Aircraft Operating Leases - Economic Aspects of Utility Consumption-End of Lease (EOL) Compensations

Commercial Aircraft Operating Leases Economic Aspects of Utility Consumption Leases that apply End of Lease (EOL) Compensations 1.

Introduction

Certain aircraft components are expensive to maintain. At some point, those components must be either (i) replaced, as is the case for components with certified limited life, (ii) repaired/overhauled, as is the case for components whose performance deteriorates over time until they can no longer function, or (iii) inspected and “corrected/repaired,” as is the case for corrosion and cracks findings in airframe checks.

The certified life of the component, the period until performance deteriorates, or the inspection interval, corresponding to (i), (ii), and (iii) above, is what is commonly referred to as utility.

The cost to replace, repair, or correct these items may represent amounts ranging from $500,000 to $10 million, or more, depending on the component and aircraft type.

The usual question is: who pays for utility consumed in commercial aircraft operating leases?

The answer to that question depends on how the aircraft lease agreement is structured.

A series of papers have been published that illustrate how this is structured in commercial aircraft operating leases.

In a paper from 2020, a simple introduction to the Maintenance Reserves / Maintenance Rent (MR) concept and Maintenance Rent Rate (MR Rate) was provided (Paper 1).1 A second publication from 2021 provided an explanation and overview of how utility is determined and accounted for in the case of Engine Performance Restoration (Engine PR), (Paper 2).2 Another publication from 2022 illustrated how MRs work throughout the life of a lease agreement for Engine PR (Paper 3).3 It is noteworthy that compensation for utility consumption is sometimes conducted through MRs throughout the life of the lease as explained in Paper 3. However, in certain cases, compensation for utility consumed is billed at the end of the lease, meaning no monthly payments are made, but a single lump sum is paid at the end of the lease, which is what is commonly referred to as an end-of-lease (EOL) payment lease.

Two types of lease agreements exist—leases with and without MRs. Leases without MRs are usually referred to as leases with EOL compensation. Whether or not to structure a lease using MR or EOL compensation involves commercial and risk considerations that are heavily negotiated between lessees (airlines) and lessors.

In general, high-credit lessees may be able to negotiate EOL compensation instead of MRs.

1

Omar Zuluaga, “Aircraft Operating Leases Maintenance Reserves - Basic Concept Explanation,” n.d., https://issuu.com/omar_zuluaga/docs/aircraft_operating_leases_-_maintenance_reserves_2 Omar Zuluaga, “Aircraft Operating Leases Engine PR MRs Basic Concept Explanation,” n.d., https://issuu.com/omar_zuluaga/docs/aircraft_operating_leases_engine_pr_mrs_basic_conc 3 Omar Zuluaga, “Commercial Aircraft Operating Leases, Economic Aspects of Utility Consumption, Leases that Apply MR” n.d., https://issuu.com/omar_zuluaga/docs/commercial_aircraft_operating_lease_d10fa92589ca39

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This considers that lessors tend to favor MRs (cash) as collateral in cases when bankruptcies, defaults, and aircraft repossessions are potential risks during the lease.

Additionally, compensation for utility consumed is usually applied not only to Engine PR, but also to engine life-limited part (LLP) replacement, airframe major checks4, APU performance restoration, and landing gear overhaul, among others. More recently, engine thrust reversers and “high-value components” of certain aircraft types are also included in the list of items that may apply MR or EOL compensations. These are collectively called Major Events.

This paper attempts to illustrate how EOL payments work at the end of the lease agreement (redelivery) for Engine PR. For familiarization, it is recommended to first read Papers 1, 2, and 3. Since the principles are the same for other Major Events, those will not be discussed in this paper.

Finally, only EOL compensation scenarios where the comparison of the status of the engine at redelivery is compared against the status at delivery will be discussed in this paper. Other types of EOL compensations, like those based on a notional engine status called “Half-Life” used for comparison purposes at redelivery, will not be discussed in this paper.

2.

EOL Compensation Rates – Introduction

To illustrate how EOL compensation rates are defined, one of the highest-costing Major Events will be used: Engine PR. For this introduction, notional assumptions are made as follows: 2.1. A notional aircraft engine that lasts on wing 20,000 Flight Hours (FHs) (Mean Time Between Removal - MTBR) before it must be removed to restore the performance at a specialized shop. This is usually referred to as a Shop Visit (SV). The time-on-wing of a new engine before it needs an SV is higher compared to the time-on-wing after each subsequent SV.5 Nonetheless, for simplicity, it will be assumed that the MTBR is the same for every SV. 2.2. The notional cost to restore the performance of that engine is $2,000,000 (SV Cost). The cost of the first and subsequent SVs differ. This is due to differences in the work scope of each SV.6 Nonetheless, for simplicity, it will be assumed that this cost is the same for every SV. 2.3. This translates into a cost per hour of $100/FH (2,000,000/20,000) (EOL Compensation Rate). As stated below, this rate may change over time, but for the sake of simplicity, it will be assumed that this rate remains static over time. This rate will be used in all the scenarios discussed.

