When comparing investment returns it is misleading to simply look at headline figures. At first glance, it might seem an investment that gained 12% last year is better than one that gained 9%. In reality, it depends on how much risk was involved in generating those returns. The more risk (or volatility), the less probable the returns. The simplest way to measure risk is to look at the standard deviation of the returns. The larger the standard deviation, the riskier the investment.
Investors use the ‘Sharpe’ ratio, a ‘rewards to variability ratio’ to better compare alternatives. The ratio uses the standard deviation (a measure of volatility) to measure the ‘risk adjusted’ return. It’s a measure of the excess return over the risk-free rate relative to the standard deviation. It helps answer the question: “Is the ‘risk adjusted’ return worth the investment risk I am taking”?
Investing in commercial aircraft has historically demonstrated returns that adequately compensate for variability. Aircraft are hard assets with long useful lives*. It’s common for a commercial jet to remain in service 25 years or more. Some even longer, such as a 1970 Boeing 737-200 (serial number 20335), which is still flying with Airfast Indonesia (registration PK-OCG, based in the city of Jakarta, Surabaya and Denpasar). At 47 years, it may be the world’s oldest commercial passenger aircraft still in service (the second oldest 737 is registered to Johannesburg based Interair, South Africa, and, Kenya’s Trans African Air has a 42-year-old 737).
Profitability is just as important as equipment longevity. The International Air Transport Association forecasts global air carrier profitability will rise to $38.4 billion in 2018, up from an expected $34.5 billion in 2017. Operating margin, overall revenue, passenger and air cargo traffic, and average profit per departing passenger are all improving. 2018 is expected to be the fourth consecutive year of sustainable profits with a return on invested capital of 9.4%, which exceeds the industry’s average cost of capital of 7.4%.
IATA’s Director General and CEO recently stated: “These are good times for the global air transport industry. Safety performance is solid. More people than ever are traveling. The demand for air cargo is at its strongest level in over a decade. Employment is growing. More routes are being opened.” Operator challenges include fuel, labor, and infrastructure expenses which are rising. Performance drivers? Passenger and cargo growth. All regions are expected to report improved profitability in 2018. Global connectivity is vital to our modern lifestyle.
As a pilot, you identify and avoid turbulence (and if in turbulence, slow your airspeed). Information limitations can impact your ability to see and avoid. Similarly, in piloting investments, techniques are available for avoiding turbulence while enhancing returns. The complexity surrounding aircraft investment and residual valuation requires sector-specific expertise. Generating income, while retaining upside and liquidity over your investment horizon requires contextual expertise. Blue skies or stormy weather? Modern weather and radar equipment suggest you work with investment managers who have demonstrated abilities structuring transactions that produce, regardless of the weather. Generating such results requires an appreciation of risk-adjusted returns.
Aviation and Rail teamwork. We have the investment roadmap.Call RESIDCO.
*Delta operates 860 aircraft with an average age of 17 years, including a 30-year-old 757, and 30-year-old McDonnell Douglas MD-80s. American also operates MD-80s, the oldest of which was delivered in 1986. British Airways oldest aircraft is a 747, registration G-BNLK, which it received on May 4, 1990
According to IMF and the OECD, 80% of the world’s major economies are at full employment. Encouraged by immediate expensing and repatriation of cash from overseas, the U.S.’ traditionally robust consumer demand is now expected to be supplemented by productivity improving capital investment. Transportation investment markets follow traffic demand and with economic growth on the upswing investment fundamentals are favorable.
Both Boeing and Airbus single-aisle aircraft are ‘flying high’ with performance metrics investors most care about: cash generation. With order backlogs in place, new equipment deliveries are expected to surpass those of 2017.
The competition between the 737 MAX and A321neo continues. Boeing’s 737 family brought in 745 net firm orders in 2017, up from 550 in 2016; for the 787 Dreamliner family, net firm orders in 2017 were 94, up from 58 in 2016; and, for the 777 family, 60 net firm orders, compared with 17 in 2016. Boeing delivered a record 763 planes in 2017; Airbus 718, and both the A320neo and A321neo order books improved.
However, problems with Pratt & Whitney engines on the A320/321neo Airbus models continue. Engine component failures are causing some of these aircraft to be grounded while engines are repaired or replaced. Both the Boeing and Airbus single-aisle aircraft types will support strong secondary markets long into the future.
