Valuing Aircraft with a Lease Attached An Appraiser’s Perspective

Executive Summary

Operating leases of commercial aircraft make up approximately 40% of the world’s fleet.

The need for Lease-Encumbered Valuations is increasing as more and more aircraft are sold or financed with leases attached.

Because a Lease-Encumbered Value (“LEV”) opinion requires access to lease contract details, providing this type of value opinion will only be possible with the cooperation from the client and lessor or lessee.

The level of cooperation will vary, therefore, the approach to determining a Lease-Encumbered Value may range from a simple analysis of calculating the present value of the rents and residual to the more complex modeling of cash flows which involve forecasting maintenance events, reserve balances, return compensation, and interpreting lease language.  Either approach is acceptable if the assumptions and methodology are clearly explained in the valuation report and the appraiser has the required skills to complete the analysis.

The purpose of this paper is to examine the methodology of valuing aircraft with a lease attached from the perspective of an aircraft appraiser using a real-world example.

Douglas B. Kelly

Senior Vice President – Asset Valuation, ISTAT Certified Senior Appraiser

AVITAS— 14520 Avion Parkway, Suite 300, Chantilly, Virginia 20151

T: (703) 476-2300 DD: (703) 476-2498 E: doug.kelly@avitas.com

February 11th, 2019

Download PDF version “Valuing Aircraft with a Lease Attached An Appraiser’s Perspective“

Introduction

Operating leases of commercial aircraft did not exist 50 years ago.  Airlines purchased aircraft with cash or financed them with debt.  Aircraft leasing began in the early 1970s and has grown from less than 2% of the fleet in 1980, to a little less than 20% in 1995, to approximately 40% today.  And with a global fleet of over 25,000 commercial jet aircraft in service, aircraft leasing is now a very big business.   In 2018, of the nearly 1,700 aircraft delivered and valued at $100 billion, lessors financed over 40% of the deliveries.

There has also been an influx of new lessors over the last five years mostly coming from China and Japan.  Today, there are over 150 aircraft lessors worldwide with the top 25 lessors controlling roughly 70% of the leased fleet.

The Figure below depicts the top 25 aircraft lessors by market value of the fleet.

Figure 1

Aircraft leasing is expected to continue growing as the world fleet expands.  Growth in the number of aircraft parallels the increase in passenger traffic and, as such, the airline industry has demonstrated robust growth in terms of both the number of aircraft and passenger traffic as depicted in the following Figure.

Figure 2

Over the last 45 years, traffic has grown at an average annual rate of 6.0%, while the fleet has grown at an annual rate of 4.2%.  Growth in passenger traffic, as measured by Revenue Passenger Kilometers (RPKs), drives the need for additional aircraft capacity.  If the fleet growth rate continues at the expected rate of 3.5%, the jet fleet will double in about 20 years to over 50,000 jet airplanes, of which about half will be leased.

As the global fleet expands, so does aircraft trading, and as a result, the demand for aircraft appraisals increases.  Because most commercial aircraft trade these days with a lease attached, and this will only continue to grow, some in the industry suggest appraisers should provide more lease‑encumbered valuations, which are also known as Financial Appraisals (see “Values and Valuers” by Dick Forsberg of Avolon, February 18, 2016).  A financial appraisal is one that determines the value of an aircraft to an investor based upon the income earning potential from its lease and residual value.

AVITAS agrees that certain appraisal assignments may require a Lease-Encumbered Value and this need is increasing as more and more aircraft are sold or financed with leases attached.  However, this does not mean that opinions of Base Value and Current Market Value or other values are no longer relevant.  It just means that the appraiser needs to provide a value appropriate for the business decision of the client.   In determining the appropriate value, the appraiser may consider their client’s instructions or may obtain legal or other professional advice, but the selection of the appropriate or relevant value is the appraiser’s sole responsibility (ISTAT Appraisers’ Handbook).

