Colony Capital Hunts New Opportunities - Investment Outlook - December 2003

Sidestepping what it sees as an over-ripe U.S. hotel market, Colony Capital is hunting hotel opportunities amidst the complexities of offshore markets and the hard driving gaming sector.

By Staff -- HOTELS Magazine, 12/1/2003

Thomas J. Barrack, Jr., founder, chairman and CEO of Los Angeles-based Colony Capital, LLC and Colony Capital Advisors, LLC

Donald Trump calls Thomas J. Barrack, Jr., founder, chairman and CEO of Los Angeles-based Colony Capital, LLC and Colony Capital Advisors, LLC, nothing less than a “brilliant” investor. While Trump may be given to hyperbole, consultants and competitors around the investment world support Trump’s contention that, “Tom can see where the world is going and where markets are going. He has that prodigal ability to look into the future and be 100% correct. It is instinctive; something you are born with. And Tom Barrack has made the most of it.” Colony Capital’s recent decisions to sell London’s venerable Claridge’s, enter into final negotiations for the Hawks Town hotel/sports/entertainment complex in Fukuoka, Japan, and acquire Sardinia’s luxurious Costa Smeralda resort certainly will test the clarity of Barrack’s forward-looking vision.

Complexity is the key factor that always draws Barrack’s eye. He is not just tossing out a sound bite when he likens hotel investment to a high stakes version of the dizzying picture puzzle “Where’s Waldo?” Complex markets, muddied by high barriers to entry, rising labor costs and difficult legal or tax requirements blur the opportunities for those who prefer simple solutions. These are precisely the markets Barrack wants and, in the near term, most of them lie outside the United States.

“The U.S. hotel market is very attractive to some investors, even though the fundamentals are less than impressive,” Barrack says. “What I see is too much capital, too few good deals and too much information. Everybody knows every asset inside out, which only serves to level the playing field. A lot of investors will be buying and repositioning hotels. We do not see prices we would be willing to pay.”

Though hotel assets may not be targets for Colony’s newly closed fund for North America, it may remain as a player in the United States. A red-hot mezzanine debt market is hard to ignore. Sources say Colony is considering raising a new fund anchored by a mezzanine financing platform. Barrack declines comment but acknowledges the opportunities of the “mezz market.”

“The mezz piece can contain compelling financial attributes at this point in the cycle,” he says. “The mezz debt is enhanced by 20% to 25% equity above it and contains current return components of between 10% and 15%. Many owners believe their properties have bottomed and are willing to stretch with mezzanine to maintain the equity. The hotel market will grow in RevPAR, occupancy and rate—but very slowly.”

Land Of Opportunity
In deal terms, Barrack has spotted “Waldos” on both the buy and sell side in the European market. Clearly, Colony is looking at the puzzle with different eyes. Sources say no one would have bid enthusiastically on Costa Smeralda based on the four hotels in place with their 6% estimated returns. Making the numbers work was contingent not only on realizing enhanced potential for the hotels, which now operate 120 days a year (albeit at some of the world’s highest per room achieved rates), but also for the marina, golf course, shipyard, commercial and retail assets and the real treasure, a 51% management stake in an unentitled 5,900 ac. (2,384 ha) of coastal land (of which Starwood retains 49%). It took Colony nearly two years after its initial bid to close the US$340 million deal.

“We had an advantage in analyzing this deal. We knew the requirements of Starwood as a U.S. public company, but we also understood the complexities of the European real estate regulations,” says Barrack, a native Californian of Lebanese extraction who has lived in the Middle East and Europe and who bought a second home in France to ensure that his children would have a multicultural understanding of the world. One of those complexities will be finding a way to win zoning approvals for expanding the hotels and adding residential units to the site—a dilemma that stymied even the Aga Khan when the resort was part of the CIGA chain he later sold to ITT Sheraton in its pre-Starwood incarnation.

