Why lead off with an article on finance leasing with this year’s special edition?
Quite simply, because a combination of factors, including evolving accounting principles, new rules on calculating required bank capital requirements, low interest rates, and current tax policy, are making this an extraordinary year for finance leasing!
What is “finance leasing?” For purposes of this article we are using the term “finance leasing” to mean any medium- to long-term net lease where maintenance, insurance and taxes are for the account of the lessee and the terms give the lessee of the equipment long-term control of the equipment, either through one or more purchase options or options to renew the lease for long terms of time at a preset rent.
To explain this situation, I have asked for the help of one present associate—my partner at Railroad Financial Corporation, David Nahass—and a former associate at RFC who today is Rail Equipment Finance Conference’s Capital Markets expert: Michael Dockman of AMA Capital Partners in New York City.
Kruglinski: Mike, when you worked for Railroad Financial 15 years ago, what kinds of finance leases were available from the market at that time?
Dockman: We were seeing a number of leveraged leases on both railcars and locomotives with terms of 20-plus years. The equity (lessor) for the leveraged leases was provided by banks, finance company subsidiaries of large corporations and independent finance companies. The debt was initially provided by insurance companies, then by institutional investors via pass-through certificates. Single investor leases (where the entire purchase price came from one investor) were also provided for shorter terms and credit standards were not necessarily as high as for leveraged leases. Pricing on leveraged leases was less than single investor leases.
On a $45,000 railcar, a lessee under a leveraged lease could expect an average monthly rent over the 20-plus-year term of the lease in the range of $300. The 10-year Treasury at that time ranged from 5% to 8%, compared with around 2% today.
I think it’s safe to say that from the time long-term finance leasing of rail rolling stock began in the 1970s until today, costs and terms have gone from being generally lessor-friendly to being generally lessee-friendly. Those first leases had FMV (Fair Market Value) purchase and renewal options, but over time lessees were able to negotiate both fixed purchase and renewal options, and these fixed price options were in many of the leveraged leases done in the 1990’s and 2000’s
Kruglinski: So who were our principal finance lessee customers 10 or 15 years ago? What kinds of companies leased from operating lessors?
Dockman: Typical finance lessees under 15- to 20-year finance leases were Class I and regional railroads, and industrial companies like power generators or chemical companies, particularly companies with investment grade credit ratings that had no problems qualifying for long term credit on favorable terms. The finance lessors at this time assumed (read: Hoped) that the equipment would be eventually purchased by the lessee under an Early Buy-Out Option (EBO) or end-of-term Fixed Price Purchase Option (FPPO), because these institutions weren’t really in the equipment recovery and releasing businesses!
Kruglinski: What eventually happened?
Dockman: For the most part, the lessees did purchase the equipment or renew their leases at lease-end. For this reason, the financial lessors had little reason to worry about recovering the equipment at lease-end and having to dispose of it for the residual amount assumed in the original lease. However, this has changed in the last five years or so, as car design and demand have rendered certain car types undesirable for lessees. Higher fuel costs, cyclical downturns, and environmental legislation have also caused railroad lessees to turn back locomotives in recent years. Having experienced this, finance lessors will likely be more focused on potential obsolescence risk and will be conservative on their end of lease residual values going forward.
Kruglinski: David, what’s changed today?
Nahass: To begin with, changes in the regulatory environment for banking institutions with U.S. tax appetite have had a dramatic impact on the leasing business. New accounting rules seem determined to make banks show all types of “non-recourse” debt as debt on any bank’s balance sheet. (Structurally, leveraged leases relied on debt that was not a liability of the equity investor [lessor].) That will mean that a bank will have to pledge expensive risk capital against those obligations even though the bank is not responsible for repayment. That additional capital pledge combined with an increase in capital adequacy has (for the most part) taken away the leveraged lease as a financial product.
In addition, as a result of similar capital adequacy concerns, many banks (say roughly 50%) no longer lease equipment for terms beyond 12 years. Whereas 10 years ago, 20-year lease terms were the norm and lease terms could extend out as far as 22 to even 25 years. Lease terms of 7-to-10 years, once the province primarily of operating lessors, is now a fertile area for bank style “finance” leases.
