This week I was reminded of a trip I took to Cuba many years ago. The country had already been under embargo for close to forty years and the streets of Havana showed it. With no car industry of its own and access to US imports blocked, Cubans relied on ingenuity and makeshift parts to keep their ageing, pre-revolution cars on the road. You’ve seen the photos – I’ve got one I snapped in front of me: a striking blue 1957 Chevy idling by the kerb in the heart of Havana. 

Having witnessed the state of the cars on the streets, I don’t know why I thought the skies would be any different. I boarded a plane in Havana to take me to Santiago de Cuba on the other side of the island. The distance is only around 500 miles but the highways aren’t really equipped to carry a 1957 Chevy, so flying is the better option. I suppose I should have known it wouldn’t be a Boeing transporting me, but I didn’t expect to find myself sitting in a Soviet era Antonov. The signage was in Russian, the hull creaked, and I spent the entire journey with my stomach up in my mouth. 

I recall this episode because Russia now finds itself under a similar embargo, unable to buy Western manufactured planes or parts. It’s a vast country, highly reliant on air transportation – its flag carrier, Aeroflot, was once the largest airline in the world. Russian airlines operate a total of around 1,400 passenger planes but most are manufactured abroad, and – as was the case in Cuba – they won’t be getting further deliveries any time soon. Of the 1,400 planes in operation, around 850 are made by Western manufacturers, principally Boeing and Airbus, and, of those, around 500 are on lease. 

This week, Vladimir Putin ordered those 500 or so leased aircraft to remain in Russia, rather than being returned to their owners abroad. With foreign air travel curtailed, Russia won’t need all of its 1,400 fleet, but what it will need are parts. Its Western-made planes are already 13 years old on average and need to be maintained. Those 500 planes it just stole provide a solid stockpile of parts to cannibalise. 

But who owns them? And why don’t airlines own their own planes? To answer those questions we need to delve into the specialised world of aircraft leasing.

Aeroplanes aren’t cheap. The hottest product on the market right now is an Airbus A321neo, which retails at $130 million. If you’re an airline, that’s a big investment to finance. In years gone by, airlines would call up their local bank. They would put down a 20% cash deposit upfront and pay the balance with interest over the next seven to ten years, mortgaging the plane to the bank. At the end of the period, the airline would take full ownership of a seven year old aircraft. For a fledgling airline with limited capital resources this wasn’t a great solution, particularly if it was unsure how many seats it could sell over the next seven years.  

As a result, a different model evolved and two companies stepped up to provide it – one based out of Shannon, Ireland and the other out of Los Angeles, California. Unlike banks, executives at these companies had deep knowledge of the airline industry. Tony Ryan, the founder of the Shannon-based company, previously worked at Aer Lingus, where he would rent out aircraft to other airlines during the quiet winter months. Seeing the potential for shorter term aircraft leasing, he borrowed $50,000 to set up a specialist provider: Guinness Peat Aviation (GPA). 

Initially, Ryan acted as a broker between airlines – matching aircraft capacity where it was needed. One of his first clients on the buyside was Nigeria Airways, which wanted to rent a Boeing 737-200 complete with flight crew, cabin staff, maintenance and insurance. Later, Ryan would buy his own planes, leasing them out to interested airlines. Later still, he would go on to found Ryanair. 

The model Tony Ryan developed is like long-term car leasing, except for planes. Airline customers are able to rent a modern aircraft for a precise period, paying monthly rental fees and building up a maintenance cost reserve out of revenue earned by its operations. Rental periods are typically 10-12 years for a first lease on a new aircraft (longer than in Ryan’s day). The average lifespan of a plan is 25 years and so a single plane can be placed with various carriers on a series of leases.

For young airlines in emerging markets, the model was a boon. But it was also attractive to mature airlines in developed markets. These airlines had historically struggled with a debilitating capital cycle – a fragmented supply side and high capital intensity crushed their profitability. Between 1960 and 2000, aggregate profits of US airlines would have been sufficient to fund the delivery of just two Boeing 747 jumbo jets. The leasing model, as well as industry consolidation, paved the way for higher returns. British Airways suggested several years ago that its return on capital on an owned-plane basis was 9% but on a leasing basis it was 15%. 

As a result, the leasing companies grew markedly after their formation. In 1979, GPA had six aircraft out on lease; over the next ten years that grew to 152. Its Los Angeles-based competitor, International Lease Finance Corporation (ILFC), grew its fleet from 13 aircraft to 79 over the same period.

Today, after a series of corporate restructurings, these two companies sit under the same roof under the name of Aercap, with a fleet of around 1,800 planes – around 7% of the passenger planes in the world. In total, over 40% of the global fleet of passenger aircraft is now leased, up from 16% in 1990. 

The Business of Aircraft Leasing

While an aircraft lease is a highly specialised agreement, the economics of aircraft leasing are fairly standard for a financing business. At the top line, the business earns a spread. It rents out planes at a rate of around 11% a year, and finances itself at around 4% a year. In between, it suffers the cost of a depreciating fleet. The lessor typically writes down the value of its planes over their 25 year life to a residual value of around 15% of the initial value. Lessors don’t employ many people – Aercap employs around 750 people, which is around 2.5x more than GPA did in 1990 even though the company is now a lot larger. Pre-tax return on assets is around 7%. A low tax rate and a bit of leverage (2.8:1 in the case of Aercap) translates that into a return on equity of 10-12%.

It wouldn’t be a business worth doing, of course, if there weren’t risks, and there are three of them.

