The first transcontinental railroad was completed in May 1869, marked by a ceremonial “last spike” at Promontory Summit in Utah. Today, 145 years later, there are hundreds of rail lines throughout the U.S. supporting the American economy. Railroads haul products for many industries nationwide, including food and agriculture, chemicals, paper and lumber, consumer goods, motor vehicles, and other commodities. According to the Association of American Railroads (AAR), railroads haul approximately 1.7 million carloads per year of wheat, corn and other agricultural products. Carrying these and other products are various types of railcars, such as covered hoppers, which are used to transport loose bulk commodities like coal, ore and grain. According to the Q2/14 Umler Equipment Index, this car type represents about 26% of the entire North American rail equipment fleet, which totals 2,001,132, a 1.13% increase over Q2/13. As the economic recovery continues to drive railcar fleet growth, the system itself is beginning to reflect the impact of attendant traffic congestion.
David McKerroll, president of Element Financial’s Rail & Aviation division, says the industry backlog is more than 100,000 cars, and idle equipment is at its lowest since AAR began tracking totals in 2009. “Railcar loadings have recovered to 2007 levels,” he explains. “Orders for new tank cars continue to be strong, and now the market for new freight cars is showing a similar trend. As the economy has recovered, the demand for railcars has increased as well.”
Part of that demand stems from what McKerroll describes as an energy renaissance in the U.S., which has added to the traffic levels on the railways. Barbara Wilson, First Union Rail president, concurs, noting that the booming energy sector has contributed to the significant uptick in rail activity. “The demand for transportation services in the energy sector is occurring in locations that either have not been traditional users of rail or regions that were at capacity servicing traditional markets such as grain,” she says. While Wilson attributes much of the railway congestion to the increased energy transportation demand, she says it is good to see such an old industry revived. “We’ve seen this new market be created, which is quite exciting for a 100-plus-year-old industry.”
As the growing energy segment has bolstered demand for rail servics, so too has rail supported the domestic energy industry’s success, according to David Nahass, senior vice president of Railroad Financial Corporation (RFC). In addition, Nahass says increasing rail volumes have turned the heads of investors, adding to demand and competition. “Rail is an integral part of the infrastructure supporting the path to U.S. energy independence through hydraulic fracking,” he says. “Increased rail volumes coming out of the recession have drawn the attention of investors that had previously eschewed investment in rail assets as too stodgy or not profitable enough. Now investors from all types of private equity firms, insurance companies and asset management firms are investing in railroad assets, specifically as operating lessors of railcars. This fosters additional competition and offers more alternatives to users/lessees of railcars.”
Growing Competition in a Frothy Market
Nahass says rail is on the radar for many types of these financial investors, not the least of which are bank investors, which he says have always been interested in rail assets but have an even more acute eye on the segment in today’s market. “Historically, the rail segment has seen fewer losses than most asset classes, and investment in rail is a hard asset investment. Railcars hold their value well over time. These factors — broad desirability, reasonable risk profile for the end users of the equipment and excellent long-term residual value — support a market that is healthy and competitive.”
McKerroll and Element Financial approach this competitive marketplace well-armed with strong relationships in multiple industrial segments, as well as through vendor programs and acquisitions. For example, he says that Element’s strategic alliance with Trinity Industries allows Element to serve a larger network of customers in the commercial & vendor finance, aviation finance and fleet management spaces. “Many of these customers have rail transportation requirements that can produce additional railcar financing opportunities for Element directly,” he says. “Some of our clients are served in one area; they may have needs in another.” Likewise, McKerroll says that Element’s recent acquisition of PHH Arval, which was the company’s largest acquisition to date, has opened up many opportunities to provide rail financing services to transportation companies.
Wilson says the rail marketplace is very strong in relation to other transportation segments, making it a very attractive asset. “Competition is plentiful,” she says. “There is excess liquidity everywhere. And rail assets are the darlings of the transportation sector. It is very hot right now, and frankly, the market is quite frothy with people aggressively bidding for deals.” Wilson explains that the rail industry has been through these “frothy” cycles before, and cautions that rail lessors and lessees must tread lightly when doing business. “Those of us who have been around to see these cycles have certainly seen this in the past. With the level of competition, and the level of frothiness in the market today, we feel that care needs to be exercised by both lessors and lessees to avoid getting too far ahead of the market.”