It is noteworthy that some leases set a pre-agreed EOL Compensation Rate at the beginning of the lease agreement, while other lease agreements leave the negotiation of the EOL Compensation Rate open until the end of the lease. Which method to use is a subject of lease negotiations before the initial delivery of the aircraft.

In cases when the EOL Compensation Rate is agreed at the beginning of the lease, the EOL rate is usually adjusted by inflation at lease end. This is because SV Costs may have increased since the delivery of the aircraft, mostly due to labor and material cost inflation. Additionally, the MTBR on which the initial EOL Compensation Rate was negotiated at the beginning of the lease may have similarly changed over time.

4

Checks usually occur at years six, nine, or twelve since new, as well as corresponding repeats depending on the aircraft type and specific task card grouping approved practices.

5 Shannon Ackert, Engine Maintenance Concepts for Financiers, 2011.

6 Ibid.

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In cases when the EOL Compensation Rate is negotiated between the lessor and lessee at redelivery, the lease agreement will stipulate how the EOL Compensation Rate should be calculated.

One of the most common methods is to use quotes (SV Cost, MTBR, Rate) from two reputable providers (in general, approved engine repair shops), one picked by the lessor, and one picked by the lessee. The providers should not be affiliated with either the lessor or lessee. The average of the two quotes dictates the EOL Compensation Rate that will be used at redelivery.

Finally, it is important to mention that strict lease requirements must be followed to make an SV a qualifying one for EOL compensation purposes. Usually, predefined work-scopes that are supported by the Workscope Planning Guide of the Engine manufacturer are stated in the lease agreement. Ordinary engine “repairs” usually do not qualify for EOL compensation purposes.

The term Shop Visit (SV) used in this paper assumes that these qualify for EOL compensation purposes.

3.

EOL Compensation Scenario – Engine New at Delivery (First Lease) This is the typical case when the aircraft is delivered to the lessee directly from the factory. In such cases, the EOL compensation calculation is made from either: i) ii)

Original Entry Into Service (EIS) until lease expiration (if no SV occurred prior to redelivery).

From the last SV until redelivery.

The following examples further explore the latter case (ii).

3.1. Major Event (Engine PR) “Fresh” at Return For this scenario, the following assumptions are made: 3.1.1. Annual utilization of the aircraft is 2,500 FHs per year.

3.1.2. The length of the lease is 8 years.

3.1.3. The Return Condition (RC) of the engine, as per the lease agreement, is that the engine has had no more than 10,000 FHs of operation since new or the last PR SV, whichever is more recent. This is usually stated as 10,000 FHs Since Last SV (SLSV).

3.1.4. The EOL compensation clause of the lease agreement states that the lessee must compensate the lessor for FHs consumed since the last qualifying SV. This means that at the end of the lease, the engine will have reached 20,000 FHs of operation and the performance of the engine does not allow the engine to be operated further.

Additionally, upon return, the engine will not comply with the RC of a maximum of 10,000 FHs SLSV. Under this scenario, the engine must go to the shop right before the aircraft is returned to the lessor. The usual leasing jargon term used to describe this is that the engine is being returned “Fresh.” In this case, the lessee is described as returning the engine in the same condition (i.e., with the same “potential”) as was the case at delivery. This is illustrated in Graph 1.

Here the lessee does not need to pay any EOL compensation to the lessor.

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Graph 1 3.2. Major Event (Engine PR) with usage (Not Fresh) at Return For this scenario, the following assumptions are made: 3.2.1.

3.2.2.

3.2.3.

3.2.4.

Annual utilization of the aircraft is 2,500 FHs per year.

The length of the lease is 10 years.

The RC of the engine is the same as that of 3.1.3 above, a maximum of 10,000 FHs SLSV. The EOL compensation clause of the lease agreement states that the lessee must compensate the lessor for FHs consumed since the last qualifying SV.

This means that in year 8 of the lease when the engine achieves 20,000 FHs of operation, the engine must “go to the shop” due to its lack of performance.

This would mean that in year 10, when the engine (and the aircraft) must be returned to the lessor, the engine has 25,000 FHs of total operation (Total FHs), the usual acronym being Total Time (TT). In addition, upon return, the engine would then have 5,000 FHs SLSV. This means that the engine complies with the RC of no more than 10,000 FHs SLSV. In this scenario, the lessee is described as returning the engine with 5,000 FHs “consumed” since the last SV. This is illustrated in Graph 2.

