Jan. 11, 2016
New lenders and new rules are reshaping the market.
Since the market crash of 2008, aircraft buyers have faced an acutely tighter credit market. For several years following the Great Recession, market analysts reported that most deals were financed with cash, and many would-be buyers simply concluded that banks weren’t lending money for aircraft purchases.
“That’s partly true, but it doesn’t describe the entire market accurately,” said Scott O’Brien, NBAA senior manager of finance and tax policy. “Companies with large cash reserves and high-net-worth individuals, well-known to their banks, were able to get credit. Now, we’re seeing some market shifts and new non-bank lenders entering the market, making financing more available to other buyers.”
Lenders say capital is flowing back into aircraft finance, and the overall U.S. economy is strong, making loans on business assets – such as aircraft – attractive investments. But the way capital flows to business aircraft has changed.
“Banks certainly are lending on business aircraft today, more so than they were in 2008, or even two or three years ago,” said Ford von Weise, director and head of global aircraft finance for Citi Private Bank. “We’re seeing increased competition in the space. Lenders who’ve never been in aircraft finance are entering the market.”
AIRCRAFT MARKET RECOVERS
The growth in lending is driven by rising demand for business aircraft, providing some relief for residual values (the amount a bank can recover from an aircraft after a lease is up, or as collateral on a loan).
“Look back to 2009, 2010, 2011 and 2012, every year the forecasters kept saying, ‘This is the year the market recovers.’ Eventually, they turned out to be right,” said Shawn Vick, executive director and chairman of Global Jet Capital.
It’s taken that many years for the fleet of pre-owned aircraft, whose values had plummeted, to be absorbed by the market. While orders for long-range, large-cabin aircraft had been strong for several years, demand for light and mid-size aircraft only started to recover in 2015.
“More corporate buyers are returning to the aircraft market now, as the stability of the market continues,” said Michael Amalfitano, executive vice president and senior managing director of business aviation at Stonebriar Commercial Finance. “That’s a sign of growth, which is welcome for lenders.”
In 2008, when asset values fell around the globe, business aircraft were hit with a one-two punch, following the Big Three automakers’ appearance before Congress.
For years after the financial crisis, “no one knew what anything was worth anymore,” said Vick, and, as the downturn lengthened, many banks had to write-down down the value of their business aircraft loan portfolios. As recently as the first quarter of 2015, some banks missed earnings targets because of business aircraft write-downs.
“After the crisis, aircraft residual values were not as predictable as they were before the crisis. That’s one factor that made some banks shy away from lending on aircraft,” explained Amalfitano. “The second factor is the impact of heightened financial regulation.”
REGULATION FRAGMENTS THE MARKET
Just as banks responded to the financial crisis by lending more conservatively, regulators responded by raising requirements for credit. The Dodd-Frank Act, passed by Congress in 2010, and the Basel III accords, agreed to by dozens of countries and implemented by several agencies in the U.S., both require banks to hold more capital against their loans.
“The amount of capital you have to hold under Basel III is directly tied to the underlying quality of the credit,” said von Weise. “So, for banks, there’s been a migration to the highercredit end of the market.”
With higher capital requirements tied to credit risk, banks have either raised interest rates across the board or moved to only serve clients with which they have long-standing relationships, or who have “investment grade” credit.
Financial models assume credit risk increases with longer- term loans, so banks are also limiting most aircraft loans to five years. (The loan is amortized over 15-20 years, but paid off in full with a balloon payment after the first five years.)
Basel III ties capital requirements not just to the borrower’s credit, but also to the underlying risk of the asset, and – because of the unpredictability of aircraft residual values since the financial crisis – aircraft are regarded as riskier.
Complicating matters further, Dodd-Frank and Basel III regulate big banks – otherwise known as “systemically important financial institutions” (SIFIs) – differently than regional banks or community banks.
“The word ‘bank’ is too generic,” said Amalfitano, “the lending landscape in the U.S. is very fragmented across a diverse group of bank and non-bank lenders.”
The migration of banks, especially the large SIFIs, to the higher end of the credit spectrum left a gap in the middle of the market that new non-banker lenders have started to fill. These lenders, including Global Jet Capital and Stonebriar, are typically backed by private equity or insurance capital and are classified as commercial finance companies or independent financiers.
Most non-bank lenders have entered the business aviation market in the last two years, led by veterans of aircraft finance. Whereas the large banks classified as SIFIs mostly help existing customers to finance purchases of new or “like new” aircraft with traditional five-year loans, non-bank lenders tend to offer different types of credit, on different types of aircraft, to different types of buyers.
“The majority of our clients are middle-market companies, including private and small public companies,” said Amalfitano. “We’re targeting pre-owned aircraft, everything from turboprops to large-cabin jets, and especially older aircraft, providing tailored financing through both leasing and loans.”
