Aircraft Residual Value Puzzle

banner-1005546_1280-copy

A perspective on the new Normal for the Aircraft Market.

Reprinted from Business Air Magazine Volume 9 2016

There are three major components to aircraft market values and to name just a few, several less influential factors such as brand reputation, product support, and current production. The major three are: Inflation, Supply/Demand, List Price/Discount. The three are highly intertwined and need to be examined together.

Lets start with inflation. Recently a very popular price index book used a plane that had a value of $3.7M new in 1978 and now was selling for 12% of new at $450,000. Doesn’t sound too bad until you factor in the inflation adjustment since 1978. After adjusting for inflation the real resale percentage is 3.3% of new! Using another example, a 2000 G lV in 2005 sold for 77.5% of new, however adjusting for inflation it was really selling for 68.8% of new.

Looking at the history of inflation rates, from 1996 to 2006 inflation went up 28.5%, or on average 2.85% per year. 2006 to 2016 the rate was 18.7%, or 1.87% per year. And finally looking at 2009 to 2016 only 11.5% or 1.43% per year. Over the last 14 years, the first 7 of those the rate of inflation was just over twice what it has been in the last 7 years.

Without any supply/demand issues in the equation, a person with a frame of reference for resale values based on 1996 to 2006 would see a reduction in value expectations of 9.8% from 2006 to the first quarter of 2016. This expectation is based solely on not considering the inflation adjustment when considering residual value percentages.

Therefore, when looking back, it is important to calculate residual value percentages adjusted to inflation. Your expectations will be more in line with the real depreciation figures.

Supply/Demand is basic economics 101. Due to long lead times for ramping up production in good times and slowing production in lean times this obviously has a high influence to pricing. Supply takes long periods of time to turn on or off, while demand can be a seismic event like 9/11, stock market crash, banking crisis or any major world economic event and literally the demand can be reduced drastically within days.

On the increased demand side, while it takes longer for the demand side to heat up, it takes years in some cases for the production side to meet the new demand. Workers have to be hired, engine makers have to up production, avionics manufacturers have to ramp up. All of these major components take highly trained workers, materials and many of these are aviation specific. Chances are if the aviation market demand is going up the overall world economy is going up creating completion for resources between our industry and commercial products.

The end result is large swings in the supply/demand equation, which makes for large swings in pricing. The secondary problem is how the demand cycles match up over time and normal replacement aircraft cycles. Typically, new aircraft are traded either every 5 or 10 years. If a high demand cycle coincides with a previous 5 or 10 year low supply, then used planes will enjoy higher prices. If it happens that the low demand cycle is matched with a 5-10 year high supply period then there is pressure on the residual values due to over supply of late model aircraft.

The third major leg of the stool is the OEM’s and their pricing/discounting. There are two elements to the pricing. OEM’s typically raise prices at a rate close to inflation. However, the first pricing pressure comes when OEM’s are continuing to raise prices faster than the real inflation rate. From the first part of this article on inflation, if the inflation rate slows the appearance of residual values going down also happens. If there isn’t significant improvements in the aircraft, this makes late model used planes appear more appealing.

The OEM finds themselves with a high list price, the falling of residual values due to a slow down in inflation. We now add low demand and high supply and the OEM’s have only a couple of choices, sit on white tails or discount to keep the white tails off the ramp and as quickly as possible start lowering production rates.

Accordingly, residual values are further impacted. The discounting by the OEM directly affects the resale value of the used plane. The percentage of new just a few years ago when planes were selling at full list can be easily be lowered 10% or more just because of new aircraft actual sales prices. All of your residual value projections have gone out the window unless you have factored in a bad cycle.

We have the puzzle put together, but what does it tell us about today and more importantly tomorrow?

If inflation stays lower than your period of reference, you can expect lower resale value percentages. Adjusting for inflation can help you determine how much of the resale percentage is due to inflation or outside sources.

Looking back at production rates can help you determine how much potential over supply is out there versus the current demand. This means price pressure until the supply side is reduced or the demand goes up.   Buying in the low production side is typically more advantageous. When buying in high demand understanding the potential price pressures and what the low band of the market can be will help lower the future shock value. As the industry absorbs the high supply years up to the fourth quarter of 2008, (with 2009 being the year the OEM’s started getting the pipeline slowed), given the current demand expect price pressure from below.

All of the OEM’s have made significant production reductions to hopefully meet the current demand. If nothing negative happens, we should see the new demand and supply match up more evenly in the next couple of years. This should allow for stable prices to an uptick in the ability to hold margin on new prices.

It is a good time to be a buyer. Prices may dip a little more in the next year or so, however, not enough to make a difference if you are buying to own for 5-10 years. Your resale value on anything you have to trade is lower than you predicted, however adjusting for inflation, the current market whether new or used, has made the same percentage adjustment based on the supply/demand pressures, so you should be positioned for a possible higher residual the next time given the typical cycles and historic inflation.

A recession could slow the recovery of values and if it happens during or prior to 2018, will make prices feel downward pressure, however by this time, the 5 year old aircraft will already be coming from the lower production rate time period. What down turn would come from a recession in the next couple of years will be tempered that it isn’t coming after a high demand and supply as it has in previous recessions, but in a low supply/low demand cycle which should make the drop in our industry less severe. New models that offer improvements that the market places value on will also allow for the OEM to maintain a better pricing strategy. It should take several years for the OEM’s to ramp up production and perhaps save themselves from a drastic over supply situation.

The new normal is going to be more reflective of a mature market that has products that last 25+ years. Demand may not get to another bubble and be steadier which will be good for everyone in the long run. More analysts will pay attention to adjusting for inflation in doing residual value analysis resulting in a clearer picture of the true depreciation. Business aviation will survive and flourish, as even with the best technology, there isn’t anything like being there in person.

Mike McCracken has 38 years in the aviation profession, 33 years in aircraft sales and acquisitions, an accredited ASA Senior Aircraft Appraiser and is President of Hawkeye Aircraft Acquisitions an acquisition and marketing company.

Leave a Reply

Your email address will not be published. Required fields are marked *