While the broad rail industry environment remains stable, carload traffic (except for intermodal) remains challenged (crushed stone, sand, gravel, petroleum, and lumber and wood products saw carload gains in January). With a tight trucking market, Washington’s infrastructure planning, growing petrochemical production, and shale oil’s return, the Class Ones expect to work this year to build and sustain an ongoing business. Questions remain with NAFTA and coal.
China continues to be a major force in commodity pricing. Price developments in industrial metals will be largely determined by Chinese demand (steel, aluminum, copper). In addition, rising Shale Oil production will act to control crude oil pricing.
Recent moves to eliminate excessive government regulation (and the passage of tax reform) are acting to boost economic growth. With stronger growth and a tightening job market, interest rates are expected to rise at both the short and the long end of the yield curve. The result is likely to lead to market stress as increasing inflation will prompt the Federal Reserve to raise interest rates even faster than currently expected. Geopolitics and the midterm elections are risks.
For 2018, we expect the world’s major economic regions will exceed expectations. The U.S. expansion will enter its tenth year in March. If it continues through August, it will officially become the longest in history. With the Federal Reserve shrinking its balance sheet and raising rates, market volatility has returned.
Are we at a peak? No.
A recession is not on the near-term horizon as financial conditions have not shown any sign of significant deterioration.
Consider that an investor’s natural aversion to risk often leads to taking more risk at market highs and less at market lows. Today’s environment requires a special degree of foresight and judgment. Attention to economic fundamentals, customer relationships, opportunities, and a focus on long-term results are key. The ultimate risk is not in what kind of investments you have, but in what kind of investor you are. Long-term returns are available to those who focus on disciplined and active portfolio management.
Transportation specialist knowledge is powerful. For uncommon sense call RESIDCO.
The Tax Cuts and Jobs Act (the ‘Act’) will be an investment game changer. It is expected to pass Congress and be signed by the President. It will lower the corporate tax rate to 21% and provide for 100% immediate expensing of capital investment (but only for five years).
Currently, the U.S. tax regime employs a ‘worldwide’ system, meaning U.S. taxpayers owe U.S. tax on all their profits regardless of where those profits were earned. The new act will employ a ‘territorial’ system, meaning U.S. companies would owe U.S. tax only on what they earn here. Offshore profits would be subject to whatever tax is imposed by the country where the money is made, meaning you would just pay the local rate and be free to move your funds back to the U.S. Existing offshore profits will be ‘deemed’ to be repatriated and immediately taxed at 15.5%.
There will be a global ‘minimum’ tax of 10% (if you pay a lower rate in a foreign country you will have to remit the difference to the U.S. Treasury). Interest deductions will be limited to the sum of business interest income plus 30% of EBIT (no depreciation). And, since the Act taxes interest earned but limits the deduction for interest paid it has an ‘implicit’ tax on leverage. For those equipment lessors who are taxed as pass-through entities, a ‘deduction’ of 20% of ‘qualified business income’ subject to limitations and phaseouts is allowed.
How The Tax Act Will Impact Equipment Financing and Leasing
Lower tax rates, 100% write-offs, and limitations on the deductibility of interest all impact the economics of the equipment financing decision. If your firm is ‘EBIT’ taxable and has access to equipment investment funding, whether from internal cash flow, bank lines or from the capital markets the lease versus buy decision may change. But, lease financing will remain an attractive alternative in both the air and rail markets. It retains its risk transfer characteristics, term flexibility, and allows those air and rail carriers, who are not otherwise able, to fully utilize the tax benefits of ownership through lease pricing.
Investment managers now have the task of analyzing the Act and acting to improve competitive position. Tax planning and profit shifting is used to exploit gaps and mismatches in tax rules. Since investment platforms seek to maximize after tax returns the goal is to move profits to low-tax entities or jurisdictions where profits will be taxed at lower rates, and move expenses to where they will be relieved at higher rates. The Act’s switch to a ‘territorial’ system will require both air and rail operators and investors to review sourcing rules to determine where income is earned.
Aviation and Rail Investments
Aviation investment has delivered returns better than competing asset classes. Both domestic and international Aviation markets continue to show demand growth with historically high load factors and aircraft utilization rates. Rail carload and intermodal traffic for 2018 is expected to improve. Investors who understand equipment values and the business dynamics of their lessees will continue to support fleet growth in this new environment.
