Differential in Lease Rates Between New & Old Widens

Interest Rate Rises Overcome Covid Event Rental Inertia

Interest rates are set to continue to rise as central banks have few other alternatives to combating rampant inflation caused by a multitude of events, not least Putin’s War in Ukraine.

The inflationary pressures are the worst in some forty years and yet interest rates remain extremely low in comparison to the rates seen in the early 1990’s. In the past, aircraft lease rental agreements may have reflected fixed dollar rates which did not change even as interest rates changed. This is still the case for some leases being on a fixed rather floating. The last 25 years or more has seen a far greater reliance on floating rates whereby lease rentals move in line with international lease rental changes. Until recently LIBOR was mostly used as the benchmark for international interest rates but now SONIA (Sterling Overnight Index Average) is one of the rates used along with others. SONIA interest rates have risen from virtually zero a year ago to nearly 1.2 percent as of late July with the prospect of much more significant rises. The U.S. Federal Reserve rate may also be used. The rising interest rates have therefore seen an increase in lease rentals irrespective of market forces.

A consequence of rising interest rates is the effect on lease rentals that were negotiated prior to the Covid Event. The vast majority of operating and finance leases in force today were agreed in the years before 2020 when the market was much more buoyant.

While many leases were renegotiated during the pandemic the original terms have been gradually restored with extensions being agreed at pre-Covid rates as recompense for the lessors taking payment holidays and for the increased risk should a similar event occur again. As a result of Covid market lease rentals for most aircraft are now much lower than before the pandemic. The lease rental that was being paid for an A330-300 now equates to the rental for the A330-900 – hence why Condor is replacing its fleet and because of much better fuel efficiency and lower emissions. This means that many lessees are paying a comparative premium for their aircraft which is now being compounded by rising interest rates and much higher fuel prices. As the international market continues to improve there will be increasing emphasis on newer widebodies at the expense of the old. Some operators are restarting operations with previously retired widebodies partly because of the paucity of new widebodies but the lessors are avoiding placing orders for widebodies. As of July 2022, the number of widebodies operating leases was lower than as of January 2022 but some twenty percent more than as of January 2021. Of the near 2,000 widebodies that are operating leases, nearly 18 percent are in storage. Many lessees, for a variety of reasons, whether it be staffing, traffic, border restrictions, cash flow, infrastructure are having difficulty in restarting operations and the drain on cash for many operators remains an issue undermining the recovery in widebody lease rentals. Lessors are still finding that lessees are having to return widebody capacity as fleets are contracted and streamlined. The stronger dollar is also having a major impact on some lessees as the cost of leasing compared to non-dollar revenues has risen by a significant amount which means that operators are not so able to add capacity at current rates.

The existing perception that the widebody sector is struggling will soon see a significant shift as it becomes apparent that there is a shortage of relevant widebody capacity. The lessors have traditionally shied away from leasing the larger widebodies because of the more limited operator base and remarketing problems not least in terms of reconfiguration costs. More recently, due to Covid and regulatory issues, the supply of new widebodies has all but dried up. Production rates have slowed to a trickle with the B787 halted and production of the B777 being focused on the freighter version. This comes after the market initially suffered at the start of Covid a surfeit of surplus aircraft not least because of Norwegian with the A380 and B747-400s also being seemingly permanently retired. The number of newer widebodies available for leasing has therefore all but dried up but as the international market opens up the preference for such aircraft will be notable and this will see a rapid rise in lease rentals while those for older aircraft will continue to weaken. The production of new widebodies is set to increase but deliveries of the B787 have still yet to recommence and the B777-9 is now not due to enter service until 2025 -more than five years later than originally planned. The very considerable imminent shortage of efficient capacity will favor the larger widebodies. Older widebodies – with such a definition now encompassing the A330 and B777-300ER – may need to be acquired for a short time but lessees will be conscious of the need to operate more efficient equipment sooner rather than later. The issue for lease rentals of widebodies in production lies with the increasing potential for re-engining in the medium term. The A350 has been in service for over seven years and the B787 for nearly eleven already albeit with modest engine upgrades which perhaps have focused just as much on reliability as fuel consumption. These two types are therefore ripe for a re-engining program to be launched in the next five years, perhaps with a stretch to the current baseline A350 and B787 offerings. The best that operators can hope for with respect to widebody net zero environmental compliance before 2050 is through the use of one hundred percent SAF rather than hydrogen.

For the lessors of newer narrowbody aircraft, the issue is one of not being able to secure delivery slots in the short term as the market increasingly transitions to newer aircraft. The lease rentals of newer narrowbodies have still yet to match pre-pandemic levels. As with the widebody sector, the rates for the majority of narrowbody leases were agreed before 2020 and the increasing in interest rates will be compounding the effect of comparatively high rentals. When a lessee sees that the lease rental for a new A320neo is lower than that for the seven-year-old A320ceo that is currently being leased and with perhaps a twelve percent cent differential in fuel burn, then the rationale for the replacement of the existing fleet is all too apparent. Again, Condor, has ordered narrowbody aircraft to replace existing units. The German charter airline has ordered 13 A320neos and 28 A321neos to replace A320ceo’s, A321ceo’s and B757’s starting from the second quarter of 2024. Ryanair conversely has seen a need to extend leases on A320ceos operated by Lauda Air because of the inability to lease B737-800s at least at rates that match the airlines expectations. Ryanair has also been unable to agree pricing on a new order for the B737-8-200. Airbus secured considerable orders from China on the eve of the Farnborough Air Show while Boeing announced 100 orders for the B737-10 and confirmed the order for 200 B737MAX aircraft from VietJet which may reduce the lessor’s ability to secure delivery slots in the coming years.