Investor portfolios can be improved by aircraft leasing companies

A safer way to profit from the robust increase in demand for flying is through the aircraft leasing industry, even though airline stocks are volatile

Kaylie Pferten describes how to access it and how it operates.

Air travel is the industry that has expanded nearly twice as fast as the world economy over the past 50 years and is expected to do so in the future. Despite shocks like the 9/11 terrorist attack on New York, the global financial crisis, and COVID, the International Air Transport Association (IATA) reports that since the 1970s, growth in commercial air travel, as measured by passenger miles, has outpaced global economic expansion by a factor of 1.7. Over the next 15 years, IATA projects growth of 3.4% annually.

Perhaps estimates of the need for 42,000 new aircraft globally over the next 20 years will grab investors' attention if that record and outlook don't. According to consultant McKinsey, the airline industry is at least 2,000 aircraft short of the total fleet size it requires because manufacturers slowed production during COVID and haven't caught up. Greg Belonogoff, a principal at AB CarVal, which is owned by the investment manager AllianceBernstein, believes that the market is likely to remain undersupplied for ten years.

That could imply making investments in aircraft manufacturers, of which there are essentially just two worldwide competitors: Boeing in the US and Airbus in Europe. However, there is a potentially more intriguing and extensive opportunity. According to McKinsey's analysis, aircraft leasing investments have continuously outperformed in recent years.

Instead of purchasing new aircraft outright, the majority of airlines now prefer to lease them as they expand and maintain their fleets. In companies that prefer to concentrate on operations rather than significant capital expenditures, the latter option ties up excessive amounts of balance-sheet funding. As a result, financing for aircraft leasing is currently a rapidly expanding asset class.

Leasing an aircraft provides a reliable source of income.

Aircraft financing is a fairly straightforward concept from the standpoint of investors. A leasing company uses a combination of debt from a finance provider like a bank and equity, selling its shares to investors. With this money, the company purchases aircraft that airlines can lease.

A portion of the company's revenue from the airline is used to pay for debt repayments over the course of the lease; financing is typically "amortized," which means the lessor makes both interest and capital payments. The remaining lease income can then be utilized to pay shareholders on a regular and predictable basis.

By the time the lease expires, the lessor will typically own the aircraft outright due to the way debt repayments are set up. After that, it may attempt to re-lease the aircraft to the same airline or one of its competitors, or more commonly, it may sell the aircraft on the used market and give investors the proceeds.

As a result, investors in aircraft leasing vehicles can anticipate both a capital return in the future and consistent, steady, and frequently substantial income payments. With a tangible asset in the form of the aircraft, it's an enticing combination of returns.

According to Matthew Hose, a senior vice president at the investment bank Jefferies, "consider aircraft leasing as being a bit like property with wings." "You're making money from a tangible asset, and when you're ready, you can sell the asset to make a capital return as well. The "

This asset class's low correlation with other assets that investors will own in their portfolios is another appealing aspect. For instance, returns fluctuate virtually independently of events on international stock markets, but they also have little bearing on the performance of investments in other alternative assets like real estate and infrastructure. Because of this, leasing an aircraft is especially beneficial as a risk management strategy. It gives investors a way to make their portfolios truly diversified.

According to Belonogoff, "the aircraft leasing sector is more or less stable, even when markets are volatile." "We believe that the uncorrelated nature of these assets is very appealing and has proven itself over several decades. If you go back to the drama surrounding Liberation Day back in April, the airline stocks saw some sharp sell-offs, but the listed aviation lessors simply continued. A "

The aviation leasing industry is not without flaws.

This does not imply that investing in this is risk-free. In the event that an airline goes bankrupt, they will be in default on the lease. Failures may leave the lessor rushing to find a new airline to rent its aircraft while attempting to pay off its debt. It might be compelled to sell the aircraft in order to satisfy its lenders, but there are no guarantees regarding the price it will receive. This is especially true given that the conditions under which airlines fail are not conducive to the value of aircraft on the secondary market.

"Carefully balancing assets and liabilities is crucial for lessors," says Hose. "They ideally want to lease to reputable airlines with solid financial standing, but it makes sense that the aircraft's quality is also crucial. One argument among lessors is whether to focus on narrow-body aircraft, where the market is more liquid, or the very large wide-bodied aircraft, which are more expensive and where shortages are particularly severe.