Because a Lease-Encumbered Value opinion requires access to the lease contract details, providing this type of value opinion will only be possible with the cooperation of the client and lessor or lessee.  The level of cooperation may vary, therefore, the approach to determining a Lease-Encumbered Value may range from the simple analysis of calculating the present value of the rents and a residual value to the more complex modeling of cash flows which involve forecasting maintenance events, reserve balances, return compensation, and interpreting lease language.  Either approach is acceptable if the assumptions and methodology are clearly explained in the valuation report and the appraiser has the required skills to complete the analysis.

The purpose of this paper is to examine AVITAS’s methodology in determining Lease-Encumbered Value (“LEV”) using a real-world example.

“If the fleet growth rate continues at the expected rate of 3.5%, the jet fleet will double in about 20 years to over 50,000 jet airplanes, of which about half will be leased.”

LEV Example

A good place to start is with the definition.  AVITAS prefers the term Lease-Encumbered Value to Securitized Value; however, the terms are synonymous.  AVITAS’s value definition of Lease-Encumbered Value conforms to that of the International Society of Transport Aircraft Trading (“ISTAT”), adopted in January 1994 and updated in March 2018, and is summarized as follows:

• Securitized Value or Lease – Encumbered Value is the appraiser’s opinion of the value of an aircraft under lease, given a specified lease payment stream (rents and term), an estimated future residual value at lease termination and an appropriate discount rate.

Comment. The Securitized Value or Lease – Encumbered Value may be more or less than the appraiser’s opinion of Current Market Value.  The appraiser may not be fully aware of the credit risks associated with the parties involved, nor the time‑value of money to those parties, nor with possible tax consequences pertaining to the parties involved, nor with all of the provisions of the lease that may pertain to items such as security deposits, purchase options at various dates, term extensions, sub-lease rights, repossession rights, reserve payments and return conditions.

In other words, LEV is simply the present value of the remaining cash flows of the aircraft under lease.   The concept of present value recognizes the time value of money, that is, one would rather have a dollar today than a dollar in the future due to inflation, opportunity cost, and risk.

The formula for calculating the present value of a schedule of cash flows is shown below:

where:

N = the number of cash flows.

Values = the future cash flow.

i = the number of periods of the cash flow.

rate = the periodic discount rate.

Calculating Present Value (PV) or Net Present Value (NPV) is made easier with the functions available in Microsoft Excel. The potential complexity of the LEV analysis is described in the comment section of the definition in that the appraiser may not be fully aware of the credit risks, the time value of money to the parties, possible tax consequences, purchase options, extensions, sub-lease rights, reserve payments, return conditions and return compensation.   Some of these complexities will be addressed later in this report but, for now, let us focus on a basic example.

At a minimum, the information we require from the client to prepare an opinion of LEV is the following:

• aircraft type, basic specifications, and build date;
• lessee;
• lease rate;
• lease term (payments remaining);
• payments in advance or in arrears; and
• return condition assumption at lease termination.

For this example, let us assume we have been provided with the following information from the client:

To complete the information necessary for the analysis, the appraiser must then establish a discount rate and an assumed residual value at lease termination adjusted for full-life condition.

Choosing an appropriate discount rate requires considering the credit risk of the lessee and asset quality along with the current interest rate environment.  An analysis of a lessee’s credit risk can be a very involved and time-consuming process of gathering and reviewing financial statements and, therefore, is usually beyond the scope of this type of appraisal.  Some subscription services such as The Airline Analyst (offered by Airfinance Journal) can assist the appraiser in this process.  However, with only basic knowledge of the airline and aircraft, the appraiser can, in most cases, quickly categorize lessees into categories of good, average, or poor credit risk.  Lufthansa, for example, might be considered a “good” credit risk.

The appraiser can do the same for the asset quality using the same categories above.  The A320-200 built in 2012 with CFM56-5B4/3 engines would also fall into the “good” category.

AVITAS assumes a discount rate of 6.5% for this airline credit and asset, given the current market conditions and expectations of an acceptable rate of return.  This rate is a 1.8% premium to the corporate BBB yield of 4.7% as measured by Deutsche Bank or Bank of America Merrill Lynch and compares to a 10-year U.S. treasury yield of 3.0%.  Higher discount rates would be more appropriate for riskier credits and assets.  More volatile market conditions can also warrant higher discount rates.  In October 2008 during the Great Recession, the 10-year treasury fell to 2.0% while the corporate BBB yield spiked to over 10% (see Figure below).

