What a difference a year makes.
In AIN’s annual report on aviation finance last year (October 2006, page 38), lenders expected 2007 to be reasonably solid or even stronger than 2006. The Federal funds target rate continued to climb from its historic low of 1 percent in 2003 and 2004. The housing market slump was making hardly more than a ripple. Oil prices were coasting back down from $60 a barrel. The bulls ruled the stock market. The value of the dollar was lower than in the past but holding.
As it looks now, the “stronger than 2006” prognosticators were right. Business aircraft manufacturers report increasing sales and bigger backlogs, and deliveries of business jets this year are expected to top 1,000. But these positive statistics are seemingly in defiance of several predicted bugaboos that reared their ugly heads this year.
The housing market downturn turned nasty in August, spreading to unexpected corners of the finance industry. The Fed cut the Federal funds target rate by half a percent in September and then by another quarter in late October, to 4.5 percent, in hopes of balancing the risks of slower growth, or even recession, with the threat of inflation. Oil prices nudged close to $100 a barrel in late October, stoking rising prices at the pump. The stock market hit new highs and then promptly retreated, then did it again and again. The dollar sank to record lows against other major currencies.
Through all this, however, business aircraft, both new and used, continued to sell like tickets to a Blue Man Group performance. A clue to why is in the acronym “BRIC” or “BRICK,” which bizav finance people began batting about nonchalantly earlier this year, as if they’d used it all their lives. It defines the latest hot markets for business jets: Brazil, Russia, India and China–with a few people adding the “K” for Korea (South, not North). And, “Oh yeah,” they add matter-of-factly, “Europe’s not doing badly either.”
“Over the past few years, we’ve seen the business jet market evolve into a more global rather than U.S.-dominated market, and we see that trend continuing,” said Michael Amalfitano Sr., senior vice president, Banc of America Leasing, Corporate Aircraft Finance. “This has helped fuel the growth of the business jet market despite the recent U.S. economic concerns.”
This international demand is turning OEMs’ order books upside down. Whereas before the ratio of U.S. to rest-of-the-world sales was along the order of 80/20, it is now 50/50 or, for some OEMs, even 40/60. This, say some people, represents a new paradigm, in which international sales smooth the historically cyclical dips in the U.S. business aviation market.
Well, maybe. Another time we heard talk about paradigm-shifting economics was right before the dot-com bubble burst on March 10, 2000. While business aviation certainly has little in common with the dot-coms, it is not yet immune to fluctuations of U.S. corporate profits. “The aviation market has always lagged the economy by eight to ten months,” said Joe Dini, senior vice president of Sovereign Bank, Manchester, N.H. “So even if we hit a recession during the first quarter of next year, my experience has shown that it will be a record year. Of course, that means that it will lag coming out, too.”
Tipping the Scales
When Honeywell Aerospace released its annual market forecast in September, one surprising statistic stood out. Of all the regions surveyed, only North America suffered a decrease in fleet-acquisition expectations from the previous year, while most of the remainder of the world anticipated vigorous growth. Despite this anomaly, the industry is still experiencing boom times, because, explained Amalfitano, it does not mean that fewer aircraft are being sold in the U.S. On the contrary, the overall market is larger; the U.S. market is simply increasing at a slower pace than the global market.
Thus, for the first time, airframers are reporting more international orders than domestic ones, spurring confidence in the industry, despite the financial turbulence from the U.S. “Overall, today we see about fifty percent of the deliveries from the current OEMs occurring outside North America,” said Rob Wilson, Honeywell Aerospace’s president for business and general aviation. “This is kind of a reversal of, say, maybe ten years ago when the deliveries were roughly eighty percent North American.”
Among the major lending institutions, the change has had a significant impact as evidenced by the location of their customers. “Probably a third of everything we do is outside the U.S. and growing. It’s increased significantly for us,” said Dave Labrozzi, president of GE Capital’s corporate aircraft finance division. This change in client demographics has come on suddenly, according to Citicorp’s Aircraft financing group. Two years ago, less than 5 percent of its customers came from outside the U.S. Today that number stands at nearly 40 percent.
“I think that’s a contributing factor to why the effect of the U.S. economy is not necessarily scaring the marketplace right now,” said Amalfitano. “If all of the OEMs have 50 percent or more of their production going internationally, then the market is much more dependent on the world economy than it is on just the U.S. economy.”
Based on the evidence, some experts feel this could portend a major shift in well established financial attitudes. “I see a lot of belief in the press and [elsewhere] that suggests the U.S. economy is not the center of the world market anymore, and that as the global economies become stronger [there is] less reliance on the U.S.,” said Labrozzi. “I think that trend will continue for the foreseeable future.”
Competition Among Lenders
Over the past few years, the demand for business aircraft has attracted many lenders new to aviation finance into the finance market. “Smaller and midsize financial institutions entered the market as they looked for ways to deploy excess capital,” explained Doug Reinarz, senior vice president of Chase Equipment Leasing. “Meanwhile, the ‘large ticket’ leasing/financing market came under immense pressure from regulatory and taxing authorities, so some of those personnel were redeployed into the single-investor, ‘medium ticket’ market and its largest sub-component: business aircraft. With more financiers came lower pricing and ultimately looser structures.”
