Lessors Are Hopeful Despite Concerns About Interest Rates and China

David Neeleman sat down to tell the story of his favorite airline, Azul. Set up by him in Brazil 15 years ago, it was in trouble—the aftermath of the COVID-19 pandemic as well as rising fuel costs and interest rates.

“The easy thing would have been to file for bankruptcy,” he said at the International Society of Transport Aircraft Trading (ISTAT) Americas conference in San Diego. But instead the Azul chairman had the airline open its books to lessors—and got major concessions from 90% of them, ultimately sufficient to avoid bankruptcy. “AerCap led the deal and everyone else followed,” he noted.

• Aircraft lessors focus on sale-and-leaseback transactions
• Delivery delays are another concern
• Supply chain disruptions create uncertainty about investment volumes

It was therefore no coincidence how he used that stage at ISTAT—among others, Neeleman came to say thank you.

Many airlines can probably tell similar stories. With most of their customers threatened with imminent bankruptcy and many, just like Azul, without access to (public) funding, the aircraft leasing industry became the airlines’ bank, and credit lines were generous. Unheard-of lease deferrals or temporary rate reductions were accepted due to a lack of alternatives. Everyone was suffering—but almost everyone survived in the end.

Lessors are hoping payback time has arrived. Much that went against them in the past few years is now working in their favor. Airlines are seeing an unprecedented surge in demand for air travel across the board, which translates into essentially everyone looking for additional aircraft. In the near term, neither Airbus nor Boeing have available production slots. And those that are expecting aircraft based on previous orders are, more often than not, finding out they will be delayed by many months.

Unfortunately, the severe disruption of the commercial aerospace supply chain is a double-edged sword for the leasing industry. While the installed base of aircraft is increasing substantially in value and lease rates are rising, growth through direct orders remains behind the normal curve as lessors’ own deliveries are affected. And Steven Udvar-Hazy, executive chairman of Air Lease Corp. (ALC), said at ISTAT that he had some additional concerns: interest rates and China.

The rate of interest rate increases will create problems, Udvar-Hazy said. “It is difficult [for airlines] to accept a rapid rise in the cost of financing. Airlines are scratching their heads.” And as a result, so should lessors, he pointed out.

“[Also] tensions with China, [and their] coziness with Russia is a concern to us,” Udvar-Hazy added. He still sees the Chinese market as a big opportunity, with a growing middle class that is eager to travel more. “But the question is, will ideological priorities be a headwind? We are watching China carefully. It is an important market for all of us, but we need to be mindful,” he said.

But there is good news as well. “A lot of airlines did not get government support [during the coronavirus pandemic],” ALC President and CEO John Plueger said at ISTAT. “[So there] is more reliance on lessor balance sheets. Leasing will continue to grow. There is a normal migration to those with strong balance sheets.”

“We have gone through COVID-19, Russia and the steepest rise in interest rates in 40 years and all credit metrics are up,” Avolon CEO Andy Cronin said.

“There is a huge rebound in demand,” agreed Orix Aviation CEO James Meyler. Orix has extended lease contracts for 33 aircraft, 10% of its portfolio, in the past nine months. He pointed in particular to the “huge increase” in sale-and-leaseback transactions.

The overall sale-and-leaseback market was valued at $28 billion in 2018, according to Orix. It is expected to be $45 billion this year and $50 billion in 2024. If the trend stabilizes, lessors that have focused on refinancing existing fleets or airline orderbooks could benefit most, while those primarily dependent on their own orderbooks with Airbus and Boeing might be exposed to supply chain and delay risks. Lessors such as Avolon, which has both significant direct orders but is also active in airline financing, are shifting more resources toward sale-and-leaseback transactions this year than they have historically, given the market circumstances and upcoming opportunities.

The focus on financing existing portfolios is based on two different factors. One, new aircraft are coming in slower than expected from lessors’ own orderbooks. And while airlines urgently need more lift in almost every segment, their balance sheets are still weakened because the industry piled up huge amounts of additional debt. The International Air Transport Association estimates that airlines have added $220 billion in debt since early 2020 and now have a $650 billion burden to carry.