America is successful because of its geography, resources, political system, and decentralization of power. America is a magnet because of our freedoms and business environment. Strong businesses drive growth and create jobs. This legislation introduces the most pro-growth tax policy in decades. With passage investors will be faced with a new competitive landscape. Lease pricing and existing portfolio values will change.
Long term value decisions are best made based on the most probable compounding of after-tax net worth. Risks comes from not knowing what you are doing. Interested in discussing what actions you should take? Contact RESIDCO.
The U.S. Economy has sustained 3% growth for two consecutive quarters. Prospects for continued growth in 2018 are strong, and there is likely to be an extra boost if tax reform is passed by Congress. Rising household wealth and job gains suggest the Federal Reserve will raise rates in December and several times in 2018. In this environment, growing air and rail transportation investment requires a strong origination team supported by a supply of competitively priced capital. Behind the business and economic analysis are the specifics of tax law, and financial reporting. How should you best prepare to manage the change expected in these areas in 2018?
The country has not rewritten its tax code since 1986. To promote economic, political, and business objectives, Congress is currently considering a major rewrite. The rewrite would achieve objectives in a ‘backhanded’ way, not through direct appropriations, but through a reduction in taxes payable. The recently passed House Bill suggests a reduction in the corporate tax rate from 35% to 20%. Existing tax law allows a deduction for business interest expense, reducing the after tax cost of borrowing. The House Bill would disallow business ‘net interest expense’ in excess of 30% of a firm’s EBITDA. Small business (with receipts less than $25 Million) would be exempted. Excess interest disallowed would be available for carryforward for five years. The House Bill would also allow the immediate expensing of the full cost of most assets with a tax life of less than 20 years. NOL rules would be altered with no carrybacks for 2018 or beyond allowed, while carryforwards would be limited to 90% of a corporation’s taxable income. If the Senate is able to pass a tax bill, the differences between the House and Senate versions would have to be ‘reconciled’ meaning provisions of a final bill remain in a state of flux. With passage, expect business transportation equipment investment to increase and drive economic growth.
Impact on Lease Investment
Financial accounting for lease investment is currently driven by the Financial Accounting Board’s Statement No. 13 (Accounting Standards Codification 840). The FASB’s new standard for Leases (ASC 842), represents the first comprehensive overhaul of lease accounting since FAS 13 was issued in 1976. The new standard was adopted in February 2016 as part of the FASB/IASB ‘Convergence Project’. It has an effective date of 2019 for public companies and 2020 for non-public companies. Since the SEC requires three years of comparative income statements for calendar year public companies and two years comparative balance sheet data, public companies are currently starting to capture 2017 lease data. Private companies should begin in that process 2018.
The new rules require balance sheet disclosure for all ‘lease contracts’ that identify a ‘specific asset’ and ‘transfer control’ of that asset to the lessee. The old FAS 13 ‘bright line’ tests for lease capitalization are officially gone, but technical ‘guidance’ in the new rules continues to allow consideration of the old FAS 13 tests to determine if a lease is to be treated as a ‘financing’. The most significant change is lessees will be required to recognize the ‘rights and obligations’ resulting from operating leases as assets and liabilities on their balance sheets. The updates for financial reporting do not change the treatment of leases for income tax purposes. For book purposes an ‘operating’ lease, that would now be on the balance sheet as an asset and liability, will generate both deferred tax liabilities for the excess GAAP basis in the right of use asset and a deferred tax asset for the excess GAAP basis in the related lease liability. The new standard will generally result in accelerated expense recognition for those leases classified as ‘financing’ leases for book purposes while operating lease annual cost will be similar to the expense pattern under current operating lease accounting.
The tax and financial reporting changes are complex and can be expected to impact investment strategies. Change is the only constant. Managing change requires experienced advisors. Work with experience.
The most important decision an investor makes is the composition of his or her investment portfolio. That is what ultimately acts to determine the level and potential variability of returns. Research shows dissimilar asset classes act to increase returns while reducing risk. From an investment perspective, an aircraft or railcar under lease represents a stable and recurring monthly cash flow immune to short term swings in the market throughout the industry cycle. Real assets create real options, cash flow certainty, and economic value.
