Just over a year ago, in the "View from the City" we wrote about the "depressing depreciation debate". Apparently the debate is not over, now more and more lessors are starting to see the consequences of overly optimistic depreciation policies. A few days ago, an aviation finance publication ran an article arguing that aircraft operating lifespan could shorten to 15 years as second-hand market values decrease.
While "depreciation" may sound like a subject for bookkeepers, regulators and accountants, it is one of the most fundamental elements to take into account in the aircraft finance and leasing business. After all, most decisions with respect to aircraft operational leasing are driven by the question, what will the value of this asset be at the end of the lease, or by how much will my asset depreciate between today and the termination date of the contract? The answer to this question will play an important role in setting the lease rates. Set the lease rates too high and you won't get the deal, or your aircraft will stay in the desert a few more years, set it too low and you (or more likely your successor) will get a rude wake-up call five or seven years from now.
It seems finally a consensus is building that assuming a 25-year lifespan and a residual value of 15% is too optimistic. Clearly, residual value performance and lease rates of even the most popular narrowbodies have been disappointing over the past few years. So, why not take a radical step and cut 10 years off the original 25-year lifespan? Well unfortunately it isn't all that simple. What's the fundamental reason to depreciate any asset? Very simplistically, including depreciation charges in the cost of a product or service should allow the owner to buy back an asset of about the same utility at the end of the life of the old asset. So, depreciation should cover the loss of value caused by the ageing of the asset. Eventually any asset will reach an age where it simply doesn't do its job anymore. A simple standard steel 20' maritime container is an example of such an asset. For decades there have been very few technological developments and after about 12 years the container is replaced by an almost identical unit. Pure ageing, no technological changes whatsoever
For an aircraft the world isn't that simple, as we all know. We believe that depreciation of an aircraft should not only be a function of technical life but also of its overall value as a production tool. This should take into account the fact that over time, more efficient or otherwise superior production tools will be developed that enter the market to compete with the older generations. In practical terms, the introduction of the NEO and Max generation with substantially lower operating costs for airlines (according to the OEM's), must logically affect the value of the current A320 Family and Next Generation (NG) models. The only way the old generation can compensate its higher operating cost, is by lowering its capital cost by more or less the same amount. Now it starts to be complicated because of many other factors. What is the purchase price premium - if any - for a Max over an NG aircraft? What's your daily aircraft utilization? How much in total dollar-terms is a 12% lower fuel burn (or how much is a barrel of oil in 2017 anyhow?) and what will interest rates do?
Like one of the mega-lessors already indicated, the introduction of the NEO and later the Max in an environment of high fuel prices is very likely to put additional pressure on current Airbus and Boeing values. As the market will not allow lessors to increase lease rates for these aircraft, this means additional write-downs, or book losses.
So, what to do about this? For the current generation of aircraft it may already be too late. While lessors are praying for a lease rates increase on the current A320 Family models, this is unlikely to happen. Nobody will risk to see their fleet go to the desert because of being so brave to take the lead in an overall increase in lease rates.
Will it only be the A319 and A320 that will suffer? Unlikely. Apart from some less favourable dynamics in the A320 operators' population, the whole issue has nothing to do with a "good" or "bad" aircraft. The crucial thing seems to be a lack of pricing power from the lessors. While there is not a huge oversupply of A320s yet (as % of the fleet), there are now so many lessors offering essentially the same product that pricing power is minimal, even versus 2nd and 3rd tier airlines. So, which aircraft types could be next? To answer this question, one has to look at a number of factors, including the lessor share in the global fleet (a potential indicator of pricing power). Number one factor is of course the A320 with over 50% of the fleet managed by lessors. Number two factor is a fallen star, the 737 Classic. The other types with lessors' shares approaching the 50% mark are the 737-800, the A319 and the A330-200 aircraft. For all of these types, direct successors are in place, or on the horizon (NEO, Max, 787, A350). While for virtually every aircraft type we have seen and will see, value curves get steeper during production life, the "last off the line" examples of the types mentioned however may suffer in particular.
So, with some risk of a "lost generation" - in value terms - being produced right now, will things be better for the next generation aircraft? First of all, one needs to have an opinion about the pace of technological improvement or cost reductions. If NEO and Max will split the mainstream single-aisle market 50/50, most likely we will have stability for another decade or longer. Should either of the two prove superior, stability will be short-lived and we may see the new single-aisle aircraft less than 10 years from now. If oil prices continue to skyrocket, new technologies may be introduced earlier anyhow. Another risk may be a new OEM dumping its products for prices far below the levels of the established players. Ryanair - for its own obvious purposes - has been hinting at a scenario where Comac C919s may be offered at price levels well below the 737 and A320. Probability of such a scenario seems low, severity could be high however.
If I were a betting man, I wouldn't put my money on a scenario under which the market will be in a nice equilibrium until 2025. Consequently, obsolescence risks remain high and assumed aircraft "value lives" may continue to shorten. Anybody using a "25-year at 15%" assumption will be disappointed. However, this doesn't mean these aircraft will not operate for 25 years. Many will, but their trading values will be almost negligible, which the relevant element for depreciation.
In conclusion, the often asked question by which percentage an aircraft needs to be depreciated is impossible to answer by a simple number. Already between an early and a late production example of the same type the difference can be huge and that's just one element.
For those investing in last of the line aircraft of the current generation, do you homework and look what happened to values of the last "Classics". As for the NEO and Max generation of aircraft? Let's hope they will rule the world for many years and give us all nice stable values. There are however some early signs that give us some reasons for concern. Already the A320NEO is in the 'top three' in terms of lessor's order-positions (after the current A320 and 737-800 models).
In addition, it seems some airlines are starting to become true asset-players and their mega-orders may have a significant speculative element.
For our industry to prosper in the long-term, it is essential to use realistic depreciation figures in the lease rates calculations. Interesting enough, it may only be after five or 10 years that this will show up. So if you play it right you can party for years and the hangover will be for your successor. Now, that's what you can call a depressing "View".
Article contributed by Bert van Leeuwen, DVB Bank SE, managing director aviation research