Diversify And Conquer - Investment Outlook - December 2004

Conservative and disciplined, LaSalle Hotel Properties keeps leverage low and dividends rolling along with a portfolio diversified not only by location, but by operator and sector.

By Staff -- HOTELS Magazine, 12/1/2004

Jon Bortz, chairman and CEO of LaSalle Hotel Properties

Jon Bortz, chairman and CEO of LaSalle Hotel Properties (LHO), jokes that there is a close correlation between the real estate investment trust’s (REIT’s) performance and his golf handicap. In early November, the stock hit an all-time high of US$31as his handicap hit an all-time low of three. He may have lost a stroke after third-quarter funds from operations (FFO) squeaked within the $0.60 to $0.63 per share consensus third-quarter guidance (coming in at $0.62, which included a dampening $0.03 charge for a litigation accrual). Just hitting the targets only looks like a miss for a company that beat the analysts by $0.04 to $0.09 per quarter for the first two quarters of this year. Having 18,500 to 19,500 rooms out of service as part of a renovation program is capping fourth-quarter RevPAR guidance at 1% to 2% below analysts’ projections (a figure that would have been within the 5% to 6% industry average excluding the renovation). But, with 17.2% RevPAR gains across the portfolio for the first nine months of 2004, a steady dividend and interest coverage ratio of 5.0x, Bortz should be on his way to bccoming a scratch golfer.

Known for a low profile and steely discipline, Bortz is a self-admitted perfectionist. His “Type A” eye for detail is as apparent on the links of the three golf clubs where he is a member as it is in LHO’s no-nonsense Bethesda, Maryland, headquarters or in his face-to-face business style with the portfolio’s operators. Five p.m is “mid-day” for Bortz. He is “hands-on,” according to a consensus of his 24 co-workers in the corporate headquarters; in his own words, he is “a bit of a fanatic.”

“The bigger the challenge, the more I like it,”Bortz says. “The goal is always to outperform,” he says. “Does loss of control scare me? Yes. I cannot control the environment, but with a manageable portfolio I can control performance. That is why LHO does not set growth targets per se. We may add four hotels a year, or we may add zero. What we will not do is add 20. Small is what we are all about.”

Think Big, Stay Small
His “small is good” mantra flies in the face of conventional wisdom about REITs needing to be large to maximize economies of scale and optimize negotiating power with management companies and franchisors. “Size is not an issue for us. What does it really get you? Sure, you may have more buying power on the property insurance side or you may be able to spread compliance costs over 100 properties instead of 20,” Bortz says. “But, as you grow, you need more people. There are no scale benefits when it comes to human resources. Nor is size a plus or minus in accessing financing—especially now. Debt capital is very inexpensive and very available. We probably see 16 proposals from lenders for every project.”

Like their competitors, Bortz and Raymond Martz, LHO’s treasurer, have been working hard and fast to lock in low-interest debt before rates creep any higher. Within four days at the end of August, LHO executed a US$34.4 million, 4.98% fixed-rate secured loan with Wells Fargo Bank and increased its senior unsecured credit facility from US$215 million to US$300 million. In this capital-rich environment, LHO should have little trouble keeping its total debt to EBITDA in its historic 4.6x range and leverage under 50%.

Unlike the competition, Bortz is not building a war chest. He predicts heavy volume, particularly in large urban hotels, as investors past their original hold periods bring more product to market. LHO will be looking closely at assets in its core upper-upscale and luxury full-service segments, but it will be shopping very selectively. Bortz feels no pressure to make a sweep before the cycle powers up. “We never promised growth; we promised income,” Bortz says. “We expect to add one to two hotels next year, so we can be purely opportunistic. We do not need a half billion dollar in deals to significantly impact our EBITDA and FFO. It is a lot easier to find two good assets than a series of US$75 million deals.”

LHO has developed a complex monitoring system that tracks trends in 15 key U.S. urban markets and supplements that with a watch on various resort destinations. Bortz will look at “anything,” but clearly prefers markets with diversified business/leisure/convention appeal: New York City, Chicago, Boston, San Francisco and the Los Angeles area—“not Orange County, but Hollywood, West Hollywood and the northwest sector.” What would he avoid? “The suburbs.” Also off the list are cities such as New Orleans, which are undergoing changes in their fundamentals. “New Orleans is seeing a lot of new supply. It is also seeing a decline in its convention business. So we sold our hotel there for a US$37 million profit,” Bortz says.

