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AINsight: Strategies To Manage Aircraft Financing Costs
By: David G. Mayer
Caption: Cash might be king, but financing still often makes the most sense for business aircraft purchases
Word Count: 1601
It is hardly a secret that the U.S. Federal Reserve Bank has cranked up the federal funds rate to tame inflation. These rate moves, which raised interest costs, spared no industry, including aircraft lending and leasing. Then, the Fed signaled last month that it might cut the federal funds rate a few times in 2024, setting off rampant speculation of when and how many rate cuts might occur.
Did the Fed announcement mean that aircraft lenders and lessors (financiers) can expect aircraft lending and leasing transactions to take off? No one knows, but even if rate cuts occur and financing shows the potential to soar to new heights, continuing challenges abound for financiers.
The notion that “cash is king” resonates with buyers, and cash still dominates the way many buyers purchase aircraft despite sensible reasons to finance aircraft purchases. Although aircraft lenders seem mostly past the 2023 regional banking crisis, many banks have imposed stricter lending standards, increased loan pricing, experienced heightened regulatory scrutiny, and constricted available funds for aircraft lending.
As a consequence, some lenders will not or cannot seriously entertain aircraft lending transactions without a stellar creditworthy borrower, a bulletproof guaranty, or a strategy to win the purchaser’s business at a higher but acceptable risk.
Structuring Financing Transactions and Contract Terms
Are these challenges insurmountable in the context of aircraft financing? Of course not. A borrower and an aircraft lender can handle these challenges with contract, interest rate, and economic structuring that, ideally, positions the borrower to seize on Fed rate cuts (if or when they occur), create acceptable loan payment obligations, and reallocate the borrower’s cash to profitable investments or business operations. Consider a few significant business and legal ways to accomplish these objectives.
Interest rate swaps. A swap is an important strategic and hedging tool to manage interest rate risk, liquidity risk, and credit risk. It is an agreement between a borrower and its lender to exchange interest rate streams from a variable interest rate loan to a fixed rate loan or vice versa. The lender may enter into a similar deal with a counterparty separate from the borrower transaction.
The underlying loan principal remains the same. A floating rate moves up or down as market interest rates change based on the applicable benchmark index such as the Secured Overnight Financing Rate (SOFR), while a fixed interest rate remains unchanged during the loan term.
A swap from a variable rate to a fixed rate, at closing or during the loan term, removes the risk of interest rate volatility, allows the borrower to plan for fixed loan payments, and enables the borrower to lock possibly lower fixed interest rates during the loan term. That might occur on Fed rate cuts or for other reasons. A swap from a fixed rate to a variable rate loan or a refinancing creates flexibility to capture lower interest rates but may entail paying early loan termination costs if the borrower unwinds a swap (called “breakage” fees) plus a loan prepayment fee if a fixed rate loan ends before penalties expire.
A borrower may ask for the option to swap currently and/or later in the loan term relating to all or part of the loan's principal. The idea is to swap when the swap furthers the borrower’s loan risk management objectives. Lenders that offer swaps will structure them based on the aircraft loan principal amount, the agreed payment dates, and the maturity date. Standard, but negotiable, swap documents will be required to initiate the lender’s swap.
Before implementing a variable rate loan strategy, it is important to evaluate the effect of the current “inverted yield curve.” That has occurred because shorter-term bond yields exceed the yields of longer-term bonds. Historically, this phenomenon has signaled a forthcoming recession. For now, it coincides with banks offering lower fixed rates than variable rates, calling into question when or whether to swap to a fixed or floating rate loan.[i]
Some borrowers prefer to fix rates to lock a payment amount, but swaps may still produce a lower fixed rate than the customary fixed-rate lending transaction. So it is always worth asking a lender about “swap rates” that may be lower than a traditional fixed-rate quote.
