“If you can’t feed a team with two pizzas, it’s too large. ”
Aircraft Finance 2008
Uncertainty about aircraft values in the current market poses a major challenge for the companies that finance their purchase. For many new aircraft, the wait for outfitted delivery is as long as five or six years. This backlog puts a lot of pressure on the pre-owned market, where inventories for some models are at all-time lows. The result confirms the law of supply and demand: supplies are low, so prices are high.
But some people in the business jet market, including many at financial institutions, believe prices are too high. They worry that there might be an "air bubble" of inflated value. To eliminate or at least reduce that bubble, potential buyers need the maximum amount of market knowledge and sophistication. Often, they lack both.
As such, officials at some financial institutions have begun to fear that they may be left holding the bag for customers' ill-advised purchases, especially when the financing takes the form of a lease. Here there is potential for the financial institution to make a serious mistake about residual-value assumptions and, to mix a metaphor, be left holding the air-bubble bag.
In an operating lease, the financial institution buys the aircraft and leases it to its customer. This is the epitome of "asset-based" finance: the financer actually owns the asset. The financial institution, however, doesn't negotiate the purchase; the customer usually does that. This means that the financial institution must live with whatever deal the customer cuts. Typically, as part of its "due diligence," the financial institution will want to have a copy of the purchase agreement (to see exactly what the deal is) and perhaps the pre-buy evaluation report (to learn about the aircraft).
The institution will doubtless also require an appraisal of the aircraft. Some lenders are content with a "desktop" appraisal based on the pre-buy report (especially if they are chiefly relying on the borrower's credit), but others will have an appraiser visit the aircraft. Either way, if the appraisal comes in below the loan amount, the institution will probably want a security deposit to cover the difference or, alternatively, additional collateral, such as a pledge of securities. This may be unnecessary where the loan is already cross-collateralized with all of the customer's assets held by the lender-a typical feature of private bank financing.
All is well and good as long as the aircraft retains its value. But aircraft, like other assets, depreciate over time. A bank typically protects itself against such depreciation by requiring the borrower to make amortization payments. Thus, as the aircraft becomes less valuable, the outstanding loan amount and the bank's exposure decrease.
These days, however, some borrowers negotiate loans with no amortization-an interest-only facility with a "balloon payment" of the principal at the end-or at least no amortization in the early years, according to Matt McNamara at Fifth Third Leasing. With the principal amount remaining constant, if the lending institution must foreclose on the aircraft, nothing protects it from the shortfall except the borrower's credit. Moreover, even that is no help in so-called "nonrecourse" deals. In those, the lender has no recourse against the borrower in the event of a default and must rely solely on the aircraft for repayment.
Nonrecourse business aircraft financing deals are unusual, and for good reason. In a classic nonrecourse loan, when the borrower defaults, the financial institution's remedy is to foreclose on the airplane. Thus, if the aircraft's value is less than the outstanding loan, the institution will come up short. In general, this is anathema to lenders, especially banks. To protect itself from this risk, the financial institution is likely to require some "cushion." For example, it might finance only 70 percent of the appraised value or require a substantial "security deposit" to help cover a shortfall. Further, since the lender is taking much more risk than in a recourse financing, the cost of the financing is bound to be unattractive for the borrower. In the end, only die-hard nonrecourse borrowers are likely to have the stomach for nonrecourse pricing and terms.
Anyone planning to do "nonrecourse" financing should read his documents carefully. The financing may be "nonrecourse" in name only. For example, the loan may be fully recourse on many contractual obligations, like the requirement to provide insurance or to keep the aircraft free of liens. In addition, some "nonrecourse" financings may require the borrower to repay at least part of the loan.
We've seen that normal depreciation can put the asset coverage of an aircraft loan or lease underwater, especially if the loan has no principal amortization. But even where principal amortization offsets depreciation, the lender is exposed to an even more significant danger: falling prices. The business aircraft market can change dramatically during the five- to 10-year period of a typical financing.
In a falling economy, aircraft availability will increase and prices will fall.
Recently, many people have been wondering whether the sub-prime mortgage fiasco would affect aircraft lending. One industry source I talked to worried that shell-shocked banks would be less willing to lend for business aircraft purchases. Another aviation loan professional told me aircraft financing might become more expensive as a result.
