The internet says that we keep our cars, careers, houses and spouses about the same length of time. Somewhere between five and ten years on average. Coincidence? Maybe. But consider the following hypothesis: perhaps this 7-year itch (plus or minus) phenomenon is a deeply imbedded bug in the human condition, invisibly guiding our behavior in all kinds of seemingly unrelated areas- even bizjets. For the purpose of this blog, let’s go with the latter.
The reason we suspect bizjets may be connected to this whole thing is the following: you can basically set a calendar reminder for 7-years after a client gets a new jet to expect the following voicemail:
“Hey, kinda thinking it’s time to evaluate some options with, you know, there’s this 8-year inspection coming up and we’re out of warranty, which is- you know that’s a factor, and also I think we can get a pretty good deal on that new one with the new whatever it’s called. So, let’s work up some analysis and see if it pencils … pretty sure it’s a good switching point with the economics and … also gotta think about financing and what the trade is worth. Probably get robbed there. Anyways. Thanks.”
Some end up buying, some don’t. But invariably the math is not what the client expects it to be. Along the way the following question arises, every time: how often should we buy a new jet? What do the numbers say? And boom, it’s the dreaded optimal replacement interval discussion again. The 7-year itch vs. Excel.
Airplanes can challenge our economic common sense. We know old machines break and are expensive to maintain. New ones are virile and warrantied. Owners hate the idea that after $500,000 and eight weeks of down-time, their plane will feel exactly the same as it did before. It seems self-evident that putting a million-dollar upgrade package into an old jet is the definition of throwing good money after bad. Time to cut bait. It must make economic sense to replace the jet.
However, in the big picture of ownership costs, the effects of maintenance and improvements don’t matter compared to the effects of market depreciation. It’s not just the amount of depreciation- it’s how they depreciate. When we say “by 6.5% per year”- it means 6.5% of last year’s price.** This means aircraft suffer higher real dollar depreciation when they are newer and more expensive. In accounting parlance, it’s declining balance and not straight line.
** This phrase always implies that depreciation is somehow constant year to year. Due to market volatility it’s not constant until we caveat with “on average” to make the math simpler.
A new $45M jet which depreciates by 6.5% per year (on average) would have the following residual values through year 30:
At this rate, an aircraft will lose roughly half its value every 10 years. On $45M, that’s a whopping $22.5M for the first 10 years, but just $11.25M for years 11-20.
Replacement economics is nothing more than a comparison of average losses when amortized over their respective terms. In other words, how much different will our average annual loss be owning the plane 5 years as opposed to 10? Doing a little division on the previous chart yields the next one:
Well that chart argues we should keep the plane indefinitely. Capital is deployed most efficiently over longer holding periods. But- we can’t dismiss escalating maintenance obligations and necessary yet eye-watering improvements. That stuff costs a lot and, at some point, must begin to offset the declining annualized capital cost.
For purposes of this blog we ran a 30-year operating cost for our mythical $45M jet using Conklin & de Decker’s excellent Life Cycle Cost Analyzer product. We further added in estimates for paint every 8 years, interior work every 8 years and a full refurbishment at year 16. Our cherished cabin management system will probably need to be replaced along the way; there will probably be some new-fangled and expensive internet box to allow streaming virtual consciousness; and surely the good people at Avionics Inc. (or the FAA) will come up with some acronyms that we want have to buy. We added placeholders for all this stuff too and came up with the following yearly operating spend, by year, through year 30:
The dotted trend line goes up- just like we expected- but it’s not that steep. What’s jarring are the spikes for big inspections and upgrades. Surely there is some benefit to cutting the jet loose before being buried by that stuff!
Not necessarily. Maintenance obligations are nothing more than pending liabilities that the market will subtract from the value of your plane. If it’s on the horizon, you are paying for the 10-year inspection one way or the other. The market will also generally recognize the value of paint, a well-conditioned interior, and a portion of certain avionics and equipment upgrades (but not all). This means that the aircraft has a higher market value after the spike than it does before the spike. That needs to be factored into the analysis.
Combining the operating expense with the residual expectations and a few adjustments for the spikes will result in the following curve (note we’ve ignored fixed cost for this exercise). This compares average annualized ownership cost by ownership period.
This line looks a lot like it did before we added in all the operating costs- illustrating the dominant effect that residual values have on the analysis. If conditions remained constant (and they kept building the same planes), this chart suggests you could buy a new $45M jet every 5 years in perpetuity and the average yearly ownership cost would be about $3.75M. However, if you held for 10 years you would save about $300k annually. At a 15-year replacement interval the average annualized cost has dropped to about $3.15M.
Looking at it another way, it’s $9M less expensive (on average!) to own one plane for 15 years than 3 planes for 5 years each.
This is probably intuitive were we speaking of automobiles, which are commonly thought to hemorrhage value the instant your cleverly negotiated “free” floormats are installed. We don’t view cars as business tools. We like cars, and a lot of us really like getting a new one every three years. There isn’t a remote thought given to the optimal ownership period for a new car. We only base our decision on the affordability of the purchase in lieu of our own personal cashflow constraints. And then we buy it anyway.
However, business jets used to be the exact opposite of the automobile when it came to retaining residual value. This had a dramatic impact on the underlying ownership economics. When aircraft don’t lose value and there are lending institutions willing to loan or lease based on those expectations, you can justify replacement as much as you want. One element driving the decade long destruction in used aircraft prices was surely overproduction based on the theory that planes don’t lose their value.
That raises the question of how one should estimate residual value possibilities moving forward. Maybe they return to their former glory? We certainly have no idea and nobody else does either. That’s the major problem with the analysis we’ve just described. The single most important variable (by a long shot) is the one which nobody has a clue how to estimate. So how exactly do we incorporate residual value uncertainty into our thinking? And while we are on the subject of glaring omissions from this possibly bogus analysis- what about taxes? And time value of money? Financing implications?
We will fail to conclusively answer those questions and others in a future edition of theJetWatch.