In a similar vein, investors cannot count on a sizable payout at the conclusion of the investment cycle because that will depend on the condition of the used market at the time the fund is attempting to sell its aircraft. The market appears to be doing well right now, and airlines are rushing to acquire more aircraft in order to satisfy the rising demand from travelers. However, recent events have taught us that a shock to the international travel industry is always possible. Even a slowdown in the economy could lower demand and, consequently, the value of airplanes.

Interest rate changes may also have an impact on returns. Even if airlines can be forced to share the pain, higher debt costs will result in less lease income to pass on to investors. Additionally, some lessors take on mezzanine debt, which must be paid back from aircraft sales before the proceeds are distributed to investors. This debt is not repaid during the duration of the lease.

However, this is a class of assets that will remain appealing in the long run. "Demand has returned and we've continued to move forward after all the major shocks to the system," Belonogoff says. Growing demand "means we need more aircraft coming into the industry and that requires more financing; lessors are also playing a bigger role because most airlines are moving from owning their aircraft to leasing them."

Where to look for current aircraft leasing investment opportunities.

Purchasing stock in aircraft leasing companies is one way to gain exposure. The US-listed AerCap (NYSE: AER), the biggest aircraft lessor in the world, is one of the few stocks in this sector. While Avation (LSE: AVAP) of the UK is one of the European aircraft leasing companies, BOC Aviation (Hong Kong: 2588) is the leading player in Asia. The majority of publicly and privately owned lessors continue to have a presence in Dublin, the Irish capital, making it the largest aircraft finance hub in the world.

Investing in this manner isn't pure-play aviation finance because investors are purchasing stocks instead of the underlying asset class, which means they might not benefit from all the advantages of diversification that the latter provides. However, aviation finance is represented by shares in these companies.

An alternative is the investment-trust sector, where several investment managers have recently attempted to democratize aviation financing. The oldest of the three funds, Doric Nimrod Air Three (LSE: DNA3), is getting close to its end of life, but there are currently three available. After selling its four aircraft to Emirates for £180 million, it is scheduled to liquidate in the first half of 2026.

In other news, DP Aircraft 1 (LSE: DPA) was introduced in 2013, a few months after Doric Nimrod, but encountered significant issues during the Covid pandemic when both Thai Airways and Norwegian Airlines, to which it had leased its aircraft, experienced financial difficulties. The fund's value fell as a result, but it has since recovered, especially since Thai filed for bankruptcy.

The fund currently owns two aircraft, both of which are leased to Thai Airways until 2026. It recently declared that these aircraft will be leased to Poland's LOT Airlines for an additional 12 years. It is currently renegotiating its financing agreements, which will determine how much of the £168 million in payments it anticipates receiving from LOT will be available for investors to receive.

Amedeo Air Four Plus (LSE: AA4) is the third aircraft leasing investment trust. It is the most complicated and, by far, the biggest of these funds. Investors are encouraged by Doric Nimrod's recent deal with Emirates, which was completed at an unexpectedly high price. The fund owns eight aircraft that are leased to Emirates, with the leases set to expire between 2026 and 2028. It is widely expected that the fund will sell these aircraft to Emirates.

The fund also owns four aircraft that are leased to Thai Airlines through 2035 and 2036. However, because the lease agreements were signed during COVID, when rates were under pressure, these aren't generating a sizable income for shareholders. Therefore, the revenue from these aircraft is needed to pay back the loans.

Doric Nimrod's mezzanine debt, which will eventually need to be paid back through the sale of airplanes, adds another layer of complexity. It is therefore unclear if investors will receive a return on their investment. However, there are supporters of the fund. For instance, earlier this year, broker Panmure Liberum recommended a buy, with a target price of 66p; the shares are currently trading at 62p. "Second-hand aircraft market conditions remain positive," according to Gerald Khoo of Panmure Liberums. Travel demand "continues to grow, with demand resilient in the face of geopolitical and economic volatility and uncertainty."

This could encourage more investment trusts to enter this market. Given the current surge in demand for private assets, some analysts anticipate more fund launches over the course of the next year or so. And that might be advantageous for investors. According to Jeffrey Hose, "the aircraft-financing model is now a proven one." "Lessors have demonstrated their ability to use the model. Simply put, retail investors need more chances to profit.