mechanism of leasing agreements.
This is the third part of the special quartet of articles on GSE rental and leasing, prepared by Marc Delvaux, former CEO and Chairman of the TCR Group (today Chairman of Nayak Advisory Board, the MRO Group recently acquired by Cheques Capital), together with our former Editor, Alwyn Brice, and aviation industry expert from ADLittle, Mathieu Blondel.
This part will cover leasing pricing principles, with a focus on the operating lease, as well as some contractual elements.
The internal rate of return (IRR)
Basically, the price setting of leased equipment under an operating lease is not strictly based on the determination of a margin (gross margin, net margin etc...), nor on the simple application of a market interest rate (such as Euribor plus margin, for instance). Rather, it is based on the search by the lessor of an internal rate of return (IRR) when investing in equipment or a set of equipment to be leased to a customer.
The internal rate of return expresses the reward rate of the investment (here, the GSE) that can be expected by the lessor over its lifetime. It is based on the one hand on the actualisation of all cash flows that will be generated and consumed by the assets over its life span (which include, from the lessor’s point of view, all cash in, mainly leasing fees and residual value at the end of the life of the asset); and, on the other hand, all cash out, like equipment purchase (the CAPEX), maintenance costs and a fraction of the lessor’s general or administrative costs, together with taxes and so on.
Please note this IRR computation will be performed over the full expected lifetime of the asset and not on the contractual duration with a specific customer, which can be much shorter than the full lifecycle of the equipment. (A customer might rent equipment for a three-year period whilst the equipment could well have a lifecycle of 12 years or more, for instance).
This calculation might be illustrated by the following graph:
The expected return (IRR) anticipated by the lessor on a leasing contract is a function of both the risk of investing in this asset and the time necessary to obtain a return on an asset and it is based on two fundamental financial principles:
(1) The expected return on an investment (and accordingly the leasing fee) is higher if the perceived risk on the investment is higher.
Amongst the risks to be taken into consideration, we could list the following: The credit risk (credit worthiness of the lessee); the length of the contract (the shorter or the more variable the contract might be, the more risky it is, as the lessor will have to re-rent the equipment at his own risk after the initial rental period – for this reason shorter contracts are usually more expensive than longer contracts); the quality of the assets (maintenance costs evolution, costs of potential breakdowns); and the residual value (the ability to dispose of the equipment at a fair price at the end of the leasing period of the equipment), which is not neutral in the price calculation
(in theory, the higher the residual value, the lower the leasing price).
Please note that in periods of technological change, this is an element that might be hazardous to determine when acquiring the equipment, given the risk of anticipated obsolescence.
(2) The sooner the return, the better for the investor. For instance, other things being equal, if an asset is worth US$100,000 and that
the revenue over a period of three years is US$120,000 (i.e. US$40,000 a year), it would generate an IRR of about 10%; if the same revenue is spread over a period of four years (i.e. US$30,000 a year), it would generate an IRR of about 8%. To get the same IRR over a period of three years, the fee over a four year period should be increased to about US$31,500 a year. This simply illustrates the
depreciation of money over time.
It is worth noting, however, that the price per year for a four-year contract remains usually inferior per year to the price per year for a three-year contract, which means that the longer the equipment is under contract, the cheaper per year it becomes for the lessee (in our example, US$40,000 a year over three years vs US$31,500 a year over four years).
The fact that the pricing of a GSE leasing contract is based on the IRR computation can also generate some significant differences on pricing in the case of a sale and rent back transaction, compared to the leasing of new equipment. Indeed, in a fleet conversion
programme, the IRR computation from the lessor’s point of view will be based on a smaller initial investment, a shorter leasing period and a different cost pattern (because of the position in the maintenance cycle) than for new.
In these cases, if the equipment is purchased from and re-rented to the lessee in a sale and lease back contract, the price of the operating lease for this second-hand equipment will then be generally less expensive than for equipment purchased new by the lessor.
