., securitizations) of larger portfolios of aircraft delivers a number of strategic objectives over and above the harvesting of embedded profit:

1. It serves as a hedge against the realization of value solely through a corporate disposal;
2. It creates financing “headroom” for further acquisitions;
3. It enhances the platform franchise value by demonstrating an active trading capability;
4. where sales are to comparatively passive investors, it adds an income stream by establishing a role as an asset manager.

In aircraft leasing, as in the economy generally, M&A activity tends to occur in the run-up towards the peak of the business cycle. During the last industry cycle, market values for aircraft rose above base values in 2005 and disposals of aircraft leasing platforms in that cycle were concentrated in the period from 2005 to 2007 (see Exhibit 10 below).

Exhibit 10: Platform Valuation Metrics

Source: Public data

Acquisitions generally take one of two forms: i) consolidating (e.g. acquisitions of Bouilloun by ACG, Guggenheim by Aircastle and Pegasus by Terra Firma; or ii) facilitating market entry (e.g. acquisitions of AWAS by Terra Firma, SALE by Bank of China, GATX by Och Ziff and Macquarie and debis by Cerberus). IPOs during this period (e.g., Genesis, Aircastle, Babcock & Brown Air) were predominantly highly structured/high yield disposals of a portion of the portfolio of a larger entity rather than disposal of an entire entity as such.

Given the cyclical nature of the business and the inherent uncertainty associated with the cycles, investors must be prepared to hold their investments over a longer term if the circumstances for an exit are not favourable. In this regard, having the support of a capable asset management platform will substantially mitigate the risks associated that arise with the passage of time – remarketing, managing defaults, technical asset management, etc. An exit executed under duress or in pursuit of a fixed term investment strategy is unlikely to realise the anticipated returns and investors are well advised to reflect on these issues at the outset.

Dick Forsberg
Head of Risk & Strategy, Avolon

Tel: +353 1 231 5825

Mobile: +353 87 969 1369
Email: [email protected] 

This article was first published in the 4th Edition of Aircraft Financing, from Chapter on “Aircraft As Investments”, published by Euromoney.