Reports of a warm reception from Italian Prime Minister Silvio Berlusconi bode well for the project. However, no guarantees have been forthcoming. Barrack’s tenure as deputy under secretary of the Department of the Interior during the Reagan administration should be a bonus, as should his training in international law.

The potential of Costa Smeralda in many ways reflects the broader potential Colony believes Europe offers at the top end of the market. As in European gateway cities, there is the value-building issue of high barriers to entry. “A trophy resort in Europe is not like a trophy in Mexico or many parts of the United States,” Barrack observes. “No one is going to be able to buy the next stretch of beach, hold it until your hotel is a little tired and build a new hotel that erodes your market.”

Barrack could also point out that those same barriers have strangled new luxury supply around much of the northern curve of the Mediterranean for more than a decade. With a billion-person travel market within three hours flying time and a luxury caché that prices nearby residential property at several thousand dollars per square foot, new residential units selling at US$11 million to US$58 million (euro10 to 50 million) could help drive internal rate of return much closer to the 20-plus percentage target typical of aggressive opportunity funds. Insiders add that with LIBOR holding borrowing costs at the 3% level, savvy redevelopment could deliver those double-digit returns without ever disturbing 75% of the land.

Colony Capital and the Blackstone Group paid US$870 million for the Savoy Group of hotels in 1998 and are currently rumored to be asking US$500 million (about $2.2 million a room) for London’s famed Claridge’s.

“Costa Smeralda was a difficult asset,” says Mark Wynne Smith, managing director, Europe, Jones Lang LaSalle Hotels, London. “Tom Barrack came at it with a far wider vision. As usual, he spotted the avenue that was not obvious at the time.” Says Christopher Rouse, senior director, CB Richard Ellis Hotels, London, “Colony is a player’s player. Costa Smeralda is typical of their deals. You will never see Colony buying for the sake of buying.”

Watch for Colony to keep shopping Europe at a time when hotels are underperforming, labor costs are on the rise, European economies are tracking the United States’ and business travel is stagnating. These pressures should combine to force more trophy assets onto the market in key markets such as Paris, London and Milan.

Sell Side
So, if Europe has so much potential, why is Colony and its co-investor in the Savoy Group, Blackstone Group, selling a undeniably irreplaceable asset such as Claridge’s? “That was a hard decision,” Barrack says. “Steve Schwarzman (Blackstone’s CEO) told me the day we decided to sell Claridge’s was the most agonizing day of his professional life. It was not easy to avoid feeling some psychological warmth toward the asset—and that is never good. You know in the back of your mind that whatever price you achieve, a one-of-a-kind asset such as Claridge’s will just keep appreciating. But every investment has a life cycle given the return requirements. One day you look at the numbers, the lights go off and you know the time is right to sell.”

No one can argue that Claridge’s is truly a trophy. Some industry watchers have wondered aloud about selling in a sectoral downturn that continues to depress London’s hotel performance, but others see no need to wait until the field is more crowded. “It is a good time to sell. The asset has as high a profile as one could want in a trophy hotel,” Rouse says. “This chance does not come up frequently. It should concentrate the minds of buyers. When you consider that office real estate in the UK has lost 40% of its value and hotel real estate has lost about 5%, you can see why hotels are increasingly being viewed as sensible investments.” The rumor mill suggests that the short list of bidders could include Saudi Prince Alwaleed, looking to build on current holdings in Four Seasons, Movenpick Hotels & Resorts and Fairmont Hotels & Resorts; Russian investor Roman Abramovich; and the UK’s Sir Rocco Forte, who just added London icon Brown’s Hotel to his RF Hotels portfolio for US$86 million (£51.5 million).

Hotel Casa di Volpe is one the four hotels acquired by Colony Capital on Costa Smeralda.

