Still Sporadic Demand But Lessors Start to Dictate Rates

As lease rentals show a measure of improvement and the majority of negative pressures that have battered investor confidence dissipate, the long standing decline in jet values may be coming to an end, at least for some types.

Lessors, still coming to terms with balance sheet adjustments resulting from previous reductions in lease rates and values, are beginning to fight back. Market conditions have improved sufficiently as to allow lessors back into the pilot's seat, albeit for some aircraft. Rental levels on a number of differing types have improved such that values have stabilized or actually increased. Henry Hubschman, president of GE Capital Aviation Services (GECAS), has reportedly seen "firmness" in some aircraft values with "no airlines getting any further pricing relief". Despite the "merger" of Air France and KLM, the prospect of another major airline collapsing, particularly among the U.S. majors, has receded sufficiently as to induce a degree of optimism. The recent agreement between Air Canada, lessors and Export Credit Agencies on revised financing arrangements represents a key stepping stone to an improvement in perceptions. The predicament of Atlas and the prospects for the 12 B747-400Fs financed under an Enhanced Equipment Trust Certificate (EETC) arrangement remains a concern, however.

This view is in stark contrast to six months ago when the market, values and rentals were reeling from a multitude of negative factors encompassing Iraq, SARS, corporate failures, languishing stock market, and tottering economies. The unraveling of complex financing arrangements led to aircraft, not all of which were in the best of conditions, being handed back to inexperienced financial institutions. Some owners sought a quick resolution and accepted offers equating to distressed sale pricing even to the extent of scrapping relatively young equipment. The magnitude of the difficulties experienced in the first half of the year are still likely to distort full year results. GECAS is expected to report an increase of some $50 million in write-offs for 2003 attributable, in part, to the previous decline in lease rentals. All GECAS aircraft due for delivery in 2004 are leased with 75 percent of those scheduled for delivery in 2005 also placed.

With data now showing an improvement, the cyclical low point for the industry occurred in the second, rather the current third, quarter of 2003. The improvement in rentals, though increasingly discernible, is far from spectacular or widespread. However, the rise in rentals offers the prospect of increases in rates for other types as well as improved remarketability. The aircraft types that have been increased activity focus mostly on narrowbodies. Some airlines are also finding difficulty in acquiring aircraft such as the B737-800. Boeing [BA] is reportedly considering increasing the monthly production rate of the B737 from 14 to 17 a month by year end and possibly to 20 per month by early 2004. Even the contemplation of such a rise points to a reversal in perceptions. Rentals of the -800 have seen a modest rise in recent months such that rates are nudging through the $300,000 per month barrier having previously been around $270,000 per month. Values of the -800 have already stabilized with new examples enjoying a slightly higher price than six months previously. Even rentals of the B737 Classic, a type that has seen a significant slide in values and rentals over the last few years, not least due to the structure of some financing arrangements, has seen a rise in rentals. The -400 in particular appears to be exhibiting an improvement with rates of ten year old examples now regularly topping $150,000 per month. This rise in B737 Classic rentals could help to slow or halt the decline in values.

Though there exists no clear correlation between the behavior of market rentals and values, at the very least it will allow the lease rate factor (the monthly lease rental expressed as a percentage of the current market value) to increase to beyond one percent, the benchmark for an economic return on a 10-15 year old aircraft. The principal effect of any improvement in rentals should be to dissuade owners from considering a distressed sale or parting out, moves that have previously served to further undermine rentals and values.

Despite the improvement in values in some areas, there exists little prospect of a widespread revival in values in the short term. The number of used aircraft market is of sufficient magnitude as to take years to dissipate. Even assuming that the manufacturers refrain from increasing production, an event that seems unlikely in view of the potential 35 percent increase in B737 production, the market will have to enjoy a sustained period of growth, similar to that of the late 1980s, as to allow a measure of equilibrium to return. While the next twelve months will see an increase in rentals for more modern narrowbodies, the wider market may have to wait until 2005.