Investing in Technology
In order to keep up with the market and get ahead of competition, learning how to better reach and serve customers comes with taking advantage of ever-evolving technological developments. Technology advancements have always caused industries to adjust the way business is done — and railcar leasing is no different. “As tracking railcars becomes more sophisticated, Element must grow with and invest in the evolving technologies to better serve customers,” McKerroll says. “That helps people monitor their fleets.”
Keeping a close eye on fleets has become increasingly more important because customers demand a proactive approach to business, Wilson says. “It’s critically important that they be able to access information on the equipment and information on what’s in service,” she explains. “We need to be able to address unplanned equipment repairs and events that occur in the system whether they are on the railroad or railroad service-related, and communicate that to the customers. What we’re trying to do is help them ensure that their supply chain is uninterrupted.”
On the advisory side, Nahass and RFC have been able to make client meetings more efficient through information sharing and software meeting programs. “Technology allows for information sharing in a manner that allows me to spend less time on airplanes,” he says. “Software meeting programs that allow different people to access data in real time and allow for changing control over the data so that in-person meetings may not be required are huge. Companies are seeing those efficiencies and allowing for outside participation from third-party advisors like RFC.”
Fuel Transportation Regulations
While technology developments are assisting rail lessors and advisors in furthering their businesses, Nahass says the uncertainty brought on by pending federal regulations may hamper the current zeal in the rail industry. “The lack of clarity in that process and the bureaucratic nature of the decision have caused confusion, additional expense and a potential short- and medium-term imbalance between supply and demand,” he says. “Right now, the Department of Transportation’s (DOT) rewriting of the tank car specification will trump all other issues that may exist, such as fear of overbuilding, component supply and track conditions.”
Wilson says that the pending regulation on crude oil transportation will have a major impact on all the railroads, shippers and equipment owners. “We’re effectively waiting on them to make a pronouncement on what the specifications will be for minimum safety requirements on crude oil cars,” she says. “Once we know that, we and the other stakeholders in the business will be able to make decisions about deploying capital with a much higher level of confidence, because we’ll know the playing ground. And that will have a meaningful economic as well as service impact on the industry.”
The regulations will require DOT-111 railcars to be fitted for safer transport of highly flammable liquids; however, if some older cars cannot be modified, they will either be repurposed or scrapped altogether because their remaining useful life is not long enough to recover the cost of retrofitting, McKerroll explains. The chance for repurposing cars for other segments sounds like a plausible solution; however, McKerroll notes that other product groups are already served by their own tank car supply and therefore this could cause a shortage in one area and an excess in another. “The shortage in supply is in the petroleum industry,” he says. “The new regulatory standards will further constrain this supply as it will push some cars out of service and cause most of the remaining cars to be taken out of service for a period of time while retrofitting is completed. They will have to allow for those to be modified in an orderly manner without taking too many of them out of service of the industry for too long. They have to be mindful of having regulations that the industry can work with to make sure that the supply of railcars is there to serve the industry,” he continues.
A recent Wall Street Journal article suggests another issue rising from the pending regulations: retrofitting could increase the weight of the cars, ultimately lowering the hauling capacity of the car. However, despite widespread uncertainty of the new protocol’s impact on industry productivity, McKerroll says he sees the future modifications as an opportunity for leasing companies. “We’re looking at that as an opportunity to provide some additional financing,” he says. “An example would be to draw up a sale/leaseback agreement on cars that will incur an incremental cost from the modification. Companies like Trinity have been preparing for that, and are making sure that they’ll benefit from that too.”
Adjusting for Personnel & Economic Cycles
One huge benefit of the rail industry is the broad and deep knowledge of industry veterans. Wilson, for example, began her career in a lending training program at Bank of Boston. She then wound her way through the equipment finance arena, focusing on rail. She served as Helm Financial’s CFO for about 12 years prior to becoming president at First Union Rail, which recently acquired Helm’s parent company.
McKerroll was one of the founders of Newcourt Credit Group, where he served as president of the Newcourt Capital division prior to serving as group CEO of CIT Structured Finance and later as group CEO of CIT Capital Finance. Nahass also spent time at The CIT Group as a paralegal, finding his way to railcar leasing upon CIT’s major push into establishing itself as an operating lessor of rail equipment. He then moved to Chicago to join RFC.