The big variable in proving Barrack’s vision correct this time may be pricing. Discussions heard on the street and seen in print in London hint at an asking price around US$500 million (£300 million). If that is indeed the case, it would set a new record of US$2.2 million (£1.35 million) per room for a hotel whose clientele includes entrepreneurs willing to spend up to US$5,856 (£3,500) per night for a suite and, on occasion, the Queen of England. Achieving that figure would necessitate a new enthusiasm for the trophy hotel market capable of pushing prices well beyond the US$1.67 million (£1 million) per room paid for the Four Seasons Milan in December 2002 or the seemingly “modest” US$729,000 (£436,000) per room tendered by Sir Rocco for Brown’s last June.

It also would make the US$870 million (£520 million) paid by Colony and Blackstone for the Savoy Group in 1998 look like a bargain—especially satisfying for Barrack considering the view that the funds definitely had paid “full price” for the group as it was then. But, that was five years and US$92 million (£55 million) worth of refurbishment ago for Claridge’s. With Claridge’s (and, some say, the Savoy Group) at the logical end of an equity fund’s hold period, Barrack is ready to move on to new opportunities created as other owners come under earnings pressure. “We are in a great position to become an acquirer,” he says. Three new international funds closed by Colony in Septemer should provide ample firepower, two of which are earmarked for regional plays in Europe and Asia.

Niche Plays
Though Europe will likely be Colony’s main theater, it continues to mine strategic opportunities in what Barrack terms a “difficult” Asian market. Japan is a market many fund investors like, but the competition is heating up. Colony had to best both Ripplewood Holdings and Lehman Brothers to structure a successful bid for Daiei’s Fukuoka Hawks Town. If the deal closes as expected late this year or early in 2004, it would add some state-of-the-art structures, including the 1,052-room Sea Hawk Hotel & Resort, a mall, convention facilities and the Fukuoka Dome baseball park to Colony’s US$2 billion portfolio of Asian assets at a significant discount to replacement cost. Equally important is development potential on an adjacent site.

Robert Stiles, managing director, Sonnenblick Goldman, San Francisco, calls the Fukuoka deal “a bold move.” “Run by Bob Zulkoski, Colony Capital Asia Pacific has made some shrewd hospitality investments recently, including a regional play, Oakwood Asia Pacific (now the second largest serviced apartment operator in Asia) and the deal for Hawks Town. Their diversified investments have proven they are not just good buyers but, perhaps, more importantly, good sellers,” Stiles says.

How much capital flows into Asian hotel real estate will be decided by the market. Barrack shares his competitors’ frustration over assets coming to market. “In Asia, owners have a cultural love of hotels. They can hang on for years, even if the hotel is not making debt service. They will give up nearly everything before they give up hotels,” Barrack says.

Gaming, not a market for the squeamish, is another one Barrack likes. One of the only licensed financial institutions in the U.S. gaming industry, Colony is uniquely positioned to become an acquirer from strategic players. Rival investors’ difficulty in obtaining licensing should provide Colony with a significant competitve advantage. Experience counts, as well. Colony proved it could navigate this tough sector with the recent sale of Harveys Casino Resort to Harrah’s for US$694 million, a comfortable gain over the US$405 million purchase price five years ago.

Last year, just three months after taking a 50% stake in Accor Casinos, Colony and its new partner fended off what the French press called “ferocious” competition to purchase Le Palais Casino—Le Touquet, one of the last large French casinos not already in Accor Casinos’ fold. The gaming sector should open up opportunities in Europe as more governments expand licensing and in the United States—especially if public hotel companies with gaming assets remain under earnings pressures. “No brand is going to want to sell to a competitor. That puts us in a great position to become acquirers,” Barrack notes.

The Closer
Barrack is a quick study, but he, like all of Colony’s international team, has a formidable reputation as someone who does his homework—and that of everyone else. Before due diligence begins, Colony’s team puts in long sessions with the buyer or seller to find out exactly what each side wants and where the problems lie. “The usual process is price, terms, close,” Barrack says. “We do just the opposite. We ask the buyer or seller to tell us the specific things that have to be done to close the deal. Then we tell them whether we can work with that. Ninety percent of the time, the answer is ‘no.’ But, then you get that one phone call.”