The world’s economic growth has dropped from 4.9 percent a year from 1951 to 1973 to an average of 3.1 percent for the balance of the last century. And, since 2000, GDP growth in the U.S. has been persistently low, averaging 2 percent, with world economic growth similarly sluggish. What drives market expansion and economic growth? New technologies, productivity improvements, the ability to produce, the desire to buy, access to capital, demographics, and investment in education and capital equipment. Broad based economic growth ‘lifts all ships’ creating opportunities, raising living standards, expanding access to services and most importantly allowing each of us to chart our own future.
Sound volume growth prospects are a major reason to include commercial aircraft in your ‘real asset’ investment spectrum. International air traffic has been distinguished by high growth rates. Global air traffic (passenger) has grown at an annual average of 4% in the last decade (despite 9/11 and other external shocks). This growth reflects increased globalization and the international division of labor. Air transport cost has tended to fall as a result of increased competition, improved engine technologies, larger aircraft, and lower cost jet fuel. On the rail side, the roads are focused on the fundamentals of providing reliable service and controlling cost as crude oil and coal freight volumes have fallen (there are many examples of striving to solve investment challenges only to find efforts defeated by events occurring in a larger context).
Holding air and rail investment requires management by a specialist organization. Risk management is complex and depends on portfolio credit quality and desirability of individual aircraft and railcar types. It’s not merely a question of loan or lease to value, but the relative importance of the unit to the operator, which governs whether they are likely to continue to operate the collateral in bankruptcy. In weak markets, extending the period an airline or rail carrier continues to operate the aircraft or railcar provides a better result than selling into that weak market.
Today, fixed income yields are low and the volatility and dampened expectations in the equity markets argue that portfolio construction and manager selection are critical. The future is uncertain. How do you grow and protect value over an investment horizon’s duration? It comes down to two important investment related disciplines; managing risk, and managing volatility. With investment clarity and consistent focus ‘real asset’ managers do this well. Our firm has a history of excellence, expertise and ethics. Team with experienced investment managers. Call the air and rail transportation experts.
Government taxes to encourage (or discourage) a variety of economic activities. The rates set influence the market’s required before-tax rates of return for both individual and business investments from a social standpoint, taxes are designed to finance public projects, redistribute wealth, and provide basic services. Since self-interest is basic to human nature this creates private incentives to engage in tax planning. Such planning has long earned the blessing of the U.S. Courts.
When you invest, whether you are an individual, or a business owner, the taxing authority is your silent and ‘uninvited investment partner’. Effective planning involves more than being aware of current marginal rates; it requires an evaluation of the longer term results of your decisions, not just for yourself but for all participants. Each party and counter party has their own current and future marginal tax rates. These future expected after tax cash flows affect current actions and decisions. Understanding this concept is important since it directly influences the prices at which assets are traded now, and, what future pricing might be.
Naturally, most taxpayers pay no more tax than they believe they must. And they spend their time and money to arrange affairs to keep their tax bite as ‘painless’ as possible. Remember, money spent on tax planning is ‘tax deductible’, and the tax savings generated are ‘tax exempt’ because they reduce taxes payable.
Are increased taxes good policy? In 1997, Bill Clinton agreed to lower capital gains rates to 20% based on economic literature suggesting the lower rate would yield more tax revenue. It did. Yet Hillary has proposed to nearly double the top tax rate on long term capital gains to 43.4% from 23.8%. Under current tax policy, ‘capital gains’ are taxed as ‘ordinary income’ if an investor has held an asset for less than a year. After 365 days the current top long term gains rate of 20% applies (plus the 3.8% Obama Care surtax on ‘unearned’ income). Hillary has suggested a ‘sliding scale’ approach requiring ‘capital gains’ tax rates during the first two years holding period of 43.4%, year three, 39.8%, and 35.8% in year four. Investments would have to be held for more than six years to qualify for the current 23.8%.
Economists generally will agree that a system of competitive markets is remarkably efficient. Remember Ronald Reagan was elected in 1980 with his message that government is ‘the problem’ and economic freedom was ‘the answer’. The dominant lesson of the Great Depression and the Great Recession is that when Government overspends, overtaxes, and over regulates, economic freedom is suppressed and economic growth is impacted. How is transportation investment best and ethically encouraged? Transportation asset Investors with a sound investment strategy hold diversified asset positions intended to weather volatility on the way to their longer-term objectives. Working with a firm that has a history of excellence, expertise and ethics produces results.
