Maintenance Reserves – The Basics
It is all about the risk. Some people are risk adverse and some are risk takers, but when it comes to leasing aircraft or engines, no one wants to be financially responsible for any big surprises. So what’s the risk?
The risk is all about ensuring the owner or lessor always is protected for the full value of the asset. The value of an aircraft (and engines) is principally determined by its vintage (age), where we are in the business cycle, and its maintenance status. Although the value of an asset typically decreases with age the market value is highly dependent on the maintenance status of the engines and airframe. An airframe or engine that is fresh from a recent maintenance overhaul has a higher market value than one that is coming due for major maintenance. So how does the owner protect the value?
Maintenance reserves, sometimes called supplemental rent, are funds collected during the term of the lease to cover the cost of maintenance. These funds are collected to account for the cost of airframe, engine, landing gear, and APU maintenance. The reserve payments, which are included with monthly rent, are based on the cost of each major maintenance event divided by the controlling interval. For example, airframe heavy maintenance is a calendar-driven event. If the heavy check is on a 24 month interval, the monthly maintenance reserve collected from the lessee must be the cost of the heavy maintenance event divided by 24 month interval. The same principle holds true for the engines, but the engines actually have two funds necessary to retain the total market value. The engine has a fund to cover life limited parts (LLP) and a fund to cover performance restoration. The LLPs have a defined number of cycles before they need to be removed from the engine. The cost of the set of LLPs is often in the millions of dollars, so the maintenance reserve is based on the cost of the LLP stack divided by the cycle limit. Similarly, the engine performance restoration, although not a “hard time” interval, is based on the number of hours the engine has accumulated. The cost of the performance restoration is also often in the millions of dollars, and this cost is divided by the anticipated interval in hours between performance restorations. This principle is the same for the landing gear with an overhaul schedule often based in years, and the APU which has an anticipated performance restoration schedule based on hours.
So how do these maintenance reserve payments retain the value of the asset?
In the graphic, you can see the green upper line represents the full life value from the delivery date to the retirement date. The red lower line represents the value of the aircraft when it is “run out.” The aircraft current market value falls between these two lines depending on its maintenance status. In the graphic, the area described as MX Reserves is the accumulation of funds from the various maintenance reserve payments described above. As the aircraft accumulated hours, cycles, and calendar months, the value of the aircraft deteriorates at the same rate as the maintenance reserve funding increases. In principle, the sum of the maintenance adjusted market value of the aircraft and the amount of money in the maintenance reserve fund should equal the full value on the top line. By having this combined value “money and metal” the owner is always financially protected throughout the life of the aircraft.
To address the one obvious question, why does the graphic show the value of a run-out aircraft going below zero at the very end of its life? Some may argue that the aircraft always has a positive scrap value, but often there is an obligation or cost associated with the disposal of the collection of useless parts at the end of a totally run-out aircraft’s life. Although slightly exaggerated, the graphic goes well below zero to illustrate that there may be a point in time where the amount of money in the reserve account exceeds the “full life” value of the aircraft.