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July 2018

There's more to the LRF than meets the eye

DVB's Kieran O'Keefe breaks down the lease rate factor (LRF),
the short hand indicator of value for an aircraft lease. He looks
at how low LRFs can go and explains how the indicator can be
used to show different lessor strategies. O'Keefe says current
lease rentals are at an all-time low with returns marginally
above the return earned by the debt providers as some lessors
ignore transaction risk in their lease agreements with airlines
and/or take an increasingly optimistic view of future aircraft
values to meet their internal rate of return targets.
The lease rate factor1 (also known as lease rental factor) is a commonly used short hand
indicator of value for an aircraft on lease. For example, we frequently hear people say that
competition in the sale and leaseback market has hit an all-time high as the LRF for a new
aircraft fell to 0.6 % or 0.5%.
This article looks at the components that make up the LRF, asks how low can LRFs go and
shows how it can also be used to explain the different lessor strategies.

Modelling Assumptions
The lease rate factor can be broken down into its constituent parts quite easily. To do this we
have taken a new B737-800 delivering in 2018 on a 12 year operating lease as an example
and used Ascend base values and lease rentals. We have assumed that the redelivery
condition is full life at lease expiry.
If we further assume standard market terms for the debt (loan to value, balloon, swap rate,
credit spread) and SG&A, the LRF is 0.75% and the Equity IRR is 5.7%. The assumptions
behind these calculations are set out in the table below.
Aircraft Assumptions Financing Assumptions
Aircraft Age New LTV 80%
Aircraft Type B737-800 Balliio $5 M
Aircraft Value (full life) $44.0 M Term 12 years
Residual Value (full life) $20.2 M Average Life 7.4 years
Tital Depreciatio $23.8 M Swap rate 3.0%
Lease Assumptions Airlioe Credit spread 2.0%
Lease Reotal per mioth $331K SG&A per mioth $20,000
LRF 0.75% Equity IRR 5.7%
Redelivery cioditio Full Life Source: DVB and Ascend
1
Lease rate factir is the miothly lease reotal divided by the day ioe aircraft value
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LRF has 5 components

It is possible to breakdown the LRF of 0.75% into its five constituent parts and see which
items are the most important and their size relative to one another.
The five constituent parts are:
1. Depreciation
2. Return on equity (ROE)
3. Swap rate
4. Credit spread
5. SG&A (overhead)
We have calculated the total lease rental cash flows over the 12 year operating lease term and
associated financing and operating costs. The costs are shown in the table and chart below on
a per month basis, as a percentage of the total costs and a percentage of the aircraft value.
Depreciation is by far the largest component; roughly 50% of the total lease rental revenue. It
is important to note that this is economic depreciation and not accounting depreciation. It is
the difference between the aircraft’s day one value ($44.0 M) and the aircraft’s expected full
life value at the end of the lease ($20.2 M).

The next largest expense is the cost of the debt financing which is around a quarter of the
total lease rental revenues. The cost of debt has two parts; the swap rate and the credit
margin. In this example, the swap rate accounts for 16% of the total lease rental revenues,
while the credit margin is 11%.
The third expense is overhead also known as SG&A (Selling, General & Administration).
We have assumed a cost of $20,000 per aircraft per month for SG&A. SG&A is around 6%
of the total lease rental revenues.
So if total expenses (Depreciation, Swap, Credit margin and SG&A) account for 83% of the
lease rental revenues, this leaves 17% for the lessor. This is roughly $55,000 per month and
equates to a cash return on equity of 7.6% for the lessor or 5.7% on an IRR basis.
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How low can the LRF go?

The above analysis shows that a LRF of 0.75% for a liquid narrow body generates an equity
IRR of 5.7% in today’s super competitive market. What happens to the Equity IRR if we
lower the LRF but keep all the other assumptions in our B737-800 example unchanged? In
the chart below, we have mapped out how the Equity IRR changes as the lease rental factor
changes. We have also shown the return earned by the debt providers as a benchmark.

The chart shows that it is not possible for a lessor to make a positive equity IRR if the LRFs
go below 0.65%. Indeed, one would ask why a lessor would want a financial return which is
less than the cost of debt (5%). The chart would appear to suggest that market LRFs should
be in the range of 0.75% and above. However, this is not what we see in the marketplace
today.