Airline credit ratings are generally far below those of lessors, which are financial services companies with flexible, in-demand assets. But the leasing industry is not happy with how it is valued by the rating agencies. “We are being held back from managing the business the way we would like to,” Aviation Capital Group (ACG) CEO Tom Baker said. “We are not getting the credit we deserve.” If lending was cheaper, more investment and faster growth would be possible, particularly in an environment of rapidly rising interest rates.

The generally uncertain global economic outlook, including predictions by some of a recession in the U.S. and Europe this year, might be a valid reason to proceed with caution, in theory. In practice, lessors are not too worried that demand might dampen as airlines retract growth plans. “So far I don’t hear a voice of concern from our customers,” Plueger said. “I was expecting a slowdown in Europe over the winter because of the rise in energy prices. But traffic in yields is holding up, to my surprise, and there is no sign of them abating.” And given the recent shocks that lessors had to absorb, Plueger pointed out: “We can use a couple of good years.”

Meyler noted that even in economies that are in a recession, travel demand is still good. Similarly, Cronin explained: “Pent-up demand is overriding all other cost factors. He also pointed out that because of the reduction in production rates, “a lot of aircraft have not been built,” constraining supply.

But is all that optimism really justified? Broadly speaking, yes, Avitas Senior Vice President Adam Pilarski said. “Airlines and lessors will probably make more money,” he predicted. One of the main drivers: Passengers likely will continue to be prepared (and able) to pay more for flying than in the past. “Airlines made more money on less traffic [in 2022],” he pointed out, contending that this might trigger some lasting change in airline strategies.

Pilarski envisions that a full traffic recovery will not likely come until 2024, which at current or even slightly depressed yield levels should lead to revenues substantially higher than 2019. Adding to the equation, however, labor costs are also steeply rising. Recent and upcoming agreements for U.S. airline pilots mean carriers must manage a much higher cost base than in the past and could lose some of the flexibility that has substantially helped some airlines in the past few years.

There are other negative factors, too. For example, Pilarski expects inflation to stick around. “There are good reasons for inflation,” he said. The move from just-in-time to just-in-case strategies is leading to larger inventories and more suppliers, thus higher costs. Globalization brought low inflation as advanced economies took advantage of cheaper labor elsewhere, but less outsourcing will likely lead to more union power and higher wages, adding to inflation. Finally, he noted, “decarbonization will be expensive.”

Pilarski is also not optimistic about interest rate trends. He contended that the U.S. Federal Reserve probably “did not raise rates fast enough” in its fight against inflation. If further interest rate increases are forthcoming, economic growth might suffer even more.

As Udvar-Hazy pointed out, the rise in interest rates is unfolding just as a “huge widebody replacement cycle” is about to begin that will drive investment needs up in the coming years. Lessors that have focused on large, flexible and in-demand narrowbody fleets are going to be less affected. Higher interest rates would also drive up lease rates as lending becomes more expensive, even for lessors with good credit ratings.

One of the biggest worries lessors are facing is one they share with their airline customers—delivery delays at Airbus and Boeing. “[Recovery] will be quite a long process. There may be hidden surprises yet to come,” Cronin said. “We have never seen OEMs being able to lift production by more than five narrowbodies a month or two widebodies a month per year.”

Avolon predicted earlier this year that both Airbus and Boeing would be one year late in their planned production increases. Sure enough, Airbus recently announced that it would slow its ramp-up to 75 narrowbodies per month.

“There is more uncertainty this week than last week,” ACG’s Baker said, “It will take a very long time.” ALC’s Plueger added: “[I’m] tired of apologizing to Wall Street about [missing] deliveries.”

“It has been very frustrating for the last several years,” Udvar-Hazy said. “The only aircraft that has been on time has been the [Airbus] A350-900/1000 and, slightly less so, the A330neo.” He pointed out that many deliveries are delayed by more than one year, and ALC has moved ahead to cancel some—it has the contractual right to step back from orders if a delay exceeds 12 months.

