Investing in railcars might seem old-fashioned. Undoubtedly, the innovation era of railways is long gone. The economics of railcar leasing, however, remain attractive. There are compelling reasons to consider this asset class as part of an infrastructure allocation to supplement an equity or fixed-income portfolio.

Despite its perceived nature, rail is still vitally important for transporting goods. About 28% of freight movement by ton-mile goes by rail in the United States. Rail is also seeing renewed interest because it is more climate-friendly than trucking.

Despite their reliance on rail freight, companies are generally not interested in owning and operating railcars. Approximately 80% of railcars in the industry are owned by leasing companies. Owing to the convenience of leasing versus buying and maintaining, the railcar leasing market is expected to grow by more than 7% annually over the next four years.

The economics of leasing a railcar consists of two components: new build costs and capital costs. The former captures the cost of purchasing and operating a railcar. The latter reflects the debt and equity costs associated with financing that transaction. For lessors that offer turnkey solutions including operational expertise and access to low-cost capital, the economics of this transaction can be attractive for companies.

Due to the political environment in the United States, now could be an opportune moment to invest in railcar leasing. Efforts to reduce America’s import dependence and increase domestic manufacturing should be a tailwind for the railcar industry. Manufacturing backlogs mean that new railcar supply is likely to lag increased demand, potentially allowing lessors to realize outsized profits in the near future.

In this article, we describe why investing in railcar lessors can benefit an equity or fixed-income portfolio. We also explore ITE Management L.P., a large, well-established business that has competitive advantages for companies seeking to lease railcars. Investors can potentially benefit from ITE’s comparative advantage by investing in this asset class.

Advantages of Investing in Railcar Leasing

Railcar leasing has several advantages as a replacement for a fixed-income component. While interest rates do impact lease returns like a fixed-income investment, the operational aspects mitigate the interest rate sensitivity. Even during the year 2022, when US Treasury and investment grade corporate bonds experienced a negative total return, the ITE Rail Fund L.P. (“Rail Fund”) generated a positive return of 10.43%.

As an equity replacement, investments in railcar lessors have been substantially less volatile, with the Rail Fund posting annualized volatility of 2% between October 2014 and October 2024. Yet for the five years to September 2024, the Rail Fund has generated a pre-tax annualized return of 10.4%. Importantly, lease returns are generally uncorrelated to other equity market factors. Lease rates and utilization ratios do have some positive correlation to general economic conditions. The factors that influence equity and credit markets, however, are somewhat distinct from those affecting the leasing market.

Next, railcar leasing can provide an inflation hedge. When commodity prices rise (particularly steel), the new build cost of railcars also rises. While this is not the food and goods-related inflation familiar to consumers, commodity prices are linked to cost of living trends. Because rising inflation is also linked to higher interest rates, capital costs earned by lessors generally increase as well (albeit with a lag). This contrasts with typical fixed-income investments which struggle when interest rates rise alongside inflation.

Finally, railcar leases are tax efficient. Railcars are long-lasting assets, with a useful life of 25 to 40 years. Tax rules allow for accelerated depreciation of these assets, however, resulting in significant tax savings in the first 4 to 7 years. This advantage has some similarities to the tax benefits found in real estate investing.

Based on certain assumptions, these tax benefits can potentially result in post-tax gross returns that are more than 30% higher than a comparable investment without such advantages. Over a 10-year period, this difference could lead to about $777,500 in additional wealth on a $1 million initial investment (before accounting for fees). This data is summarized in the table below.

These advantages reflect the current state of tax laws. Should the rules change in the future, railcar leasing could become less tax efficient. However, there does not appear to be significant political interest in changing accelerated depreciation rules at this time.

Alpha Generation in Railcar Leasing

The advantages of investing in railcar leasing are compelling. However, investors still need to select a manager with the potential to generate alpha in this asset class. To do so, we need to understand the drivers of performance in railcar leasing.

The railcar market is competitive. Railcars are largely substitutable for one another and companies seek the best combination of execution, operational excellence, and leasing costs. This means that lessors have to differentiate themselves based on these factors.

Operational efficiency is a primary success factor. Effective operational management, combined with better access to capital, can help lessors minimize their operating & maintenance and financing expenses. At well-run firms, this can result in greater pricing power and better profit margin than competitors.

With thousands of railcars to manage, fleet management is critical to overall railcar returns. High utilization ratios are essential to ensure that assets are always working to generate yield. Diversification across subindustries and railcar maturities also helps manage risk. Finally, low capital costs can help generate alpha through judicious use of leverage.

Based on these factors, there is one railcar lessor with a strong track record of steady execution and positive historical returns that investors can consider: ITE Management.