Figure 3

Next, the appraiser must decide on an assumed residual value at lease expiration and adjust for return conditions.  At AVITAS, the assumed residual value is different than our half-time Future Base Value opinion that can be found in our BlueBooks, Online System, or formal appraisals.  This is because we adjust it to reflect a higher confidence level similar to what a prospective buyer might assume.

The amount that we discount our Future Base Value opinion will depend on expected overall market conditions at the time of lease expiration and the value volatility of the particular aircraft.   Typically, we will assume 0% inflation to remove inflation risk and then apply a “markdown” or value reduction of 10% for conservatism to account for market risk, provide a higher confidence level, and account for transaction costs.  While a markdown of 10% may be typical today for an A320-200, other aircraft types may warrant a larger or smaller reduction.  The markdown for an A380, for instance, will most likely be significantly higher to reflect the uncertainty in forecasting the residual value at lease expiration.  Ultimately, this markdown should adjust the residual to the level a prospective buyer would assume.

Once we determine this half-time residual value opinion, then we adjust for return conditions.  Most leases for young aircraft require the lessee to return the aircraft in the same condition as at delivery either by performing the maintenance work or paying the equivalent compensation as an economic settlement.  Since our assumption from the client is 100% life remaining, we need to calculate the adjustment from half-life to full-life.   The major events of scheduled maintenance include airframe checks, landing gear, engine overhauls, engine life limited parts, and APU.   The total cost of these maintenance events for an A320-200 is $16.74 million in 2019 dollars.

Because we are beginning with the value assumption that the aircraft is midway between its scheduled maintenance events, we are only going to add 50% of the total cost ($16.74 million x 50% = $8.37 million) to derive a residual value that represents 100% life remaining.   The return condition adjustment of $8.37 million is escalated by 2.5% per annum to calculate the adjustment of $8.79 million in 2021 dollars.  Historically, maintenance escalation has been closer to 4% overall so the assumption of 2.5% escalation may be considered conservative.

Details of the residual value calculation from half-life are shown in the Figure below:

Figure 4

Now that we have all the inputs and assumptions necessary to calculate the LEV, we can calculate the present value using the formula described earlier.  An illustration of the series of rent cash flows being discounted monthly is shown below:

The calculation of the present value is made easier with the PV, NPV, and XNPV functions available in Microsoft Excel (see Excel for Office 365).  To use the PV function, the cash flows must be constant throughout the period.  If the cash flows are not constant, such as a variable rent payment or adding a future residual value at lease termination, then the analyst must use either the NPV or XNPV functions.

We prefer to use the XNPV function in Microsoft Excel because it can calculate the present value for cash flows that are not necessarily periodic.   If all the cash flows occur at regular equal-time intervals, then the NPV function is acceptable as well.

The syntax of the XNPV function is:  XNPV(rate, values, dates)

XNPV is calculated using the formula below:

where:

• rate = the discount rate to apply to the cash flows.
• di = the ith, or last, payment date.
• d1 = the 0th payment date.
• Pi = the ith, or last, payment.

The AVITAS Online Value System uses the same formula as the XNPV function in Excel for calculating the present value of cash flows (rents and residual) in determining Lease-Encumbered Value.  In other words, the future cash flows are discounted daily based on a 365-day year.

Figure 5 on the next page shows an example of the LEV input and output sections of the AVITAS Online Value System.  The output section at the bottom of the Figure shows the schedule of cash flows consisting of the dates of each remaining payment, rent ($330,000 per month), residual at lease expiration, and the return condition adjustment at lease expiration.

Figure 5

The results indicate a total present value or LEV of $34.35 million.  This value is a 9.9% premium to our Current Market Value of $31.25 million and a 23.1% premium to Base Value of $27.9 million.  Changing the discount rate to 8% would decrease the LEV to $33.5 million and assuming 50% return conditions rather than 100% reduces the LEV to $26.6 million.  Obviously in this case, the assumed residual value adjusted for return conditions has a much greater effect on the LEV than the discount rate.