We are also in the middle of an extended period of amplified “bonus” depreciation for new cars and locomotives and historically low interest rates. Provided lessees maximize the value these circumstances offer, this allows companies across the credit spectrum to see effective lease borrowing costs that are at historical lows. In some investment grade cases rates below 2.50% are not uncommon.
What has also been helpful in encouraging the leasing environment is that North American rail assets generally continue to hold their value as well as any asset class around the globe.
Kruglinski: How are these new medium term finance leases being priced?
Nahass: Generally, these leases are being priced based on the perceived risk to the lessor of repayment and recoupment of the residual investment. For a typical $95,000 railcar, a high investment grade company might see 12-year lease rates of $475 per car per month for 12 years, while a low investment grade might see $575 per car per month for eight years. Total cost may be from the 2.50% I just mentioned to a higher rate of 4.25%.
[Author’s note: If you are not working out a comparison of the rent Mike Dockman reported on deals years ago, against the rent for much more efficient equipment more than twice the price today, you have missed the purpose of this article!]
Kruglinski: Would today’s medium term finance leases have the same EBOs and FPPOs of the older longer-termed finance leases?
Nahass: Yes, but, of course with shorter terms, the purchase options will be correspondingly more expensive.
Kruglinski: Can you still do a longer-term finance lease? And if so, are these leases as economically beneficial as the older long term leveraged leases?
Nahass: For the better credits, terms extend to 15 years. There are still 20-year players and situations where an institution will make an exception to win a deal, but, as they say, 15 is the new 20.
These leases are good leases, but they are not as economically effective for borrowers as leveraged leases completed in a competitive market.
Kruglinski: Finally, do equipment end-users need an advisor like Railroad Financial Corporation to assist them in arranging a finance lease?
Nahass: Any company with a good banking relationship with a large regional or national bank can usually find someone at the bank to give them a quote on finance leasing railcars or locomotives. Banks have had good experience with rail equipment investments.
RFC’s customers have used us for almost a quarter century because we offer them access to dozens of competing finance lessors to assure the best possible pricing, as well as the expertise to assure them that lessee-friendly terms and conditions are made part of the lease.
This is particularly important with regard to maintenance, return and insurance requirements.
Kruglinski: Final question: Why do banks and financial institutions do this kind of business?
Dockman: Simple, equipment leasing is one of the last devices available to them to defer taxes on their other income. Rail equipment and rail equipment lessees have traditionally been “good” risks for banks with few defaults or losses. Returns on rail equipment leasing have historically been very profitable for them.
Michael Dockman can be reached at firstname.lastname@example.org.
David Nahass can be reached at email@example.com.
Tony Kruglinski is a Contributing Editor to Railway Age, President of Railroad Financial Corporation, and Chairman of Rail Equipment Finance Conferences. Tony can be reached at firstname.lastname@example.org.
As much as we all know who they are and what they are, there are many people in our industry who only know North America’s railcar operating lessors from an outsider’s perspective. Few really understand them from the inside out. One of those individuals who does understand the operating leasing industry from this unique perspective is our good friend Jack Thomas, president of First Union Rail, one of North America’s largest operating lessors of railcars with a fleet of nearly 90,000 cars.
Kruglinski: What types of railcars does First Union own and lease out? Where are your biggest concentrations of cars? What percentage of your fleet is currently out on lease? Finally, how many customers does First Union have?
Thomas: First Union provides all types of leases and financial structures for the use of rail equipment. FUR has a very diversified fleet of 90,000 assets consisting of covered hoppers, coal cars, scrap and steel cars, automotive equipment, forest product cars, intermodal equipment and tank cars. Although not a hard, fast rule, we somewhat try to mirror the composition of the North American fleet. Currently, FUR is well above 90% in fleet utilization with approximately 400 customers.