Here the lessee must pay the lessor an EOL Compensation of $500,000 (5,000 FHs x $100/FH)

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4.

EOL Compensation Scenario – Engine Not New at Delivery (Second and subsequent leases) This is the typical case when aircraft are delivered to a subsequent lessee after being used by a first lessee since new. In many instances, a qualifying Engine SV may have already been performed before delivery to a subsequent lessee.

In such cases, a comparison is made between the condition at delivery versus redelivery, and any compensation is determined based on any deficits or excesses. This concept is commonly known in leasing jargon as an “Upsy/Downsy,” whereby a positive cash flow to the lessor is attributed to an “Upsy” compensation, and a negative cash flow is denoted as a “Downsy” compensation.

4.1. Major Event (Engine PR) – Superior Condition at Redelivery Compared to Delivery For this scenario, the following assumptions are made: 4.1.1. Annual utilization of the aircraft is 2,500 FHs per year.

4.1.2. The length of the lease is 6 years.

4.1.3. The engine was delivered with 10,000 FH SLSV. This means that the engine can be operated for 10,000 FHs before it needs an SV. 4.1.4. The RC of the engine is the same as that of 3.1.3 above, a maximum of 10,000 FHs SLSV. 4.1.5. The EOL compensation clause of the lease agreement states that: (i) if the lessee returns the engine with more than 10,000 FHs SLSV, the lessee will compensate the lessor, and (ii) if the lessee returns the engine with less than 10,000 FHs SLSV, the lessor will compensate the lessee.

This means that in year 4 after delivery, when the engine has achieved 20,000 FHs of operation since the last SV, it must “go to the SV” and receive a performance restoration.

Subsequently, the engine will be operated for 5,000 FHs during years 5 and 6 of the lease before redelivery of the aircraft. The engine will also comply with RC. As such, upon return, it will have 5,000 FHs SLSV. This is compared to the 10,000 FHs SLSV the engine had at delivery. This means that the lessee will return a “better” engine compared with the status of that same engine at delivery. This then becomes a “Downsy” compensation for the lessor. This is illustrated in Graph 3.

Here the lessor must pay the lessee an EOL Compensation of $500,000 (5,000 FHs x $100/FH)

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4.2. Major Event (Engine PR) – Inferior Condition at Redelivery Compared to Delivery For this scenario, the following assumptions are made: 4.2.1.

4.2.2.

4.2.3.

4.2.4.

Annual utilization the aircraft is 2,500 FHs per year.

The length of the lease is 10 years.

Engine delivered with 10,000 FHs SLSV. The RC of the engine, as per the lease agreement, is that the engine must have no more than 15,000 FHs SLSV. 4.2.5. The EOL compensation clause of the lease agreement states that: (i) if the lessee returns the engine with more than 10,000 FHs SLSV, then the lessee compensates the lessor, and (ii) if the lessee returns the engine with less than 10,000 FHs SLSV, then the lessor compensates the lessee.

This means that in year 4 after delivery, when the engine has achieved 20,000 FHs of operation since the last SV, it must “go to the SV” and receive a performance restoration. The engine will then be operated for 6 more years (15,000 FHs). The engine will also comply with RC. As such, upon return, the engine will have 15,000 FHs SLSV. This compares to the 10,000 FHs SLSV it had at delivery. This means that the lessee will return a “worse” engine compared to the status of that same engine at delivery. This then becomes an “Upsy” compensation for the lessor. This is illustrated in Graph 4.

Here the lessee must pay the lessor an EOL Compensation of $500,000 (5,000 FHs x $100/FH)

Graph 4 5.

Conclusion EOL compensations are an important way for lessors and lessees to calculate and compensate utility consumed at the end of a lease.

The definition of the EOL Compensation Rate is equally important since it involves specific costs and operating intervals that ultimately define the compensation rate utilized. The definition of these variables during lease agreement negotiations is critical as they define what will occur at the lease end.

Understanding the mechanics of EOL compensations enables lessees and lessors to effectively plan aircraft returns and corresponding monetary compensations.

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About the Author Omar Zuluaga is a former Vice President and Head of Technical Support at AerCap. Currently, he works as an independent advisor providing services to institutional investors, management consulting firms and corporates.

He has spent eighteen years working in technical areas of the aircraft operating leasing industry. Prior to that, he worked in airline technical operations for ten years.

One of Omar´s principles is to share his knowledge and experience, which is why he delivers instruction about main aspects of commercial aircraft leasing, focused on technical clauses, to different audiences.

Omar Zuluaga holds a Bachelor of Science degree in Aviation Electronics from the Riga Civil Aviation University in Latvia (formerly RKIIGA) and a Master of Science degree in Aviation Management from Arizona State University. www.linkedin.com/in/omar-zuluaga

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