Banks certainly are lending on business aircraft today, more so than they were in 2008, or even two or three years ago.
Several non-bank lenders offer capital leases and operating leases, as well as traditional loans, for terms of five, seven or 10 years. Both banks and non-bank lenders will finance 70 to 100 percent of the aircraft’s value, depending on the borrower’s credit and the aircraft’s estimated residual value.
THE BIG QUESTION MARK
While aircraft residual values have stabilized on average, compared to when the market was in free-fall, it is still harder to predict what a particular aircraft will be worth in 10 or 12 years than it was before the crisis. In general, lenders tend to assume business aircraft are depreciating faster than before
“There has absolutely been a change in the rate of depreciation for business aircraft since the recession,” said Vick. “It’s very much a situation that’s still in flux.”
Before the recession, it was commonly assumed that business aircraft would lose 4 to 6 percent of their value every year. Today, for aircraft that are new to five years old, Amalfitano reports that lenders assume a rate of depreciation of 6 to 8 percent. For aircraft 10 years and older, lenders might assume an annual rate of depreciation higher than 10 percent, but it’s not a simple function of the aircraft’s age.
“The rate of depreciation for a given aircraft make and model, in any category, is based on the available inventory, market demand and the production lifecycle for that model,” said Vick. It’s also driven by manufacturer warranties and the extent of any engine maintenance programs.
More than ever before, however, it’s driven by avionics technology. Regulatory deadlines for ADS-B and data link equipage are making some aircraft that are more than 15 or 20 years old prohibitively expensive to upgrade. Even for newer aircraft, synthetic and enhanced vision and other avionics technologies are evolving faster than ever.
“What we don’t know is – because it’s a new phenomenon – are aircraft seeing shorter financial lives because of the faster technology cycles for avionics?” said von Weise. “That’s the elephant in the room when it comes to aircraft residual values and financing terms.”
If the aircraft financing market is more fragmented today, with different types of lending available depending on the quality of the borrower’s credit, how do lenders determine your creditworthiness?
“We use the old-fashioned factors of creditworthiness: total assets, liquidity, cash flow and level of debt,” said von Weise. “Essentially, we’re asking: ‘Do you have enough money to buy the airplane? Do you make enough money to pay for it? And do you have enough cash to cover costs that come up?’”
In addition to the borrower’s credit, lenders also weigh their ability to secure the collateral and its underlying worth.
“Of course, we want to lend to a strong, growing business that’s well-managed,” said Amalfitano. “but we’re also looking at the aircraft as an asset: Is it equipped with modern technology, including upgraded avionics? Does it have warranties from the manufacturers, maintenance programs and the proper insurance? How is it being used, is it under management? And how deep is the resale market?”
Finally, borrowers should be aware of increased scrutiny under “Know Your Customer” standards and anti-money-laundering laws. “In this day and age, anyone who believes they’re going to finance an aircraft without that kind of transparency is likely not going to be successful,” said Vick.
- Secured loan – Sometimes called “direct lending” or simply “financing,” this is a traditional amortized loan, like a mortgage, where the financial institution lends all or part of the money to purchase an aircraft up front. The borrower takes title of the aircraft and can deduct depreciation for tax purposes, but if the borrower defaults on the loan payments, the lender has a security interest in the aircraft as collateral.
- Capital lease – In this arrangement, sometimes called a “finance lease,” the lender acquires the title to the aircraft, not the borrower. However, in many ways the borrower acts as the aircraft owner: The aircraft must be capitalized on the operator’s balance sheet, and the operator can still take depreciation for tax purposes.
- Operating lease – This structure is usually favored by operators that intend to hold the aircraft for a shorter period of time (five to 10 years), or otherwise want to limit their residual-value risk. Like a traditional lease, the lender retains title. In general, the aircraft is not capitalized on the lessee’s balance sheet and the lease payments are treated as operating expenses, similar to fuel. Aircraft tax depreciation deductions are usually not available to the lessee.
“When some well-known large banks were not lending as usual, or as they had been, the general perception was that banks weren’t lending,” said Eduardo Ferreira, vice president and aircraft finance officer at 1st Source Bank. “In reality, banks didn’t stop lending. Adjustments in lending practices simply demanded higher credit quality and lower risk.”
1st Source is a regional bank, smaller than the largest banks (which are also known as “systemically important financial institutions”) but larger than a community bank or non-bank lender. (The name 1st Source can be confusing, because 1st Source has a Specialty Finance Group covering the whole United States and Latin America.)
Regional banks, which have always been involved in aircraft financing, are staking out their segment of the market.
“At 1st Source, we specialize in aircraft transactions under $15 million,” said Ferreira. “As we move further away from the economic downturn, more banks seem to be looking at aviation as an appealing investment. Especially considering current aircraft values.”