Kruglinski: First Union serves a variety of industries. From your perspective, what industry is posing the greatest challenge at the moment? What industry is posing the biggest opportunity? And could elaborate a bit on what First Union is doing to deal with the challenge and to exploit the opportunity?
Thomas: Most products shipped in tank cars today are a big challenge to determine whether there will be a secondary market for that car after the initial lease term. The oil and gas industry, with the frac sand and crude oil cars, is the single largest growth industry today. With the increasing lead times for new equipment more planning will be required to insure that the equipment will be needed when it is delivered.
Kruglinski: Jack, most people look at our large operating lessors as complex service providers. But you also are a customer of significant size for railcar builders and many, many component suppliers. Can you give us some idea of the amount of money that First Union spends each year on new cars, components and maintenance services and which are the principle areas in which this is spent? For instance, wheels? Axle?
Thomas: As you are well aware, the industry is very cyclical, so from year to year there are significant swings in the total dollars spent. But to give some color, we spend between $200 million and $400 million dollars a year. Total maintenance spend has been substantially increasing year over year and is now $90 million to $95 million, with about a third of that total attributed to wheelset replacements. Roughly 10% of our annual maintenance spend is for direct purchase of components from suppliers.
Kruglinski: Jack, the rental rates that operating lessors receive have risen, some might say dramatically, over the last two years. Can you give us some general comments on whether you think that overall, the rents now possible in the market support new investment in railcars?
Thomas: Well, certainly rental rates have increased, but from very depressed levels. Rental rates vary by car type, but overall they are approaching or near normalized levels. Clearly, there is strong new car demand for a number of different car types. We wouldn’t order new equipment unless we felt that both the initial and projected renewal rental levels would provide us with a fair return on our investment. We are closely monitoring the increase in new car prices because at some level they may begin to negatively impact demand.
Kruglinski: You have also been an advocate of fair dealing between the operating leasing fraternity and North America’s Class I railroads. Can you comment on this role and where operating lessors and Class I’s stand today on issues relating to Class I car maintenance standards imposed on operating lessors?
Thomas: A letter was recently sent to the AAR signed by current and former members of the Associates Advisory Board outlining the concerns of operating lessors. The letter frames the issues very well and I paraphrase the salient points of that letter:
• The continuous improvement of the safety, efficiency and cost competitiveness of the North American freight rail system is critically important for both railroads and private railcar owners.
• In order for this progress to continue, the AAR rule-making process must properly allocate the costs of this continuous improvement in alignment with the distribution of the benefits.
• Simply put, the party that primarily benefits from the implementation of a new or modified rule should similarly pay its fair share for such rule implementation and compliance.
• This is an urgent issue, and every day that passes without resolution puts an unfair economic burden on private railcar owners.
• If this problem is left unresolved, private railcar owners will be forced to curtail investment, eroding this important source of capital for our North American rail system.
Freight rail market growth to 2050: The impact on leasing
By Bill Rennicke, Partner, Oliver Wyman, and Manny Hontoria, Partner, Oliver Wyman
Tony Kruglinski asked us about growth in the freight rail equipment leasing market over the near and long term. Along with underlying commodity demand, how big the freight rail equipment leasing market gets over the next several decades will be closely tied to the size and fluidity of the rail network. Too much or too little capacity will be critically important to the rail equipment leasing industry—here’s why.
Rail traffic growth drives short-term and operating leased equipment demand. And rail volumes grow pretty much in line with how well the economy does—a relationship we don’t expect to change. But unlike almost any time in the past 75 years, rail network capacity is close to tapped out. Traffic growth won’t mean much if the capacity “bucket” doesn’t grow as well.
Let’s look at some figures:
• U.S. GDP growth is likely to slow a little in the long term. Various estimates call for GDP to grow in the range of 2.4% to 2.7% through 2050 (down from 3% per year 1997-2007). But even then, the economy could grow from $14.3 trillion in 2009 to $38.1 trillion in 2050.
• The 2007 AAR/Cambridge Systematics National Capacity Study, the most comprehensive recent review of long-term railroad growth, estimated 88% growth in rail activity from 2007 to 2035. (Post-downturn, many do not see the 88% level being reached until 2040).
