Toby Kolstad: Who'll fund the next rail-car investment wave?

by Toby Kolstad

About 20 years ago, I gave a speech in Denver to members of the Railway Supply Institute's Leasing Group in which I posed the following question: "Where will railroads find the next group of suckers to fund their new rail cars?" The derisive term was not a slap at the audience but my characterization of railroads' dismissive attitude toward the many small investors, alleged to be doctors and lawyers, who had lost millions of dollars from investments in new box cars and covered hopper cars in the Interstate Commerce Commission's car hire incentive program of the 1970s.

The audience comprised senior executives of most of the rail-car leasing companies, the survivors of an industry that had been decimated by the railroad traffic losses and rail-car surpluses of the early 1980s. The speech was warmly received and the discussion that followed gave me the impression that these executives already had considered my question before I raised it.

In subsequent years, most of the lessors that had been represented in the room that day invested in a conservative manner and did not make the same speculative mistakes that had brought ruin to so many during the early 1980s.

However, many companies entered the rail-car leasing business during the 1990s that had not learned the lessons of the 1980s, and much of the funding for new equipment the railroad industry needed during the past 20 years was provided by these new companies. The competition they provided the survivors of the '80s — and their aggressive leasing tactics — kept rental rates very low; in hindsight, perhaps too low.

Meanwhile, the recessions of 2001 and 2008 created huge car surpluses in most rail-car fleets, driving down lease rates and on-rental percentages for all leasing companies. The low lease rates during the rather short-lived "good" times may not have been enough to offset the losses during the unexpectedly frequent "bad" times, and rail-car investments made during the 1990s look less attractive today than when they were originally conceived. The poor returns have prompted many leasing companies, including two of the largest, GE and CIT, to consider exiting the rail-car leasing business.

To The Victors Go ...

The only winners during the financial turmoil of the past 30 years have been the railroads. They have shifted the cost of ownership to others. In 1970, railroads owned most of the rail-car fleet; today, they own less than 20 percent of it.

Along the way, railroads have reaped the rewards of low rental rates that three periods of surplus equipment have inflicted on the new owners. To add insult to injury, railroads have made rail-car ownership even more expensive by raising freight rates for moving defective cars to repair shops, mandating more frequent equipment upgrades and tightening inspection standards to prevent equipment failures. Most cost increases could not be easily passed to the lessees, especially in recent years when competition has been so fierce just to keep cars on lease. Ultimately, though, these costs will have to be passed to the equipment lessees and rail transportation will get more expensive.

Unlike 1987 when I gave the speech, the leasing industry shake-up is still under way and no one knows for sure who will survive the recent market collapse.

Moreover, there are still hundreds of thousands of surplus rail cars of all types; just when the rail-car market will finally come into balance is still being debated. But one thing is not in doubt: One day, rail-car demand will increase, and tens of thousands of new cars will be needed annually to replace old cars and handle new railroad traffic.

When that happens, lease rates and car prices will rise — probably high enough to reward the investors from the 1990s. But: Will they be high enough to attract new money into rail-car investments? Is it too early to pose the question again: "Where will the railroad industry find the next group of investors to fund their new rail cars?"

Investors eventually will fund all the new rail cars that will be needed in the future, but lease rates and investor confidence will have to rise significantly for that to happen.

Toby Kolstad has been in the railroad industry for more than 30 years, with stints at the Illinois Central Gulf Railroad, Denver & Rio Grande Western Railroad, a car builder and lessor. Currently a consultant on rail-car matters and president of Rail Theory Forecasts L.L.C