First, the lessor needs to get hold of funding. In the early 1990s, GPA collapsed after growing much too quickly with insufficient funding. Tony Ryan put orders in for hundreds of new planes – the largest single batch of aircraft orders ever placed at the time, putting himself at the mercy of funding markets just as the industry hit a recession. One of his executives, Christopher Brown, went on to publish a diary of the company’s downfall, Crash Landing. It begins on Monday 30 April 1990 (“Last Friday was a bad day”) and charts the demise from there. 

The funding risk is one Warren Buffett highlighted at his 2016 shareholder meeting:

“You will not see us get into aircraft leasing, it doesn’t interest me in the least. We looked at that often. Various aircraft leasing companies have been offered to us – that’s a scary business. Some people have done well in it in recent years, by using short-term money to finance longer-term assets, which have big residual risks. That just isn’t for us.”

These days, lessors try to mitigate the risk by tapping into diverse funding sources – bank lines, securitisations, bond issues, equity raises. The bigger ones see scale as an advantage. Their diversification across airlines spreads their risk (Aercap deals with around 300 airlines) and their dominance in the debt markets draws in demand. “Because the [Aercap] deal was so big,” remarked one investment banker recently, “it showed up in all of the indices and so was seen by more money managers than previous aircraft lessor deals.”

Second, lessors run the risk that the value of their planes diminishes – that’s the residual risk Warren Buffett refers to. Lessors try to mitigate this by managing their portfolios proactively – selling planes well before their retirement and anticipating the sorts of planes that will become fashionable. According to Aercap, fashionable planes built to new technology standards comprise around 60% of its combined company fleet.

Leasing companies also mitigate the risk by buying planes in bulk directly from manufacturers at a discount; lessors today account for a significant chunk of the global order book for passenger aircraft. Again, this is where scale has an apparent advantage. In the early days, according to Christopher Brown, “the aircraft manufacturers would be glad to see us depart the scene.” These days, lessors are an important customer. 

The third risk lessors run is that airlines don’t pay them. Over the years, Aercap has absorbed credit costs equivalent to around 1% of its lease revenue. Airlines can get into trouble for a host of reasons – competitive pressures, economic recession, currency mismatch, uncooperative lenders, fuel price shocks. But for lessors, the mobility of the security – the ability to repossess a plane and fly it out – mitigates the risk. Or at least it’s supposed to. For years, executives at leasing companies have regaled investors with tales of how they pulled planes out of far-flung places.

At his company’s 2015 investor day, Aercap’s chief risk officer told one such story about repossessing two Airbus A330-200s from Yemen when conflict escalated there:

“...we were very quick in evacuating the first aircraft, with the assistance of the airline, from Yemen to Ethiopia. We took control of the second aircraft during a regular scheduled rotation in Jakarta. We took control of our engine quite quickly, as well, in a maintenance shop in Singapore.”

Within six weeks, the planes had been repossessed, reregistered, refurbished and leased back out to a new customer in Turkey.

Often, the challenge is to secure the maintenance records as much as the aircraft. Every aircraft has a set of maintenance records and as time goes by, they build to become a significant part of the value of an aircraft. At Aercap’s 2019 investor day, the same chief risk officer provided an update on a new case linked to the Pakistani airline, Shaheen Airways, which went bust the prior year.

“We are immediately on site, and…at the end of the first business day of the bankruptcy, we’ve recovered all our technical records. That’s important because at the end of that day, a big padlock gets put on the HQ doors. And if you haven’t got your records out, your airplane’s going nowhere.”

All of Aercap’s experience confirms what the chief risk officer said back in 2015, “it's very, very important to note that we have a 100% success rate in repossessing aircraft. We've always got our aircraft back from difficult situations, 100% of the time, and we've got them back promptly.”

What lessors didn’t anticipate is that planes could be requisitioned on such a large scale by a state. In his book, The Black Swan, Nassim Taleb introduces the turkey problem: “Consider a turkey that is fed every day, every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race… On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

The airline leasing model is now subject to a revision of belief. While the Cape Town Convention, put in place in 2001, was meant to provide some comfort by establishing a set of internationally recognised rules for the industry, Russia – a signatory – has paid it no regard. 

Instead, lessors are reliant on insurance. Normally, it’s the responsibility of the airline to insure planes on lease, both for hull damage and for war risk. When Malaysia Airlines Flight 17 was downed over Ukraine in 2014, it was covered by the airline’s war risk policy; and when Malaysia Airlines Flight 370 disappeared the same year it was covered half by each. In the current situation, the risk is between the lessor and the lessee rather than the lessee and the plane, so these policies may not count. Rather, lessors will fall back on contingent insurance – if they have it. The problem is that this is a specialised form of insurance that hasn’t been tested on this kind of scale. And with only around $100 million “war” premium booked by the insurance industry to cover $10-15 billion worth of losses, insurance companies will push back hard. ¹

Airline lessors have been active for nearly fifty years. For most of that time, they’ve proven to be less cyclical than their airline customers. Aircraft rental revenues across the biggest lessors fell by only 14% on a rolling twelve month basis following the onset of Covid, showing much greater resilience than airlines’ own revenues, which collapsed. Their business is less sensitive to fuel prices and less labour-intensive than an airline’s and so cash flows tend to be more stable. 

But credit risk is an asymmetric game whatever its form – most of the time things are fine, suddenly they’re not. “Turkey risk” will no doubt get repriced.

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Byrne Hobart at The Diff published a good write-up on the airline lessors last year. In Practise also published an analysis following an interview with a former industry CEO. And Third Bridge Forum has a bank of useful interviews with industry experts.