While LEV is often greater than an appraiser’s opinion of Market Value, in certain circumstances, the LEV may be less than Market Value.  This may be the case when a lease rate was negotiated during a recession with a weak airline credit.  For this reason, lessors typically negotiate a shorter term, so they can adjust the rate upward when the market recovers.

“A financial appraisal is one that determines the value of an aircraft to an investor based upon the income earning potential from its lease and residual value.”

Advanced Concepts of LEV

The example above reflects a simple approach to determining LEV that can be handled by most appraisers.  However, sometimes the assignment may demand using more advanced techniques that should only be attempted by those with the requisite skills, knowledge, and experience.

This may include reviewing the lease documents (including all amendments and side letters), understanding purchase and lease options, and interpreting the lease language.  Lessors and lessees at times may disagree on the interpretation of the language in a lease such as the return conditions.  The definition of engine shop visit is commonly negotiated and debated as is the lessee’s substitution rights of engines.

If maintenance reserves are required to be paid by the lessee, then the appraiser must forecast the maintenance inflows and outflows until the lease expiration and consider the minimum return conditions.   Sometimes sellers will withhold a portion of the reserve balances and leave it to the buyers to determine if the aircraft is adequately reserved for future maintenance events.  Therefore, forecasting maintenance events accurately becomes critical to determining the correct price a buyer should pay.

Forecasting the maintenance condition by month until the end of the lease may require judgment from the analyst on the build standard of engine shop visits and what engine life limited parts should be replaced (new or used) based on the cycles remaining and expected time between overhauls.

For those lessees who do not pay maintenance reserves, there may be a return compensation requirement at the end of lease to compensate the lessor for the change in maintenance status.  Usually the return compensation clause will benefit the lessor; however, when the return compensation is two-way and the maintenance status is better at lease end than at delivery, then the lessor makes payments to the lessee.  This is commonly referred to as “upsy/downsy” compensation.

These factors and other complexities of aircraft leasing can make determining LEV much more challenging than the simple approach described in this report.

Conclusion

Of the 25,000 commercial jets in service today, approximately 40% are leased.  Leasing has become a big business and, with the fleet expected to double in 20 years, leasing is also a growing business.   As the global fleet expands along with aircraft trading, the demand for aircraft appraisals increases.

AVITAS believes that certain appraisal assignments may require a Lease-Encumbered Value and this need is increasing as more and more aircraft are sold or financed with leases attached.   This does not negate the value of the traditional opinions of Base Value and Market Value.  For many assignments, the values may be complementary, and the client may desire to have all of them included in an appraisal.  While the appraiser may consider the client’s instructions, it is ultimately up to the appraiser to select the appropriate value for the assignment.

Because a Lease-Encumbered Value opinion requires access to the lease contract details, providing this type of value opinion will only be possible with the cooperation of the client and lessor or lessee.  The level of cooperation may vary, therefore, the approach to determining a Lease-Encumbered Value may range from the simple analysis of calculating the present value of the rents and a residual value to the more complex modeling of cash flows which involve forecasting maintenance events, reserve balances, return compensation, and interpreting lease language.  Either approach is acceptable if the assumptions and methodology are clearly explained in the valuation report and the appraiser has the required skills to complete the analysis.

.

 “However, sometimes the assignment may demand using more advanced techniques that should only be attempted by those with the requisite skills, knowledge, and experience.”

Download PDF version “Valuing Aircraft with a Lease Attached An Appraiser’s Perspective“

Glossary of Terms

The following are some of the key terms found in a typical lease agreement:

Rent

The rent is usually paid as a monthly rental amount, but sometimes it may be negotiated as a quarterly or semi-annual payment.  The lessor will determine the rent based on its own cost of funds, required return on investment and the credit quality of the lessee; however, ultimately the rent is a negotiated amount based on the market conditions at the time.