These executives are only three of the wide-reaching collective experience the rail industry has to offer newer entrants into the space. Wilson notes that it is imperative for upper management teams throughout the industry to impart wisdom on newcomers who are willing to learn so they can take the helm when their time comes.
“It’s amazing how much experience people have and how much value we can add for the customers as a result of that expertise,” she says. “The collective experience is huge. It’s a long-term learning curve, and this transition to the next generation is a significant concern of mine,” she says. “We’re proactively addressing this to the best of our ability, but it really is an industry issue, and it’s going to have impact on the players. We’re at the early part of this curve, but as I look forward into the next decade, it will be increasingly important to transfer the knowledge from the senior folks to the junior folks.”
As personnel cycles through, so too will the economy, which will be a major factor in determining if rail will continue on its positive trajectory, according to McKerroll. “I think when you’re looking at the rail industry you have to look at the overall economy,” he advises. “You have to keep your eye on the industries rail serves. You have to see how they’re doing and what the potential demand is going to be going forward. The good thing about the rail business is you’re [involved in a number of] different industries and your leases are long-term, so any shift in demand won’t affect your portfolio dramatically at any point. There is a boom now, and you try to look to see how long you think that’s going to last.”
Nahass says that the current cycle is more interesting than past cycles because of its capacity to run for a decade or more, as opposed to roughly six-year intervals. “In many ways it changes the point of view of how investors see the market, he says. “It drives the return expectations for different types of investors getting into the market and creates higher used car valuations. It will be fascinating to see what happens when there is a cyclical adjustment to the market. Will these new investors stay engaged or will they sell their positions when the market shifts downward? It will be interesting to see.”
Asset Longevity
Economic cycles may affect rail productivity and success; however, rail equipment assets are enduring and diverse, and therefore make attractive assets that stand apart from other verticals in the equipment finance space.
“A railcar operating lease portfolio provides predictable and stable cash flows from long-life assets that will last 35 to 40 years and sometimes longer,” McKerroll says. “A well-managed railcar lease portfolio is diversified by different industries, types of cars and lessees.”
Wilson says fleet diversification is critical to success and risk mitigation. “There are times when you do everything right but if the grain harvest is weak, then grain cars are going to be off lease regardless of what we do as a service provider,” she explains. “With a large, diversified fleet, we can mitigate the aggregate portfolio risk of the wheat/grain season by having assets deployed in other industries servicing other commodities that aren’t directly impacted by the same cycle. It’s critical to be comfortable with the residual and the remarketing risks of the assets we’re acquiring, as well as have confidence in a pretty deep bench in mechanical and marketing team members to keep the assets on rent,” she says.
Nahass notes that, aside from the long asset life and the cyclical industries rail serves, railcar leasing is set apart by the fungible nature of the assets. “This leads to potential investors being able to rely on the realization of a high residual for a portion of their return,” he explains. “The residuals assumed by companies investing in rail are based upon the assumption that if the equipment is returned to an investor there are, in most cases, pools of additional users of that same equipment. This allows for a continued and ongoing return on capital invested in rail equipment.”
Working in Rail
McKerroll, Nahass and Wilson are very much invested in the grand opportunities that rail has to offer, from new financing prospects to long-life assets, as well as a sense of comradery throughout the industry.
“It is a great business, with low loss rates, excellent yields and it is backed by high-quality, long-lived assets,” McKerroll says. “We know this business well, and our main focus is to grow it further by leveraging best-in-class partners and a growing internal staff of experts.”
“One thing that is awesome about working in and with people in railcar leasing (both lessees and lessors) is the quality of the people,” Nahass says. “I’ve known many people for decades and they are talented, successful and intelligent people. It’s great to be associated with them.”
“I feel like I have been very fortunate throughout my career to have a number of mentors who have helped me grow as an individual and helped me learn a lot about the industry,” Wilson says. “I’ve always found that people in the rail industry are a great people to work with. It’s a very welcoming group. It’s a very smart and experienced group. People tend to be very straightforward and honest. I have really enjoyed my career in the industry.”
Megen Donovan is an associate editor of the Monitor.