• Louis Thompson of the OECD recently projected 110% growth in rail freight ton-kilometers from 2005 through 2050 for the U.S. and Canada.
What do these numbers lead us to? Broadly, the suggestion that rail traffic could double by 2050. With reasonable assumptions about productivity, that would mean adding 900,000 railcars and 16,000 locomotives to the current fleet.
Although it’s difficult to determine the precise size of the operating lease market, the top 10 lessors plus TTX account for around 700,000 freight cars, or close to half of the North American fleet. For operating lessors, if today’s short-term and operating lease market share holds, they could have nearly half a million more cars under management by 2050. Looking out just 5-to-10 years, if the puts and takes from energy exploration increases and possible coal transportation decreases play out and the current fleet grow by just 4%, lessors could see over 50,000 growth-related net additions during the next decade.
That’s not the end of the story. Without surplus capacity, the velocity at which traffic moves through the network also will impact equipment demand. If that capacity keeps getting tighter and the network becomes constrained, traffic will move more slowly and more equipment will be needed to compensate.
How important is velocity? If congestion decreases equipment utilization by say, 10%, the 2050 fleet might need 2.4 million cars and 44,000 locomotives, almost double the current fleet. Over the short term, poor utilization and bottlenecks might increase demand by 4,000 or 5,000 cars per year.
The consensus right now is that if nothing is done, capacity could become continually constrained year over year. In fact, if 2035 traffic were put onto the current rail network, more than half of the system would be near or over capacity. That might seem like a good thing at first: capacity shortfall would drive up equipment demand. But in the long run, the system would choke. Slow and inconsistent service would drive traffic off the rails, and leased equipment demand would drop—possibly for good.
So the burning question is: Can railroads keep up with capacity demand? Or more to the point, what will it cost to keep capacity growing at the same rate as traffic? For 2007-2035, the AAR estimated that cost at $150 billion; Oliver Wyman believes the true cost through 2050 is more likely to be in the range of $200 billion.
Class I railroads account for the lion’s share of infrastructure capex. Currently, they put about 17%-to-18% of revenue into track maintenance/renewal and expansion. They expect to spend a record $13 billion in capex in 2012, fueled by a regulatory environment that has supported healthy railroad performance.
During the last decade, Class I railroad-marked cars have represented a declining share of the freight car fleet, so the Class I’s rely on shippers and leasing companies for the rest. Since the pressure to focus capital on infrastructure is only going to intensify, it’s likely that leasing will be used to cover most of any fleet increase.
Exactly how much capex the railroads can support to expand infrastructure will depend largely on the government’s regulatory stance. Policy changes to watch out for include tax-related investment incentives, rate and service regulation, safety and security, labor and fuel policy, changes to truck weight/size, and highway construction funding. How these issues play out will impact equipment demand over the long term, by determining whether railroads earn their cost of capital, whether trucking becomes more or less competitive, the viability of public and private funding, and what happens to network capacity and velocity.
With these considerations in mind, we believe that up to the mid-century mark:
• Rail traffic will keep growing at or near the rate of GDP, leading to at least a doubling of traffic by 2050 and solid 10%-to-15% growth in the next decade.
• Railroads will continue investing in capacity and the network won’t become substantially more congested. The probability of congestion-driven changes to leased equipment demand is remote.
• At present, no technology or spending level suggests that network velocity will increase much, either. So the fleet will keep growing at historical productivity-adjusted rates.
As the railroad industry grows over the next five to 10 years, the rail equipment leasing industry should grow faster than rail traffic. Long term, our crystal ball tells us that if it’s not broke, don’t fix it: the railroads will want to continue focusing their spending on infrastructure, while relying on the leasing industry to be the go-to provider of rolling stock.
1. Source: “The World in 2050,” PwC. Figures are PPPs in constant international 2009 dollars.
2. Source: “A Vision for Railways in 2050,” Louis Thompson, International Transport Forum 2010, OECD.