Advantages Disadvantages of Leasing Aircraft Research Paper

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Leasing Aircraft

The emergence of low cost carriers has marked a shift in the aircraft industry away from owning aircraft and towards leasing and subleasing of aircraft. National and legacy carriers have long struggled with profitability, and their business model is in part a reason for this. Low cost carriers have attempted to resolve the business issues of heavy debt burden and excess capacity by leasing aircraft rather than owning them. There are other advantages to aircraft leasing as well, including a reduction in maintenance costs. Aircraft leasing has become part of the low cost carrier business model. This paper will examine the issue of aircraft leasing, in particular with respect to the financial considerations. A conclusion will be drawn with respect to the leasing decision and whether or not it is recommended for airlines today.

Overview of the Industry

The aviation industry is one of the world's largest businesses, worth an estimated 7.5% of global GDP (Investec, 2010). Traditionally, airlines purchased aircraft, often with financing from the manufacturer. In 1994, only 18% of commercial aircraft were leased. Since that time, fueled by the rise of low cost carriers, leased aircraft now account for 40% of the global commercial aircraft fleet and this figure is expected to continue rising (Ibid). Lessors tend to be financial institutions, or subsidiaries thereof, and they enter the business because they can finance the aircraft at very low rates and then lease them out at rates that are profitable but still competitive for the airlines. Low cost carriers in particular became attracted to aircraft leases because they were unable to secure sufficient credit to purchase planes and expand rapidly enough to meet their business objectives. Low cost carriers soon identified other benefits of leasing as well.

The air travel industry is considered to be cyclical and has suffered two major demand-side shocks in the past ten years. The first came in the wake of the September 11th terrorist attacks in the United States; the second came in the wake of the global economic downturn. The industry is now growing again, lead by air travel in the Asia Pacific market, and the success of the Middle Eastern carriers. There is double the number of aircraft in the skies compared with 1990 (Investec, 2010). The low cost carrier model in particular is spreading around the world, with the concept being introduced in Southeast Asia, China, India and the Middle East. This has fueled growth in leasing. It is expected that in 2011 there will be over 7200 leased planes. There are even indications that legacy carriers are increasing the amount of leased aircraft in their fleets, cognizant of the benefits of leasing (A.T. Kearney, 2011). There is also evidence that more companies are entering the leasing industry, and that aircraft leasing is becoming capitalized (Investec, 2010).

Benefits of Leasing

There are four main benefits to leasing aircraft instead of buying. They are financial liquidity, capacity flexibility, rapid expansion, fleet consistency and reduced maintenance costs. Financial liquidity has been critical for low cost carriers, but this benefit can accrue to any firm in the industry. Traditional aircraft purchases are typically financed with debt, and this reflects on the balance sheets of many airlines. These debt obligations are long-term. The airline then has to fill that capacity. The airline, however, is highly-leveraged and a very low portion of its earnings go towards profit. This leaves the airline with a low level of liquidity. It is also worth considering the main financial benefit of purchasing vis-a-vis leasing comes after the purchase is paid off. This takes upwards of twenty years. A net present value calculation would indicate that cash flows twenty years in the future are not worth much. In addition, the aircraft may not even be serviceable, or at least not efficiently so, at that point in time.

A related benefit is increased capacity flexibility. Leasing gives the airline greater ability to manage obligations on the airline's cash flow. When the industry experiences a demand shock, as happens fairly frequently including twice in the last ten years, most airlines lose money because they have to meet those obligations from their cash flow regardless of how much revenue they are actually earning. From an operational point-of-view, the airline is in a situation where it is faced with reduced load factors. If the airline was able, it would reduce the flights it offers in order to increase load factors. When the airplanes are purchased, such reductions would leave planes idle, but being paid for. Under a lease arrangement, the airline has more flexibility to manage its capacity by cutting flights and planes at once. This allows for load factors to be maintained across the company as weak routes are cut during demand shocks. In addition, the cash flow obligation is reduced as well to match the operating reductions.

The financial flexibility afforded by aircraft leasing also allows them to expand rapidly. Airlines always issue some equity, but are primarily dependent on debt. For newer airlines, the lousy financial track record of legacy carriers makes it all the more difficult to raise the capital needed to expand quickly. Rapid expansion is necessary because building a large route network is essential for generating traffic within an airline and for building loyalty programs. With debt financing unavailable, leasing becomes the only option for many airlines seeking to expand their coverage rapidly (Jeremiah, 2011).

Fleet consistency is another issue that can be resolved in part by leasing. Many low cost carriers in particular operate uniform fleets. This allows the airlines to reduce their training and maintenance costs considerably, and to maintain stores of parts for minor repair work. While many older, larger carriers need to maintain a variety of different aircraft, smaller airlines can use just one type, especially if they are leasing. The major aircraft manufacturers often have backlogs, so for an airline to achieve fleet consistency will involve acquiring aircraft on the secondary market, with leasing or subleasing being the easiest means of doing so.

Low operating costs are essential to airline profitability, and leasing plays a part in this strategy, for a couple of different reasons. The first is that fleet consistency reduces the complexity of the maintenance function, thereby reducing its cost. The second is that leasing allows major repairs to be offloaded to the owner of the aircraft. The degree to which the airline can do this will depend on the specific details of the contract and the amount and type of insurance coverage that the airline carries. Another reason why leasing lowers maintenance costs is that it allows for the airline to have a low average fleet age. A younger fleet is reflecting not only in direct maintenance costs but also in fuel efficiency, as newer aircraft are designed better than older aircraft and they are less prone to breakdown as well.

Disadvantages of Leasing

Despite the strong case to be made for leasing or subleasing aircraft, there are some additional considerations that need to be taken into account. Leasing has a few drawbacks that should be mentioned. The first is that leasing does not guarantee any airline a supply of the aircraft it needs. The second is that short-term costs are often higher under leasing arrangements. The third is that the airline has less control over the quality of the aircraft. Lastly, lease rates are not a fixed cost -- they can increase and have in recent years as demand for leased aircraft has increased sharply.

The supply of aircraft, whether purchased from the manufacturer or leased, is fixed. The leasing model gives all airlines engaged in leasing the flexibility to shrink or grow their fleets according to demand conditions in the industry. While there are benefits to this, a major drawback is that some airlines may not be able to lease aircraft if there are no extras available. Firms that purchase their aircraft plan further in advance, and while their ownership gives them higher costs, the benefit in exchange for those costs is the ability to acquire new aircraft whenever the firm wants. For discounters using leased aircraft this is not always going to be the case, especially during upswings in demand (Jeremiah, 2011).

Short-term costs are often higher under lease arrangements. For many small airlines, the total cost of leasing includes not only poor financing rates but also high insurance costs, these costs can be higher for leasing than for buying. In addition, the airline never owns any aircraft, therefore never has any airplane in its fleet that is earning it money but for which it is not paying.

Airlines also have less control over the quality of the aircraft. The airline does not own the craft, and while the airline is often in charge of the maintenance, it does not necessarily have control over all of the quality aspects of the craft. In addition, when airlines purchase aircraft they often have the ability to have the interior of the aircraft tailored their specifications. This is…

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