How to Manage Aircraft Financing Costs

As the U.S. Federal Reserve Bank cranked up the federal funds rate to tame inflation, the cost of aircraft lending and leasing increased. Then, last month, the Fed signaled that it might cut the rate a few times in 2024, setting off rampant speculation about when and how many cuts might occur.

Did the Fed’s announcement mean that aircraft lenders and lessors (financiers) can expect transactions to take off? No one knows, but even if rate cuts occur and financing shows the potential to soar to new heights, challenges will continue to exist for financiers.

The notion that cash is king resonates with aircraft buyers, and cash remains the way many of them make their purchases despite sensible reasons to finance. 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 funds available for aircraft lending.

As a result, some lenders won’t—or can’t—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? Of course not. A borrower and an aircraft lender can handle them with contract, interest rate, and economic structuring that, ideally, positions the borrower to seize on any Fed rate cuts, create acceptable loan payment obligations, and reallocate cash to profitable investments or business operations. Consider a few 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 make a similar deal with a counterparty separate from the borrower transaction.

The loan principal remains the same. A floating rate moves up or down as interest rates change based on the applicable benchmark index such as the Secured Overnight Financing Rate (SOFR), while a fixed rate remains unchanged during the loan term.

A swap from a variable to a fixed rate, at closing or during the loan term, removes the risk of interest-rate volatility. The move also allows the borrower to plan for fixed loan payments and to lock in possibly lower fixed rates during the loan term. That might occur due to Fed rate cuts or for other reasons. A swap from a fixed- to 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 means yields on shorter-term bonds exceed those on 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.

Some borrowers prefer to fix rates to lock in a payment amount, but swaps may still produce a lower fixed rate than the customary fixed-rate lending transaction. So, it’s always worth asking a lender about swap rates that might be lower than a traditional fixed-rate quote.

Collateral true-ups. A lender requiring a collateral true-up structure has the right to demand 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 might range from 35 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 appraisal early in a transaction to establish the aircraft’s initial fair market value.

For example, assuming no interest is payable, which is rare for preowned aircraft, a buyer might purchase a jet with a price of $10 million and borrow $8 million. The LTV is 80 percent on the first day of the loan (because $8 million is 80 percent of the purchase price). If the aircraft’s value drops below the specified LTV, a lender might 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 their amount and timing. If the parties can’t agree on a value, they can obtain an appraisal for that purpose.

Amortization periods. Extending the loan amortization period lowers 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 that 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 they don’t use an LTV, leases use a rough corollary: the aircraft’s “residual value,” which refers to its value at the end of the lease term.

The lessor purchases the aircraft from the seller, which may be the lessee (referred to as a sale leaseback transaction), and agrees that the lessee can use the aircraft ostensibly like an owner in exchange for rent and compliance with aircraft insurance, operational, maintenance, return, and other requirements affecting the use and possession of the aircraft.

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 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 aircraft’s delivery date. The borrower can then pay off the bridge loan or any remaining portion of the purchase price with a securities line of credit or cash, convert its current bridge loan to a long-term lease or loan, or find another financier for the long-term lease or loan. By itself, bridge financing might 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 inflation. The almost 0 percent rates of yesteryear will not return soon, if ever. If and when the Fed cuts the federal funds -rate, financing may get a lift. However, when properly structured and negotiated, loans and leases make economic sense today and will continue to do so for the foreseeable future.

This article should not be construed as legal advice. Its comments, recommendations, and analysis are those of the author. Your use of the article does not create an attorney-client relationship between you and the author or his law firm. You should consult your trusted advisors on these subjects and not rely on this article except as a reference source.

David G. Mayer is a partner in the global Aviation Practice Group at Shackelford, Bowen, McKinley & Norton, LLP, in Dallas, where he advises clients on private aircraft matters, including regulatory compliance, tax planning, purchases, sales, leasing and financing, risk management, insurance, aircraft management and operations, hangar leasing, and related corporate work. Mayer frequently represents corporations and high- and ultra-high-net-worth individuals and other aircraft owners, flight departments, lessees, borrowers, operators, sellers, purchasers, corporations and managers, as well as lessors and lenders.