Collateral true-ups. A lender requiring a collateral true-up structure has the right to demand a prepayment of a portion of the principal of the loan to maintain a specified loan-to-value ratio (LTV). The LTV refers to a ratio, expressed as a percentage, of the principal amount borrowed divided by the appraised or agreed value of the aircraft. The principal amount of the loan may range from 35 percent to 100 percent of the appraised or agreed value, with the most common range being 75 to 80 percent for recourse loans. Consistent with best and common practices, financers order a written professional appraisal early in a transaction to establish the initial fair market value of the aircraft.
For example, assuming no interest is payable, which is rare for preowned aircraft, a buyer may purchase an aircraft with a price of $10,000,000 and borrow $8,000,000. The LTV is 80 percent on the first day of the loan ($8,000,000/$10,000,000 = 80 percent). If the aircraft value drops below the specified LTV, a lender may require the borrower to make a material and/or unanticipated principal repayment. Not all lenders require true-ups but, for those that do, a borrower should at least negotiate limits on the amount and timing of true-ups. If the parties cannot agree on a value, they can obtain an appraisal for that purpose.
Amortization periods. Extending the loan amortization period lowers the amount of current payments, which reduces the borrower’s cash flow demands during the loan term and necessitates a “balloon” payment of the unpaid principal balance at the end of the loan term. The longer the amortization period, the lower the periodic loan payments. This structure varies widely, where lenders may accept up to a 10- to 20-year amortization on loan maturities of five to seven or more years. Swaps may work here, too.
Additional Types of Financing
Leasing. True tax and operating leases along with at least three other types of leases have features that loans do not. Tax and operating leases constitute 100 percent financing. Although these leases do not use an LTV, leases use a rough corollary, the aircraft “residual value,” which refers to the aircraft value remaining at the end of the lease term.
The lessor purchases the aircraft from the seller, which may be the lessee (a sale-leaseback), and agrees that the lessee can ostensibly use the aircraft like an owner while rent is collected and aircraft insurance, operational, maintenance, return, and other requirements are imposed.
Consider a true tax lease to reduce rents where the lessor uses depreciation deductions. An operating lease works similarly to a tax lease but may not involve a lessor’s use of tax benefits.
In these deals, generally the higher the residual value, the greater the potential to negotiate reduced rent payments. Lessors likely prefer to retain most of the tax benefit derived from depreciation deductions. Lessees should understand the lease calculations and assumptions before accepting the pricing—a lease pricing expert can help.
Bridge financing. Bridge financing involves the payment by a lender or lessor for all or a part of an aircraft purchase price in installments required by the purchase contract. This arrangement applies mostly to new aircraft.
During the installment payment period, the financier frequently makes a floating-rate loan secured by the purchase agreement. The loan comes due on the aircraft delivery date and may then convert to a long-term lease or loan. The financing typically includes the interest accrued (capitalized) before the aircraft delivery date.
This type of lease or loan structure enables the buyer to use the prevailing fixed and/or variable interest rates on and after the delivery date of the aircraft. The borrower can then pay off the bridge loan and pay any remaining portion of the purchase price in cash, use its current bridge loan financier to switch to a long-term lease or loan, or find another financier for the long-term. By itself, bridge financing may entail higher interest costs and resistance to approving the transaction if the financier does not expect to provide long-term financing. Structured correctly, a swap can manage interest rates starting on and after the delivery date.
The Endpoint
Interest rates are much higher than a few years ago, before the Federal Reserve started raising the Fed funds rate aggressively to address painful inflation. The almost zero percent rates of yesteryear will not return soon, if ever. When—or if—the Federal Reserve Bank cuts the federal funds rate, financing may get a lift. However, properly structured and negotiated, loans and leases make economic sense today and will continue to do so for the foreseeable future.
The material in this blog is not intended to be, nor should it be construed or relied upon as, legal advice. The comments, recommendations, and analysis expressed in this blog are those of the individual author, David G. Mayer, and they may not reflect the opinions of AIN Media Group. Your use of this blog does not create an attorney-client relationship between you and the author or his law firm, Shackelford, Bowen, McKinley & Norton. If specific legal information is needed, please retain and consult with an attorney of your selection.