Stress for airlines may be opportunity for lessors.
The war in Iran is putting pressure on airlines. Higher jet fuel prices are cutting into profit margins, and the risk of a prolonged conflict may reduce travel demand in Europe and Asia. But for lessors, these gathering clouds may come with a silver lining.
Lessors occupy a unique position in aviation finance because they own the airplanes—hard assets with intrinsic value—that they lease to global airline carriers. The economics of the business are driven by long-term contracts, aircraft scarcity and the growth of a global middle class with the appetite for and the ability to travel.
We think a focus on lessors can provide exposure to global aviation without being tied too closely to the fortunes of individual airlines. Over the last decade or so, data shows that the simple average return on invested capital from aircraft leasing has generally been higher—and steadier—than the equity returns of listed commercial airlines.
A Different Business—with Portable Assets
To be sure, the crisis is far more manageable then the one airlines faced when the COVID-19 pandemic grounded airline fleets around the world. But it still presents challenges, especially for many European and Asian carriers. Roughly half of the global aircraft fleet today is leased. Smaller airlines may lease nearly all of their aircraft, while large carriers often have a mix of owned and leased planes in their fleets. For both, leasing provides flexibility and the potential to reduce overall expenses.
This matters because aircraft leasing is a different business than operating airplanes. Airline profitability can be highly sensitive to fuel-price volatility and fluctuating passenger demand. For lessors, the economics are driven by long-term lease contracts, which provide greater visibility into future cash flows, and strong global demand for aircraft.
And lessors aren’t tied to a single route, airport or customer base. Because they own the planes, they can redeploy them from a slow market to a healthier one. That’s important at a time when global fuel shortages tied to the Iran conflict are a pressing challenge for European and Asian carriers with routes that traverse the Middle East. If they cause an extended reduction in travel to and from these areas, a lessor might decide to pull planes out of those markets and redeploy them in others, such as North and South America.
In other words, lessors exist alongside an airline’s capital structure, not within it. Airlines, meanwhile, must typically demonstrate capital distress before seeking to renegotiate leases.
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Where Have All the Airplanes Gone?
At the same time, the aviation market is struggling with a deeper structural issue: there simply aren’t enough aircraft to keep up with rising demand for travel. Aircraft production began to decline in 2019, creating an estimated gap of 5,000 to 8,000 aircraft. And because aircraft are highly engineered assets, manufacturers have been unable to quickly add capacity to replace that lost production. We expect the gap to persist for years.
This matters because aviation demand has grown more swiftly than global gross domestic product—roughly 1.5 to 1.7 times faster over long periods, according to the International Air Transport Association. When hostilities in the region end, we expect that demand to rebound swiftly.
Increasing supply will be a slower process. Rapid expansion of the middle class in Asia and the Middle East has increased the number of people with the means and the motivation to travel. This mismatch of supply and demand will still be with us when current travel restrictions end, which should support lease rates and asset valuations.
Fuel Prices May Lift Lease Rates—Eventually
Higher oil prices do not immediately flow through to lessors. Airlines typically absorb the initial margin pressure first. Over time, however, carriers typically pass some of those costs through to passengers. If oil prices decline, fares may remain elevated for a period, allowing operators to recapture some lost margin.
That doesn’t mean there won’t be some near-term turbulence for investors. Lease rates also tend to lag fuel prices and interest rates, sometimes taking a year or more to catch up. But eventually, a market with limited aircraft supply, high operating costs and scarce capacity, is likely to increase rates and return potential for investors in leasing strategies.
Managing Obsolescence and Downside Risk
Of course, even tangible assets such as aircraft come with risk. For now, some operators are investing in additional maintenance cycles to prolong the working lives of aircraft that in the past might have been ready for retirement. In the years ahead, lessors will need to manage technical obsolescence as next-generation aircraft become a larger share of the global fleet.
They will also need the tools to evaluate both the assets and the operator. A strong aircraft can often be redeployed if an operator struggles. A weaker asset paired with a weaker operator can create a different risk profile.
Could a longer-than-expected conflict—or the risk of additional conflicts—put pressure on lessors? It’s certainly possible—but in our view, not likely.
Investors, though, should be asking a different question: Will the structural imbalance in aircraft supply and demand persist? We think it will. That should create opportunities to invest in leasing strategies with the potential to capture long-term economic growth.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.
James McManus is a vice president and Managing Director for AB CarVal.
Brian Resnick is a Director and Senior Investment Strategist for Alternatives.
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