High Interest Rates/Cost of Borrowing and Their Effects on Aviation Businesses
Interest rates are on the rise. The cost of borrowing is on a steady incline and it is having adverse effects on all parts of the industry. While the economy as a whole will face challenges that trickle down from rising costs, flight schools and aviation businesses must be aware of the ways the industry will also be affected by an increase in the cost of borrowing.
Key Takeaways:
- Interest rates are on the rise, this invariably affects the cost of borrowing. All areas of the economy are affected by these situations. Flight schools, airlines, and other parts of the industry will certainly also feel the change
- Aviation businesses are going to be affected, which is an additional hurdle given the ensuing challenges from the pandemic. Some areas more than others, particularly areas of the industry with less credit and buying power will be the most affected.
- Flight schools and other aviation businesses are having to be aware of how these rising costs are affecting them and their operations to prepare for the future environment of borrowing which may bring additional costs.
How does interest rates work?
As you may know, Interest is the amount you pay to borrow money. If you’re lending, such as a savings account, interest is the amount you earn when you let someone else borrow money. The formula for simple interest is A = P (1 + rt), it’s a useful formula to remember for referencing basic interest.
If you’re borrowing, a lower interest rate is understandably better. Knowing how interest rates work can help you get the lowest possible rate, a firm understanding of interest rates and how the market may influence such is necessary. Rates of interest are usually the result of three factors: the base rate, lender’s policies and credit history. ase rate is set by market factors, such as the Federal Reserve’s current requirements. Lending policies about consumer interest rates may be impacted by the cost of doing business for each bank and other factors, such as inflation
Interest rates and the cost of borrowing
Fixed Rate Loans: A fixed rate loan has the same interest rate for the entirety of the borrowing period. Borrowers generally prefer fixed rate loans that won’t change in cost. With fixed rate loans, the cost of borrowing money stays constant throughout the life of the loan or credit and won’t change even with factors such as market fluctuations. Installment loans like a mortgage, or car loan at a fixed rate allows the borrower to have the same payments. consumers have stable but tight finances, this protects them against the possibility of rising interest rates.
Variable Rate Loans: A variable rate loan has an interest rate that adjusts over time in response to changes in the market. In general, variable rate loans tend to have lower interest rates than fixed versions, in part because they are a riskier choice for consumers. Rising interest rates can greatly increase the cost of borrowing, for consumers who can afford to take risk, or who plan to pay their loan off quickly, variable rate loans are a good option
The cost of borrowing changes with changes in interest rates.
As interest rates increase, the cost of borrowing money also increases. Buying certain goods and services becomes more costly, such as homes and cars. Consumers typically respond to rising rates by buying less, reducing demand in the market. If the demand for goods and services decreases, businesses cut back on production, which leads to laying off workers. Laying off workers increases unemployment, and the cycle is continuous. An increase in interest rates has shown to slow down the economy, while decreases in interest rates tend to have the opposite effect.
Increases in interest rates cause a decrease in inflation. When interest rates increase, goods and services become more expensive, reducing the demand for goods and services. When demand decreases, prices decrease too, which reduces inflation.
A nation’s interest rates are largely controlled by its central bank along with market forces. Adjusting interest rates to spur or slow down the economy is part of monetary policy, which a central bank is responsible for. Governments are responsible for fiscal policy, which involves adjusting taxes or government subsidies.
When the economy falters, the central bank can step in to adjust rates. The Federal Reserve in the United States is keen to react to rising inflation or a recession using this tool to lower the cost of borrowing so that firms and households can spend more and invest; with the goal of keeping the economy chugging along smoothly.
Aviation businesses should be concerned about higher Rates and costs of borrowing.
Some worry we’re on the path for an unfavorable bubble situation; While aviation leasing currently still provides a good return; people are now wondering if the cyclical nature of aircraft leasing will also be redefined. If interest rates continue to rise, the industry may start to struggle. The cost of funding rises with rising interest rates and which is a cause for concern when considering, will investors remain with their assets as a strategy to diversify, or will they move to alternative means with potentially higher yield returns?