Call the air and rail transportation experts. Call RESIDCO!
 National Center for Policy Analysis, Hillary Clinton’s Capital Gains Tax Proposal, Brief Analysis No. 825, April 14, 2016 by Pamela Villarreal.
 WSJ, “Why This Recovery is So Lousy”, August 4, 2016, Phil Gramm and Michael Solon.
Times are changing! Expect a pro-growth business policy agenda in Washington (with little to no Congressional gridlock). Competitive tax rates. Less restriction on energy reserves, shale, oil and natural. Approval of the Keystone XL oil pipeline. A cut in regulatory red tape and an end to the ‘war on coal.’ A reform of Obamacare and a review of trade agreements. The objective? Benefit Americans and bring back jobs. Most economists now expect higher GDP, inflation, interest rates, and tax and regulatory relief, along with a stronger dollar in 2017.
In this environment, transportation equipment leasing equipment provides both an opportunity to invest and a source of cash. While it is affected by demand and supply changes, transaction activity and trends in the overall economy, it acts as a hedge against inflation since shorter term leases have the ability to reset rates, and inflated asset values are a source of leverage. Both Air and Rail investments operate in transparent markets with predictable cash flows, downside risk protection, and relative liquidity.
The rails transport the bulk of major products for industrial and personal use. This year a bumper grain crop and record soybeans (shipments are up 6.5% this year), with autos maintaining lofty levels are offsetting other commodity groups (coal, intermodal, and petroleum) which remain challenged. Expect rail fundamentals to improve with growth in the industrial economy.
Air operates in a global network. It generates strong cash on cash returns. Inefficient older engine technology is being replaced with new engine options which produce a 20% fuel efficient operating cost per seat improvement. Warren Buffet bought the Burlington Northern in 2009. Now he is investing in airlines. His Berkshire Hathaway SEC filings show the company has taken a stake in three of the four major U.S. airline companies and an undisclosed stake in Southwest. Avolon is completing the acquisition of CIT’s aviation portfolio for $11 Billion. Airlines are issuing secured debt.
Transportation equipment investment means the ability to earn attractive profits. Exogenous shocks do occur. The solution is to invest in real assets where equipment valuation, utilization, rent levels and fundamentals are understood. Where are the tools and processes for making these investment decisions? Where is a reliable source of strategic insight? Build your portfolio with a team of experienced transportation equipment managers who are brilliant on the basics. A team that has practical tools and experience. A firm with a history of excellence, expertise and ethics.
Call the air and rail transportation experts. Call RESIDCO!
The ability to pass legislation, ratify treaties, have Cabinet members and Supreme Court Judges approved comes with party control of both Houses and Administration. Will Republicans stay united?
 Renegotiate NAFTA? According to the treaty, any of the three signatories can withdraw from the agreement six months after notifying the other two parties.
 Deutsche Bank believes the sector will benefit from lower regulation under President-elect Donald Trump. The airlines contribute $1.5 trillion to the U.S. economy, and provide 10 million jobs, November 15, 2016, Investopedia.
 American issues $1.21 billion in EETCs to finance acquisition of 298 new aircraft with a book value of $1.66 Billion.
Demand in Aviation Global passenger traffic is growing faster than expected. The International Air Transport Association (IATA) expects 6.0% revenue passenger kilometer (“RPK”) growth for the year, above the 5.5% long-term trend. This level of RPK growth is indicative of the robust demand in the aviation sector. Rising fares coupled with continuing (but still relatively) […]
Rail Traffic Landscape AAR statistics demonstrate rail freight traffic volumes correlate closely with changes in overall GDP (except for grain, coal, and crude oil product movements, which are not tied to GDP). With tax policy improving the outlook for GDP growth (2018 is now expected to be 2.9%), the Conference Board index of leading indicators […]
When comparing investment returns it is misleading to simply look at headline figures. At first glance, it might seem an investment that gained 12% last year is better than one that gained 9%. In reality, it depends on how much risk was involved in generating those returns. The more risk (or volatility), the less probable […]