Concerningly, some of the root causes of the delays and supply chain struggles will not go away, lessors fear. “I cannot unequivocally say that any of the new engines is meeting our expectations,” Udvar-Hazy said, referring mainly to the Pratt & Whitney PW1100G powerplants for the Airbus A320neo family and the CFM International Leap family powering both the A320neo and Boeing 737 MAX. “None are as reliable and dependable as their predecessors.” The frequency of needed repairs and associated supply chain issues is outweighing the benefits of lower fuel burn, he said. “The promise is not being delivered. All the engine guys are at fault.”

Udvar-Hazy doubted that the delays could be considered “excusable,” a definition that would exempt manufacturers from compensation payments according to standard contracts. AerCap CEO Aengus Kelly recently made clear that he agrees, and most CEOs of OEM customers likely do as well. ALC is building in schedule cushions and has become more cautious to commit aircraft, “because we cannot be sure [about schedules] and we have to make sure not to disappoint our own customers,” Udvar-Hazy said. These cushions are worth real money.

The uncertainty includes the question of how much everyone will actually be spending. ALC has a $6 billion capital expenditure budget for 2023. “But I cannot tell you if it is going to be $4 billion, or 4.5, 5 or 5.7 billion,” Udvar-Hazy said. A lot of deliveries have shifted from 2022 to 2023, adding to the bill. However, many that were planned for this year are now shifting into 2024 or even 2025, and those must be subtracted. Investors that want a good degree of planning certainty are finding themselves in the wrong industry for the time being.

OEM deliveries are not the only thing in flux. Moves of significant aircraft portfolios from one lessor to another could continue, following some significant recent deals. On March 6, Shannon, Ireland-based Stratos took over Magi Aviation Capital, a widebody specialist. A Standard Chartered portfolio of 120 aircraft is up for sale. SMBC Aviation Capital acquired Goshawk Aviation, a narrowbody specialist, last year. Meyler’s Orix plans to spend $2.5 billion adding aircraft without having an orderbook at either Airbus or Boeing, but also plans to sell $2 billion worth of aircraft as it aims to modernize its fleet. Other lessors will likely take on the departing aircraft, assuming higher future lease rates will make deals profitable in the end.

“We have looked at [mergers and acquisitions] over the years,” SMBC Chief Financial Officer Aisling Kenny said. “Goshawk was the right target at the right price and we got the timing right.” The larger distribution channel that SMBC now has would also benefit airlines and OEMs, she asserted.

One of the big open questions for the coming years is whether there is going to be significant additional consolidation in the leasing sector. The major players have neither need nor appetite for further deals, given that their economies of scale already are better than those of most other lessors. AerCap’s acquisition of Gecas has catapulted it to a position out of reach for others.

One issue both potential buyers and sellers will likely have to consider is rising interest rates. Because of the increases, “high acquisition prices are over,” Kenny pointed out. Those that are considering selling, but feel no pressure, might stick to their assets in that environment.

ALC is probably one of the parties least interested in consolidation. “Some portfolios have come up. But we buy better than most [airlines and other lessors],” Chief Financial Officer Greg Willis said. Therefore, any targets are likely to have a base of contracts with OEMs that are worse than ALC’s own. For the same reason, sale-and-leaseback deals may not work either. ALC therefore is very focused on its own delivery stream with Airbus and Boeing.

“There will be consolidation,” Plueger nonetheless predicted. “But new entrants will also keep coming. Lessors and aircraft as an asset class have done very well. This will attract more capital.”

One of the new players is Greg Conlon’s High Ridge Aviation. Conlon was CEO of Gecas and left the company once its takeover by AerCap was completed, but is back in the industry with a new platform. “We look at a broad range of [merger and acquisition] activities,” he said. “We are very open to [buying] portfolios and platforms. We are starting to see some interesting things out there.” Platform transactions are often complex and challenging, he finds. “You can spend a ton of time on them,” he noted.

Robert Korn, co-founding principal of Carlyle Aviation Partners, said that more consolidation will “be beneficial. A lot of subscale players need to consolidate. They have to become more relevant for airlines and OEMs.”