If a replacement plan is associated with the contract to rejuvenate the fleet, the lessee might thus expect a price increase once the second-hand equipment is replaced by a new piece of equipment. Although this does not, at first sight, support a fleet rejuvenation programme, lessors are generally well equipped to deal with these situations and offer flexible solutions to the lessee for a smooth fleet
rejuvenation programme (which is of the upmost importance in the current trend towards greener GSE, for instance).
Price per hour
Most leasing providers also offer a price per hour mechanism, which basically makes the leasing per hour less expensive when the equipment is intensively used (and more expensive per hour of utilisation when the equipment is less or not used). This is the result of both better fixed costs coverage when the GSE utilisation volume increases and, as explained above, the faster return on the asset leased.
However, for the lessee, the total invoice decreases if the equipment is used less (i.e. a higher price per hour but fewer hours), and vice versa.
Volume discounts
As discussed earlier, it is not unusual that besides the price grid, a lessee can also benefit from a volume discount agreement, which can be based on several criteria and which most of the time is aiming to align the interests of the lessee and the lessor.
For instance, the larger, the longer and the less volatile the leasing volume is for the lessor, the higher the volume discount that can be expected from the lessee.
Some contractual elements
A contract for a couple of pieces of equipment is, by essence, much simpler than a contract for full sale and lease-back transactions that implies the taking over of equipment, the transfer of personnel and the taking over of a workshop facility. In those cases, beyond these specific takeover contract arrangements, the leasing contract would be usually regulated by a couple of main documents:
- The Frame Contract defines the global contractual relationship between the lessee and the lessor at group level.
- The Full-Service Rental Agreement is the application contract, often at airport or specific contractual level that will, amongst other things, describe the equipment leased, the pricing, the resolution mechanism in case of damages, and so on.
- The Service Level Agreement defines operational topics like workshop opening hours, service levels, maintenance cover (or not), the minimum equipment levels that should be always available, repair tariffs, and so on. These SLAs are most of the time very local, as operations might differ a lot from one airport to the other.
- The Volume Discount Agreement, which is likely to be based on a mix of both local and global business between the lessee and the lessor. In this set of agreements, some points of particular attention for both parties should be, amongst others, the termination of part
or all the contract; the damages resolution process; the flexibility with regards to the amount or usage of equipment (fleet reduction or increase, fleet adaptation to aircraft changes or seasonality); the price grid and the pricing revision formula (CPI); the GSE minimum requirement; the maintenance services included in the service fees, as well as any eventual additional services (equipment cleaning or early morning assistance, for instance).
In addition, consideration should be given to the factors of use, misuse, the spare parts, the minimum availability levels, and so on.
Finally, please note as well that in some leasing agreements (mainly the financial lease), some customers expect buy-back options from time to time at the end of the contract. Although this might look at first sight like a protective mechanism for the lessee, it is in fact not an easy matter to deal with for the lessor, nor for the lessee.
As described above, the leasing fee is being calculated on the full lifecycle of the equipment; any shorter period would introduce a bias in the computation and the leasing fee will be usually more expensive for the lessee, which would also have the effect of making the contract less flexible, with the potential for sterile discussion at the contract’s end.
Conclusions
The pricing mechanism of leased equipment is based on a rather sophisticated IRR computation over the lifecycle of the equipment. The price is the result of an equation model which is based on key parameters, such as cost of capital, initial investment, future costs patterns, residual value, utilisation rate of the equipment, and so on.
When interpreting a leasing offer, it would be advisable to understand what the underlying hypotheses in the make-up of the pricing mechanism are, together with the numerous options and features contained in the contract in a global perspective, taking into account the lessee’s own priorities, rather than just discussing the price level as such.
Similarly, the set of contracts and agreements which frame any leasing transaction deserve a good operational understanding from both the lessee and the lessor to grasp the operational effects of what are, by essence, legal documents. In this regard, some simplified ‘contract terms user manual’ could be prepared for the operatives in the field so that their rights and obligations are contained within the documentation, in a practical and easy to use manner.
The fourth and final article in the December GHI Annual will conclude the main points of our global study that has been published in December, February and June issues, and attempt to assess possible futures for the concept, whilst giving some takeaway
points for existing and potential new stakeholders in this business.