This brings a number of concerns:
Higher interest rates: Higher interest rates is more than just an increase in the cost of borrowing; it also decreases access to capital markets and creates downward pressure on aircraft values. We may see some dropping out of the market – and while those less well-hedged, less well-funded lessors leave, the industry giants, aviation businesses with better credit and US dollar reserves are more likely to survive in this environment and potentially expand their domains.
Aviation leasing: One appeal in this environment could be geared toward mid to end-life aircraft leasing. Brand new aircraft are greatly expensive, and that without account for the complex legal issues surrounding that purchase. Alan Booth, in an Ocorion article, mentions that most aircraft will last 20-30 years if handled well. While it has been analyzed that some big aviation businesses do not use their aircraft for nearly that amount, it opens an opportunity to be used by airlines with weaker credit ratings and less buying power. Older fleets are often more complex to deal with, however, smaller players may have to resort to these options in this environment.
Used parts: Used aircraft engines can be a very attractive leasing prospect for investors who are priced out of the new aircraft market. Engines can often have a lifespan that differs from the aircraft they power, and they are considered commercially separate assets. There is a massive market around aircraft engine leasing, and this can actually be more affordable for smaller aviation businesses – and more attractive for investors worried about interest rates.
Who Stands to be affected the most?
While these increases are going to have effects on all parts of the industry as a whole, some areas will be affected more than others. Airlines have the more probable fate to stay alive as they have higher credit and buying capabilities, and rates may not rise for them as much as they will for flight schools or other aviation companies. Over the past 20 years aviation businesses got used to lower cost of borrowing.,which became progressively lower overtime. Now companies that have relied more on debt that on capital for their business are going to be affected.
Airline debt: Flight Global shares that IATA estimates airline industry debt levels have increased by more than $220 billion to over $650 billion during the pandemic. Airlines are still attempting to recover from the pandemic, from that alone they face a years-long effort to pay down the debt accumulated to survive these recent challenges And there are no quick fixes – even before the potential impacts of the Russia-Ukraine conflict are considered. Airlines are in an awkward phase of the crisis recovery, highly indebted, with unpredictable revenue streams as a result of changing government restrictions, costs rising, and outside factors that increase costs further. All the while, they are keen to stay on the front foot, particularly when it comes to maintaining competitive advantage amid these concerns.
Flight school debt: While flight schools do not have the level of large-scale debt as airlines, it is still important to consider what debt they do have currently, and how it’s more than likely to increase under these economic conditions. Flight schools typically incur debt from their aircraft and credit lines used for working capital as they seem to cover overhead cost until they can collect total receipt. While the pandemic offered some relief for small businesses and a demand for flight instructors and schools is still increasing, it is a key element for flight schools in consolidating the debt they do have, especially if they are not based under fixed interest rate.
Higher cost of borrowing and flight schools.
This environment for higher cost of borrowing will have vast implications for flight schools. They have already been responding with challenges that trickled from the pandemic. Higher cost of borrowing is now being added to these adversities, some particular effects this has for flight schools are as follows:
Incoming students: Higher interest rates are going to certainly have a reflection on the students ability to afford flight schools. Many do rely on loans and credit in order to fund their education and oftentimes are subjected to high variable interest rates and these are only going to increase in this environment. While the pilot shortage is driving for an increase for flight schools with new students, more about this can be read in our article ‘The Pilot Shortage – A Challenge for Airlines, Possible Boom for Flight Schools., this may be slowed during these inflationary periods unless the potential pay for new pilots also increases to subside the cost of their education.
Higher cost of operations: Interest hikes are no doubt going to affect the other cost of operations such as maintenance, leasing aircraft, labor, and other necessary variable costs. When the cost of these operations increase, flight schools will have to either absorb the cost in hopes that inflation is only temporary, or subsidize the added cost by displacing them on students or instructors. Flight schools at the very least will have to increase efficiency in order to stay afloat.