Cheaper debt
It has been suggested that lessors with cheaper equity and cheaper debt are able to outbid
other players and this is what is driving down LRFs. The credit spread should reflect the
credit risk of the airline lessee and not the lessor. So even if the lessor borrows on a recourse
basis and thereby reduces its cost of debt as borrower, the benefit of the lower cost of debt
should not be passed onto the airline as lessee if the lessor is correctly pricing the credit risk
of the airline. However, to win deals, lessors are doing exactly this. Using the assumptions
for our new B737-800 above, a 50 bps reduction in credit spread equates to 2 or 3 bps
reduction in the LRF or roughly $10,000 per month.

Cheaper Equity
Similarly, lessors with access to low cost equity should price their leases based on the
riskiness of the aircraft asset and the transaction and not on their hurdle rates for investments.
Clearly, this is not happening. Typical returns on equity for new aircraft on lease have drifted
downwards from 12% to 6% not because the industry has become less risky, but because
increased competition among lessors is driving down lease rentals for airlines.

Japanese Operating Leases (JOLs)

Japanese tax investors have always enjoyed an advantage as their return on equity is
augmented by the tax benefits they receive from owning aircraft assets. The cost of equity for
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these Japanese investors is 1% to 3%. Historically Japanese operating leases have focused
only on tier 1 credits and new liquid narrow body aircraft on long term leases. For this
reason, the impact on the overall aircraft leasing market of this cheap Japanese tax equity was
limited. However, we are now seeing JOLS being used to acquire older wide body aircraft to
tier 2 credits and leases with 3 to 4 years remaining. JOLs are growing in volume as new
players are tapping the Japanese tax investor market for funding.

Mismatch Funding
It is possible lessors are funding their acquisitions in currencies with lower swap costs such
as Euros or Yen. Or even financing these long term assets with short term funding. However,
this is a gamble on future exchange rates and interest rates which could equally go against
them as continue in their favour. We have seen this recently in the Korean market where
investors have relied on the positive cash flow from the one year US dollar/Korean Won
cross currency swap rate to meet their target rate of return. However, as the US dollar interest
rates rose last year, the return on these transactions fell dramatically and these investments
are now underperforming as a result.

Optimistic Residual Values

Another likely answer is that lessors have become more optimistic about future aircraft
values. While greater competition has driven down lease rentals, it has also driven up the
market value of used aircraft as new entrants buy used aircraft portfolios from the larger
lessors. Lessors now regularly achieve sales proceeds in excess of the Ascend values. The
portfolio securitisation market also provides a sales exit for portfolios of aircraft at market
prices well above Ascend values.
As noted above, the assumptions driving depreciation account for 50% of the LRF. Small
changes to the depreciation assumptions will have material impact on the equity IRR. The
positive impact on the equity IRR is magnified if the aircraft is sold mid-term rather than
waiting until the lease expires. This is because buyers will pay more for a relatively young
aircraft on lease with several years remaining to expiry. To a certain extent, the competitive
pressures which are forcing LRF down are also driving residual values up, which is allowing
the bigger lessors to offer low lease rentals in the expectation that the future upside in the
residual value will offset any losses over the lease term.
In our B737-800 example, assuming a sales price at lease expiry of 10% above the Ascend
full life base value equates to a $10,000 reduction in lease rental. This means a lessor could
justify offering a lower lease rental to an airline and keep its equity IRR unchanged by taking
a more buoyant view of future aircraft values.

Lessor Strategies
However, paring back the credit spread and adjusting residual values upwards brings
marginal gains which are limited in size. By far, the most important driver of equity IRR is
the initial purchase price. Buying below the market price radically improves the equity IRR.
It explains why the bigger lessors such as Aercap, GECAS and Avolon place large orders
with the OEMs. This strategy allows them to get discounts for buying directly and in bulk.
They make a profit by placing the aircraft on lease and selling down to small lessors, unable
or unwilling to place their own large aircraft orders. This strategy is not without risk and
requires scale to place the large orders and an infrastructure to be able to place the aircraft on
lease in the market.
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It is possible for smaller lessors to be profitable by buying used aircraft from the larger
lessors at a premium provided they offset the higher cost with lower SG&A expenses. This
should be achievable as smaller lessors do not require the same marketing infrastructure as
the larger lessors.

Conclusion
Current lease rentals are at an all-time low with returns marginally above the return earned by
the debt providers. Some lessors justify these lower rentals by pricing transactions based on
their low cost of capital rather than the risk of the transaction. Others are taking an
increasingly optimistic view of future aircraft values to reach their target IRRs. Larger lessors
who place aircraft orders with the OEMs are best placed to take advantage of this increased
competition by buying aircraft at a discount and selling older aircraft at a premium to the
smaller lessors.

Kieran O'Keefe is Managing Director, Aviation Financial Consultancy at

DVB Bank SE.