But the subprime mortgage debacle doesn't worry veteran aircraft lender Mike Gaffney at Banc of America Leasing. "When something like the sub-prime bubble bursts," said Gaffney, "there's a flight to credit safety. Interest spreads can actually go down under these circumstances for good credits." The old chestnut that banks want to lend only to people who don't need the money is as true as ever, and when there's a credit crunch, lenders compete even more fiercely for good borrowers. And people buying business aircraft generally have excellent credit.
For now, the climate for business aircraft finance remains strong and competitive, with continuing rate compression. "If there's a problem," said Key Equipment Finance's Bill Dougherty, it's too many banks chasing too few assets." Dougherty speculated that the advent of VLJs (very light jets) might attract new buyers to the marketplace and thus provide more financing opportunities. VLJs will especially appeal to institutions seeking to loan no more than $5 million. For many financial institutions, however, one attraction of business aircraft lending is the ability to loan $30 million or more on a single asset. Once in place, the loan is easy to administer. In most cases, covenants like quarterly business cash-flow targets that are essential to business loans are irrelevant to an aircraft financing, and an annual financial update is all that is required.
Since a $10 million Hawker involves just as much work for a bank as a $40 million Gulfstream, the bigger the aircraft, the better. Many banks actually have a minimum transaction size. Mary Schwartz, head of global aircraft finance at Citi Private Bank, said its minimum transaction is in the $3 million to $5 million range, which effectively rules out many VLJs. Most of Citi's loans are on fairly new, larger and long-range aircraft.
Another expanding area is overseas business aircraft loans and Schwartz reported significant growth in such loans. This corresponds to a trend among aircraft manufacturers such as Gulfstream and Bombardier, which are selling an increasing percentage of new aircraft in Europe, the Middle East and Asia. Some lenders, such as Richard Crofton at CIT Equipment Finance, actually seek out and specialize in overseas aircraft financings.
The Lease Option
Financial institutions have, I think, traditionally preferred leases, especially if they can use the tax depreciation. In setting residual values, savvy leasing companies are apt to err on the conservative side and consider aircraft prices, not only today, but over several years in the past. If they make the right assumptions, they can come out ahead.
Many buyers also prefer leases, as they give the lessee the right to walk away at the end of the lease, leaving the leasing company with the problem of disposing of the aircraft, which can be a valuable feature when prices fall. Moreover, many aircraft buyers can't use tax depreciation. They may not employ the aircraft in a trade or business, or if they do, the business may lack sufficient taxable income. In theory, a lease allows the lessee to take advantage of tax depreciation through the relatively lower payments of the lease, as compared with a loan.
Even if you can use depreciation deductions, a lease may be the way to go. A leased aircraft doesn't appear as an asset on the lessee's balance sheet. This leads to a couple of advantages. As one leasing-firm executive put it, a company may choose to lease its aircraft in an effort to make it less obvious to investors that it has four business jets. Downplaying the ownership of business jets is coming back as a reason for some companies to lease aircraft even though they could use the depreciation. And if it's important to make your after-tax financials look as good as possible, leasing can eliminate the depreciation hit to income. Finally, if there will be significant nonbusiness use of the aircraft, a lease may be an attractive way to avoid the potential loss of depreciation deductions caused by the 2004 Jobs Act.
But it is hard to discount the advantages of loans. Loan financing requires that you, not the lender, own the aircraft. If you're worried about market depreciation, this may not be appealing, but if you have an appetite for tax depreciation, it should be. On a standard five-year MACRS depreciation schedule, the taxpayer can write off more than half the cost of the aircraft in the first two years. If you buy a $20 million aircraft, that's like getting a $4 million interest-free loan from the IRS.
Equally important is the flexibility that debt-financing provides. Subject to any prepayment or blackout period at the outset, the borrower can pay off the loan at any time. Falling interest rates, the availability of cheaper loans and a desire to sell the aircraft are all good reasons to refinance or terminate a financing. You can usually get out of a lease in midstream when there's no early buyout, but unless you plan to replace your aircraft with a new one that will also be financed by the leasing company, it's likely that you will pay a stiff penalty.
This is a challenging time for aircraft finance providers and a good time for aircraft finance buyers. If you're in the market to finance an aircraft, shop around and solicit several proposals. You may be surprised at how well you can do.