Insurance premium hikes: As discussed in our previous article “Increased” General Aviation accidents and their effect on insurance premiums.. Insurance costs are also greatly affected when the cost of borrowing is higher, especially because insurance agreements are typically made in payment and subject to change with market conditions. Flight schools are going to have to look to see how increased insurance premiums are going to affect them.
How should Flight Schools, and aviation businesses prepare for higher cost of borrowing?
Industries that have been unprofitable will eventually be forced to undergo consolidation. Many unprofitable airlines continue to remain in business despite years of substantial losses, because various stakeholders cannot afford to let them close, flight schools, and other aviation companies do not carry the same privileges that airlines do with investors or stakeholders.
Mitigate High Fixed and Variable Costs: Large lease or loan repayments for expensive aircrafts will have to be made regardless of business conditions.Even if aviation businesses and flight schools resort to using used aircraft or parts, it would call for a larger labor force to run their complex operations, making payroll expenses another component of increased fixed costs. Volatility in oil prices is yet another challenge that companies have struggled with in this environment. Aviation businesses are going to have to find ways to mitigate these costs and become more efficient to survive. One major way that flight schools are increasing efficiency is with technological interfaces and software programs.
Understanding how demand can suddenly change: The industry is vulnerable to events outside of our control that will have vast effects on the market and the industry such as natural disasters and socio-political conflicts. These components can drastically change operations and demands for aviation businesses. The COVID-19 pandemic is one major example with this, along with the current political conflicts in the globe. Having a broad insight of what the future may hold for the industry and planning ahead for those environments are going to have to be a necessary part of companies business models in order for them to stay afloat.
Focus on capital and assets rather than debt: While some aviation businesses have largely focused on generating capital and inquiring debt when interest rates were low, they will now have to play the environment differently under these conditions and focus on maintaining the capital and assets they do have to leverage themselves and seek ways to efficiently collect new assets.
What does a future of borrowing look like for flight schools and the rest of the industry?
The future does not offer an immediate solution to look forward to, in fact, the trajectory of the economic environment we are in is seeming to worsen in terms of interest rates or at the least stay at their current state for some time. The pandemic has changed the way businesses operate — including the finance industry. Some financial institutions have become more conscious of consumers and businesses during the past year and have pivoted to offer greater flexibility, support and leniency to borrowers. However, other businesses have experienced the opposite — with greater challenges accessing capital.
Business funding will become more agile and need more efficiencies: Flight schools will have to start using their borrowed funds to invest back into themselves. Currently and more certainly in the future, aviation businesses will be investing in technologies to help them better plan and prepare for cash flow and manage expenses. This will be necessary for funding approvals that have reasonable borrowing rates, especially for this environment. Liquid Capital shares that, PwC claims nearly one-third of Chief Financial Officer’s (CFOs), already look to tech-driven products and services to revamp their business in light of pandemic related challenges and allocate funds where it’s needed the most. Using digital savvy-tools, CFOs can better manage their cash flow by increasing efficiency with state-of-the-art technology and programs, this is especially true if they own the technology entirely. Aviation businesses are using these avenues and others for funding their business strategically.
Alternative lending: The harsh reality of the future is that banks are not lending larger loans as eagerly. It is a daunting task for aviation businesses, which often have low-to-moderate risks associated with their organization, to receive funding from traditional operations. one example of how banks run on a risk-averse basis, is that last year, about 70% of U.S. small businesses owners applied for the Carers Act Loan (backed by the Federal government but executed by banks). Alternative lending companies are starting to step in for funding, seeking to accommodate the finances that traditional bank lenders cannot fill.
As a result of all things mentioned, it is going to be necessary for businesses to be aware of rising costs and the economic environment that we are in and what is projected for the future. Flight schools and aviation businesses have had to deal with the hurdles of the pandemic and other recently emerging factors, and now the newest added challenge is increased cost of borrowing. One thing is for certain, the industry has adapted to changes and managed to stay afloat and can continue to do so, however, the environment is ever-changing and it’s difficult to generate the proper solutions so suddenly. Being aware of the prospective environment along with being flexible to overcome new challenges as they are presented are going to have to be a key integration for flight schools and aviation businesses.
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