Term

A typical term for new narrowbody aircraft is 6-10 years while widebody aircraft lease for 10-14 years. Used aircraft terms are around half of new aircraft, at 3-5 years for narrowbodies and 5-7 years for widebodies. In times of recession when rents may fall significantly, lessors tend to manage their exposure by shortening the lease terms so that they can then raise the rents when the market improves.

Security Deposit

Lessors generally require a first and last monthly rental payment as a security deposit to protect them in case of a default by the lessee. The negotiated security deposit varies and is generally a function of the creditworthiness of the lessee and may be waived.  Security deposits take many forms, the most common being cash. The use of Letters of Credit (“LC”) is also common, whereby the lessor may call on the LC in the event of a default without further discussion or negotiation with the lessee.

Maintenance Reserves

Maintenance reserves, when paid under a lease, can serve to protect asset value and mitigate credit risk of weaker airlines.  In the event of a default by the airline, the aircraft may require expensive maintenance work before it can be re‑leased or sold to another airline or investor. Maintenance reserve payments are made by the lessee to the lessor to accrue for the scheduled maintenance events that require significant cost and aircraft downtime. The areas of maintenance covered by reserves may include airframe checks, landing gear overhauls, engine overhauls, engine life limited parts, and auxiliary power unit (APU) overhauls.

When maintenance reserves are paid under a lease, the airline generally pays a monthly amount to the lessor based on the airline’s utilization of the aircraft. When a particular maintenance event (e.g., a landing gear overhaul) is performed, the airline lessee requests a drawdown of the maintenance reserves that were paid. The lessor reimburses the lessee for that maintenance expense to the extent that the maintenance reserves were paid to the lessor in respect of that maintenance event.  Normally, the lessor is only responsible for paying out no more than the amount collected. If the maintenance event costs more than the cumulative maintenance reserve payments for that event, the airline is responsible for any shortfall. Conversely, if the cost of the maintenance event is less, some leases may allow for maintenance reserve balances to accrue to the lessor.

Aircraft operating leases are highly negotiated and not all leases include provisions for maintenance reserves. Like security deposits, maintenance reserve provisions may be waived for airlines with good credit.

Return Conditions

Residual value of the aircraft is a key consideration in the lessor’s profit model. Maintenance condition directly affects aircraft value. For certain older vintage aircraft, the maintenance condition at the end of the lease can be up to 100% of its value.

Almost all leases contain clauses that describe the conditions that the aircraft must meet at the end of the lease term. These conditions will determine the ease of transferring the aircraft to the next lessee or selling to a prospective buyer. Primary return conditions may include requirements on the condition of the airframe, landing gear, engines, APU, components, Airworthiness Directives, repairs, modifications, and records.

Return Compensation

In lieu of maintenance reserves, lessors may require a return compensation clause in the lease for the lessee to reimburse the lessor for the difference in the maintenance condition at lease termination compared to the maintenance condition at delivery.  This is usually extended to stronger airline credits.  When the return compensation is two-way (also known as “upsy-downsy”), then the lessor is required to reimburse the lessee if the maintenance condition at the end of lease is better than at delivery.

AVITAS is a full-service aviation consulting aviation consulting firm with senior staff that has comprehensive hands-on expertise from all facets of the aviation industry.  Founded in 1985, AVITAS is the leading aircraft expert advisor to financial institutions, airlines, manufacturers, law firms, maintenance facilities, and government agencies.  Our offices are located in Washington, D.C., New York, and London.

AVITAS Online offers you immediate access to aircraft and engine values.  Whether you require specific and customizable values with serial/registration number look-up or a generic value by aircraft/engine type, AVITAS Online offers the most granular view of asset values.

Using our powerful and fast analytical interface, you can obtain single real-time values for your aircraft or engine and, via our fleet import functionality, value your whole portfolio in seconds.  And with our portfolio monitoring feature, you can keep track of your fleet values daily for up to 4,000 aircraft.

AVITAS is pleased to announce the addition of Lease-Encumbered Values to our Online Value System.  You can find out more information about this powerful new feature at www.avitas.com or call (703) 476-2300.