What often is missed is what happens after the deal is done. Industry insiders say Colony brings a lot more to its partners than capital. Benjamin Cohen, vice president of the management board of Accor, rates Colony as a strong financial partner for the hotel industry as long as they can bank on management efficiency from their industry partner. “Thomas Barrack is a highly skilled financier. He is always on the road, always capable of quick decisions based on performance and trust,” says Cohen, himself an icon for his dynamic turn as Accor’s CFO. “Colony has good people on the ground. Sebastien Bazin (Colony’s managing director, Europe) plays a key role throughout Europe. He brings an in-depth knowledge of the local markets.”

During the very few moments Thomas Barrack, Jr. is not worrying about work, he likes to alleviate stress by playing polo or riding a wave on his surf board.

Adds Joel Mingasson, president of Accor Casinos management board, “Colony not only brought their financial muscle and know how to the table, but are able to offer assistance with Accor Casinos’ international development and the necessary contacts at a high level in Europe. Their experience in real estate, an important factor when we look for development projects and sites in Europe, has proved extremely valuable.”

Operators who have worked for Colony give it high marks for its vision, straight talk regarding performance expectations and delivery on promises. On the human side, Colony provides what staff needs to deliver an unforgettable guest experience. The payback: An absolute unwillingness to accept mediocrity. “Tom Barrack is a great believer in a hotel’s human assets,” says Jennifer Fox, former general manager of the 539-room The Orchid at Mauna Lani at the time of its sale by Colony and now GM of the InterContinental Hong Kong. “He takes time to understand the local customs and work environment. While he may demand peak performance, he is also a man of his word, a true gentleman. If he says he will do something, it is as good as done. He makes you want to do a good job.”

Barrack is a firm believer that operators who think hotels are about “eating and sleeping” are missing the point and profits. It is the guest experience that counts, and that derives more from an investment in human capital than 300-count sheets. “If you want to build market share, concentrate on the human factor. Spend more money on training than bed linens,” says the world traveling Barrack. “There is no esprit de corps when the staff knows that you are going to field x-number of people during high occupancy and trim that back to y-number when you are empty. You cannot tell the guest there is no bell service at a 5-star hotel and then expect to charge a 5-star room rate.”

Barrack’s 360-vision of the hotel industry as a real estate business and an operating business hints at the passion he has for the job. When asked about how he de-stresses, he may drag out photos of himself caught in action during a polo match or in the curl of a wave but the look on his face says he never leaves work completely. “I would pay the board to do this job,” says Barrack. Based on comments from friends and rivals, that just may be the case. It is unlikely the man Trump calls “highly under-appreciated” will ever be tested on this observation.

Industry Trends
Colony Capital’s CEO Thomas Barrack, Jr. defines the trends likely to shape the hotel market in 2004 and beyond.

Watch for U.S.-based chains to continue to segregate bricks and brains. “Real estate is a millstone around the necks of the brands. Those that offload it know they will get much better multiples. The U.S. (stock) market is driven by an income and analysis approach, which bases value on RevPAR and GOP. No hotel company gets points for owning real estate.”

Sell rooms, not brands. “There is no brand loyalty. Travelers want the best location at the best price, and they know there are a million ways to shop and compare.”

Deliver more for less. "The arrogance of hoteliers and real estate owners is bizarre. People are paying less for computers, washing machines and airline tickets than they did five years ago. Are they really going to pay more for hotel rooms at a time when business travel is decreasing? That won’t happen. Operators are going to have to give more for less.”

Look for an accelerated transaction pace. “If public hotel companies cannot grow RevPAR, and they cannot grow sales, neither of which is likely to increase substantially for three to four years, how are they going to grow their value? They will have to bring more quality assets and more trophy assets to market. We will see more off balance sheet deals.”

Expect more stock buybacks. “Debt is cheaper than equity. Hotel companies will take advantage of the arbitrage to buy back under-valued shares. We will also see some companies go private until there is a reason to go public again.”