More foreign players in the North American market?

Railway Age, July, 2005 by Anthony Kruglinski

Well readers, something this writer has predicted repeatedly in the past is coming to pass--big time! The rest of the world, at least the financial portions in the equipment leasing business, has "discovered" North American rail equipment leasing.

I've written various times that currency advantages and a dearth of home-grown investment opportunities would eventually result in foreign lessors seeking out investments in North American railcars and locomotives. The recent announcement that a Singapore investment fund is taking an 80% interest in Helm Financial and its fleets of coal cars and locomotives is the most recent evidence of this trend. Interestingly, I understand that the Helm deal only was offered to such non-traditional rail equipment investors as domestic and foreign venture capital and hedge funds. (Put another way, I'm told by Helm's domestic leasing competitors that they weren't even invited to bid.) Assuming this is true, it probably reflects the view of Helm and its advisors that the best deal they could cut was from a new "player."

Who else is already here? Lloyds TSB from England is reported to be the true investor in the 10,000-plus car fleet currently being rented by a Babcock & Brown affiliate. Mitsui has been a player for some years with its MRC affiliate, and this writer has heard of at least three other Japanese trading companies interested in investment opportunities in our market. Royal Bank of Scotland and its domestic U.S. bank affiliates Citizens and ICX also are making a full-court press in the rail arena. (In England and Europe, RBS's Angel Train Contracts subsidiary and related affiliates are already some of the largest lessors in their respective markets.) Who else has target rail business of various kinds internationally? Halifax Bank of Scotland (U.K.), HSBC (U.K.), HSH Nordbank (Germany), Calyon (France), and a variety of others.

All of these folks have eventually tumbled on the basic "truths" about our rail equipment marketplace: The equipment is designed for universal service; it's built to last for up to 50 years; and, most important, history shows that it is really, really hard to lose money on investments in North American rail equipment if you make a long-term commitment to the business. All you have to do is compare our loss experience with investments in aircraft and marine equipment in other markets to make that case.

The problem has been, however, that the income to be derived from leasing railcars and locomotives is very, very cyclical. Acquiring rail cars and locomotives for lease to railroads and other end-users requires a long view and a long term commitment that "smooths" out these earnings peaks and valleys and makes the overall investment look like a decent one.

But, if you invest U.K, pounds, which are trading at historic highs to the U.S. dollar, you have an advantage. Ditto for anyone investing Euros or Yen. In fact, with this kind of advantage, even the sometimes-mediocre returns a lessor has to face during periods of economic malaise or equipment surplus might not look that bad. And if you're owned by a bank and not an industrial, there's an argument that your required returns' level might not need to be so high.

There's a glitch, though. If you want to control the equipment--if you want to own it and the up-side in the investment--you generally have to have the capacity to use the U.S. tax benefits of ownership. That means that you have to have U.S. income that is taxed, and against which the depredation benefits of ownership can be applied to make most investments make economic sense. Note: In virtually every case, the North American rail equipment leasing market assumes that these tax benefits are being used and demands a lower rent to the end-user as a result.

For most foreign banks and trading companies, this is the rub. Even if they have some U.S. income, it's generally not enough to fully use the huge tax write-offs that come with the seven-year tax depreciation scheme that applies to U.S. rolling stock. (Canada? Don't even ask. They have even more restrictions.)

Now if you happen to purchase an entire operating company that has a business of owning and leasing railcars or locomotives, and is therefore generating its own U.S. taxable income against which the tax depredation of equipment ownership can be applied, you have a way around the issue. Why not just do what the railroads do and engage in tax-affected finance leasing to bring down your costs of acquiring the equipment that you're using? That would work, but the fact is that operating lessors of rail equipment need to engage in fleet management on a regular basis. What do I mean? Buy and sell equipment as the market requires. But once you're tied into a 15- or 20-year finance lease, it becomes very difficult.

So what's my current prediction? Look for more operating lessors seeking to cash out at the top of the market before the next cyclical decline in rental income hits. And look for more foreign players in our patch. None of this is bad news for railroads and other lessees. They'll all benefit from lower costs!