These looser loan structures, while not as volatile as the sub-prime loans that sent the housing industry into a spin, involve greater risk than experienced aviation lenders are willing to accept. “I’ve seen some competition provide 100-percent financing on old aircraft, creating loans that were underwater from day one,” said one lender, who wished to remain anonymous.
“They also did interest-only structures for older or less desirable aircraft, which depreciate quickly, again causing the loan to be higher than the value of the asset. If the market deteriorates, the owners of the older, smaller airplanes are the ones who are most likely to get rid of them. That will cause aircraft values to go down, and conceivably that could cause ‘troubled loans’–those that people will walk away from because they owe more than the value of the asset.”
Bob Kent, president of Scope Aircraft Finance, said buyers need to consider the expected resale value when buying an aircraft and provided some examples. “Say you buy new a high-demand light jet for $7.9 million. You finance 90 percent and amortize the loan over 20 years. If you sell the airplane after three years, your loan balance will be $6.6 million. That three-year-old model is worth $7 million [disregarding inflation], so you’ll get $400,000 cash back from the sale proceeds after paying off the loan. Everything is rosy.
“Or say you buy a well known turboprop for $5.1 million, but finance 85 percent over 15 years. The loan balance in three years will be $3.8 million, which is right on the sale price. But if you buy that same airplane, finance 90 percent and amortize the loan over 20 years, your loan balance will be $4.3 million after three years. Since that three-year-old airplane would be worth $3.8 million, you’d have to fork over an additional $500,000 to pay off the loan.”
Kent cautioned that these figures represent up-market activity. “In a flat or down market,” he said, “there would be very few owners who would be in a cash-positive position on sale, even with the higher down payment and shorter amortization.”
In finance terms, the “spread” is the difference between the interest rate a borrower pays for the loan and what the money costs the financial organization. If the spread is too small, or “compressed,” it makes more economic sense for lenders to invest their money elsewhere. For the last few years, the spread has been quite compressed, primarily due to increased competition. Though this is generally good for borrowers, it gives lenders nightmares. But if the spread becomes too small, lenders simply stop providing loans.
“The added capital has compressed margins as the market continued to grow,” said Amalfitano. “However, with the yield curve beginning to normalize as longer-term rate spreads widen, we will see if these latecomers who jumped on the bandwagon may be the first to retreat, while the more established players are positioned for the long run. Those lenders who simply chase deals at low debt margins will not be able to sustain any cyclical changes in the business. Those lenders who understand the asset–the aircraft–and have a tax-lease product will continue to prosper despite market fluctuations.”
Reinarz said that the influx of lenders is probably temporary and will ease once the lenders experience losses or get bored with the business. “The long-term players will ride through the ups and the downs. So, over a couple of years, spreads will begin to widen and structures will revert to pre-boom levels…for now, however, spreads remain tight.”
Looking Forward to Next Year
All lenders contacted held similar views about the business aviation market for next year. Mary Schwartz, global head of aircraft finance at Citi Global Wealth Management in New York, said, “If the economy remains strong, the market will continue to grow. The global nature of business has proved beneficial to the industry, as there is a real need for travel. This has made private jets more acceptable and often necessary for companies and individuals. Hence the rise in the international market, which should be sustained for another few years.”
Kent of Scope Aircraft Finance, said, “I expect sales to remain strong, in line with current levels. Any factors affecting overall economic activity also affect jet sales.”
“The manufacturers still have a one- to three-year backlog of new orders, depending upon the model, so manufacturers should enjoy another record production year in 2008,” said Amalfitano of Banc of America. “Largely as a result of this backlog, used jets are in high demand and this should continue in 2008 as well. If the economic volatility of the global debt markets persists longer-term, we could experience some lessening of demand for business jets. However, we believe the economy will be strong enough for that not to become a concern. With a growing GDP at 3.1 percent, strong corporate profits and continued growth of individual wealth, business aviation forecasts show more boom years ahead.”
Reinarz of Chase Equipment Leasing, said, “If there is no substantial change in corporate profits, global equity markets, the credit markets or the current geopolitical situation, then I foresee continued strength, though perhaps it could slow slightly from its red-hot pace. Other influencers in the longer term are the pace of change in the non-U.S. civil aviation operational and regulatory sense, such as opening of airspace and the construction of more infrastructure.”
“The market should see a slight increase in activity next year based on the projected increase in new aircraft deliveries,” said Labrozzi of GE Capital Solutions. “As most new aircraft buyers are existing aircraft owners that will, in turn, sell their existing aircraft, an increase in aircraft supply is likely. The increase in supply might lead to a slight softening of aircraft prices, although ongoing strong demand for large-cabin, recent production aircraft is unlikely to affect pricing substantively for this class.”
Reinarz of Chase Equipment Leasing said, “When the market experiences a turndown, the first affected will be older aircraft. If I were looking for an indicator of softening, I would watch the availability, transactional flow and pricing level of older aircraft, as older aircraft are always more volatile than newer aircraft, and would feel the first and most profound effects if the market softens.”
Curt Epstein contributed to this report.