In aviation finance, there are a variety of leasing arrangements from which parties may choose to best structure their transactions. This article summarises the key features of one such type of leasing arrangement: the operating lease.
What is an operating lease?
An operating lease sets out the arrangement by which the owner of the aircraft (the Lessor) and the lessee of the aircraft (the Lessee), which is typically an airline, agree that the Lessor will grant the Lessee the use of the aircraft for a prescribed period of time in consideration for the payment of rent.
When is an operating lease used?
There are various advantages of an operating lease for both a Lessee and a Lessor which can determine whether this leasing arrangement will be used.
The advantages of an operating lease from the point of view of a Lessee, is that it provides the Lessee/airline with a certain level of flexibility. For example, an operating lease:
- enables the Lessee to keep a diversification in its fleet if the Lessee/airline foresees use of that kind of aircraft for only a (relatively) short period of time;
- makes it easier for the Lessee to upgrade its aircraft; and
- means the Lessee can avoid taking on the residual value risk of owning a type of aircraft if the market for that particular aircraft is not buoyant.
From the point of view of a Lessee therefore, having certain of its aircraft under operating leases provides a level of diversification in its fleet which it may not otherwise have as it allows a Lessee to upgrade its aircraft at more frequent intervals than if they were they were to operate aircraft as a registered owner.
For owners/Lessors the advantages of operating leases are that:
- whilst the Lessor remains the registered owner of the aircraft, operating leases typically contain provisions whereby the operational risk, insurance risk and maintenance risk is borne by the Lessee; and
- the aircraft can be leased on multiple leases during the asset's lifetime, meaning that the Lessor can receive rental payments over the life of the asset that cumulatively are in excess of the original market value (and the purchase price paid).
What are the key features of an operating lease?
Term: the agreed lease term in operating leases, generally less than 10 years, will typically be shorter than that of their finance lease cousins. Finance Leases tend to be aligned with the underlying financing that is in place, which in turn will typically be aligned to the lifespan of the asset. Operating leases typically have shorter terms due at least in part, to the need for the Lessor to be able to monetise its asset to the full extent possible, which is enabled by a series of shorter term leases over the relatively long life of the asset (here, the aircraft).
Rent: the operating lease agreement will set out the agreed amount of rent to be paid to the Lessor during the course of the lease term. The amount of rent that will be paid will depend on general market conditions as well as:
- valuation/purchase price paid. The Lessor will be looking to recoup where possible its initial capital expenditure on its purchase of the aircraft through the income stream of rent under the operating lease.
- demand. Due to the long lead times and backlogs in aircraft manufacturing there will not always be a steady stream of aircraft of a type and age that may be in demand at any particular time. This will have an effect on the respective bargaining position of the Lessee and the Lessor in their commercial negotiations with one another;
- tax. Any potential tax benefits that may be available to the Lessor/owner.
In operating leases, the rent will typically be required to be paid on a 'hell or highwater' basis. This means that the payment of rent will be required to be paid by the Lessor as an unconditional obligation irrespective of the occurrence of any "default" on the part of the Lessor or "fault" of the aircraft itself, so, for example, rent would still require to be paid notwithstanding any defect in the Lessor's title to the aircraft or in the airworthiness of the aircraft.
Risk: in an operating lease structure, the Lessor will retain the ownership risk (as owner of the aircraft) and assume the risk in the residual value of the aircraft on return of the aircraft at the end of each lease term. The residual value of the aircraft will be affected by the maintenance and the condition of the aircraft. Therefore, in order for the Lessor to protect the value of the aircraft and to a certain extent offset the residual value risk, there will likely be fairly extensive covenants placed on the Lessee in the operating lease which deal with these issues. In an operating lease, the Lessor will typically also seek to " transfer" those liabilities for which they as owner would typically be responsible. This would be achieved by the Lessee agreeing to extensive indemnity provisions; these provisions will normally be subject to certain carve outs, including breach of the lessor's covenant of quiet enjoyment and any claims/loss that may have occurred as a result of a Lessor's financing arrangements.
In summary, a Lessor or Lessee's decision as to whether to enter into an operating lease will be dictated largely by the needs of their respective businesses and the market conditions prevalent at the time. The decision of a Lessor and Lessee as to whether an operating lease is best for them will be taken once they have reviewed their individual business needs and objectives.
How can Brodies Help?
Our Aviation & Space team are able to advise on the legal implications of operating leases for aircraft. Click here for more information about Brodies Aviation & Space Team.
Contributors
Senior Associate
Partner