ITE: A Competitive Railcar Lessor and Operator

ITE operates a railcar and transportation leasing fund. Due to several competitive advantages, this fund could be an interesting asset class investment for railcar leasing investors. The firm manages over $10 billion in hard asset value and has a team of more than 60 professionals.

ITE’s wholly owned portfolio company American Industrial Transport (AITX) serves as the firm’s operating platform. AITX manages the 3rd largest rail fleet in North America with more than 210,000 cars and about 870 full-time employees. ITE has been expanding their operating fleet in recent years, including acquiring SMBC’s former rail fleet.

The firm’s principals have significant domain expertise in finance, resulting in better access to capital. Jason Koenig, Co-Founder and Managing Partner, has a background in M&A and private equity. David Smilow, Co-Founder and Partner, successfully founded & exited two financial services companies. Their expertise is supplemented by operating partners who are industry experts in the assets.

Senior Operating Partner Jennifer Polli has spent her career in various investment and operating roles in the intermodal transportation sector. Prior to joining ITE, Jennifer led TRAC Intermodal, North America’s leading intermodal marine chassis leasing and management company. Operating Partner Steven Unger has spent his career in the rail sector. Most recently, Steven was President and Chief Commercial Officer at AITX, overseeing the firm’s leasing and repair business.

In addition to this operational and financial expertise, ITE’s railcar portfolio is managed effectively. The firm has a 97%+ utilization rate and a highly diversified asset base. Due to strong working relationships with lessees, they also have an 84% lease renewal rate as of the last twelve months to October 2024. These leases are staggered to mitigate the risk of concurrent maturities leading to underutilized assets. ITE further increases these advantages by leveraging their portfolio, typically in the conservative range of 2-3x. 

Between 2016 and 2023, ITE’s Rail Fund has posted average annualized returns of 10.65%. The fund’s lowest full-year performance was in 2020 when it returned 8.03% due to a reorganization in an underlying commodity sector. Similar risks have been mitigated by increased diversification of the portfolio. ITE’s Rail Fund also has a -.05 correlation to the S&P 500 and -0.02 to the Barclays Aggregate Bond index. 

Finally, we believe that ITE’s fee structure is justified by the firm’s track record. The fund’s 1.5% management fee and 20% incentive fee are deserved by their strong and consistent operational & financial management performance.

Investing in Railcar Leasing with ITE

We believe that railcar leasing can serve as a portfolio-enhancing component of either an equity or fixed-income allocation, depending on a client's portfolio objectives. Within this asset class, ITE’s platform has delivered alpha-generating opportunities. For interested investors, the firm is a competitive asset management choice.

Commitments are currently open for the ITE Diversified Transportation Asset Fund L.P (“Diversified Fund” or “Fund”) which feeds into their underlying Rail Fund. The majority of the Diversified Fund’s assets are in railcars, which management expects to continue being the case for the foreseeable future. The Diversified Fund’s portfolio will also acquire intermodal transportation assets to lease, such as shipping containers and aircraft. As such, investors should be aware that they will have exposure beyond just railcars.

The Fund is only open to new commitments when ITE is in the market to expand its portfolio. Direct investments are available to Qualified Purchasers with a minimum of $1 million. There is a two-year capital call commitment period. Investors have a 6% annual distribution option paid quarterly along with an annual withdrawal option at the end of the lock-up period.

For certain investors, Sandro Wealth can facilitate an investment into a separate fund that feeds into ITE’s strategy. This accredited feeder fund has a $100K minimum. It could be a suitable option for investors looking for exposure to the railcar leasing market under the standard $1 million minimum commitment.

If you’re interested in investing in railcar leasing through ITE Management or other options, we invite you to contact us for a consultation. At Sandro Wealth Management, we specialize in helping clients identify and benefit from private market opportunities.

Disclosures:

Sandro Wealth Management, LLC (“Sandro Wealth”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Sandro Wealth and its representatives are properly licensed or exempt from licensure.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Targets are estimates based on certain assumptions and analysis made by the Advisor. There is no guarantee that the estimates will be achieved.

Diversification does not ensure a profit or guarantee against loss. Past performance shown is not indicative of future results, which could differ substantially.

An investment in the ITE Diversified Transportation Asset Fund and the ITE Rail Fund (the “Funds”) involves significant risks and is suitable only for those persons who can bear the economic risk of the loss of their entire investment and who have limited need for liquidity in their investment. There can be no assurance that the Funds will achieve their investment objectives. An investment in the Funds carries with it the inherent risks associated with the underlying investments and trading strategies. Each prospective investor should carefully review the Confidential Offering Memorandum and Limited Partnership Agreements before investing.

The information provided on behalf of the ITE Diversified Transportation Asset Fund and the ITE Rail Fund is not intended to constitute as a solicitation of an offer.