Resorts are strictly a deal-by-deal consideration. Though the Lansdowne Resort in greater Washington, D.C., will be developed into a major regional resort, Bortz says it is not necessarily a template for resort deals to come. “We find projects like this that are hard to do. We get a better deal at a better price and much higher returns,” he says. The most likely acquisitions for 2005 will be in the business-oriented urban sector. “That is what is coming to market.”

According to Robert Koger, president, Molinaro Koger, Washington, D.C., LHO is not about to make a rash buying decision. “They are very disciplined. They are about quality brands in quality markets. They are not the company to buy anything, anywhere,” Koger says. He cites Bortz’s reputation as a “closer” on both the buy and sell sides: “He and the LHO team have the ability to overcome challenges. Every deal has obstacles. They come up with solutions that work for both sides.”

Strong Core
Finding deals that fit LHO’s criteria requires a 360-degree vision. LHO has moved beyond the usual effort at geographic diversification to weight its portfolio fairly evenly in the urban, resort and conference sectors.

The Lansdowne Resort in greater Washington, D.C., will be developed into a major regional resort facility.

The mix has cushioned LHO against hard times, keeping performance on a more even keel than industry averages post-9/11. Bortz acknowledges that while equalized weighting may leave some money on the table depending on the cycle and the market, it protects shareholders’ investments over the long term by diversifying risk. Achieved daily rate (ADR) currently is up over last year at all but three of LHO’s hotels. Gains among urban hotels were strong enough to offset declines among the company’s convention hotels. Bortz cites the continued lethargy in the group sector as a key reason for third-quarter FFO that did not dramatically exceed analysts’ targets. Given current bookings, he sees better times ahead for convention hotels early in 2005.

Projects are analyzed against five-year cash flow and appreciation potential. LHO’s typical internal rate of return (IRR) hurdles are in the 10% to 12% range. To reach it, Bortz blends a small core of assets that can generate revenue from day one with turnaround candidates and properties with redevelopment potential. Even with a five-year hold horizon, Bortz says he does not mind making investments that will time to produce IRR. “We aim for a balance between steady cash flow and an asset that will really pop. Everybody gets excited about assets with repositioning upside but they forget that they need assets that deliver immediate cash flow,” he contends.

LaSalle is optimizing synergies at the recently acquired the Hotel George in Washington, D.C.

LHO also steps outside of the industry’s comfort zone in terms of its choice of operators, mixing big brands such as Marriott, Sheraton and Hyatt with third-party management companies and independent/lifestyle operators such as Noble House Hotels & Resorts and Kimpton Hotel & Restaurant Group LLC. Le Méridien Hotels & Resorts was also in the mix. Now, LHO is in litigation seeking damages and recovery of termination fees.

Sources say LHO is the “squeaky wheel” for its operating partners. With little new supply coming on line and a number of 4- to 5-star assets changing hands, every deal is important for third-party management companies and brands. That, Bortz says, is what enables an 18-hotel REIT to demand—and get—concessions such as shorter terms and cancelable management agreements. More than 80% of LHO’s contracts are cancelable, putting pressure on its operators to meet performance expectations and maximizing LHO’s exit flexibility if they do not.

“What is the incentive for brands to sign a cancelable agreement? If they do, they get the business. If they do not, someone else will,” Bortz says. LHO carefully matches the brand—or lack thereof—with the hotel and the market. In West Hollywood, Bortz says research has found a brand is a negative factor. In other locations, such as airports, a brand is “a must.” Which brand is “best” is purely relative. Bortz is always on the lookout for new brands and brands on the upswing. “Four years ago, I would not have done a deal with Sheraton. They were going the wrong direction. By the time we were looking for a brand in Minneapolis, they were showing a lot of improvement. It is a brand with a lot of potential and a good brand for that property. In business transient markets, nobody beats Marriott. Hyatt does well for particular properties. Unique properties, especially in resort locations, can do just as well or better without a brand,” Bortz says.

This Marriott in Indianapolis is an example of LaSalle staying within its comfort zone with operators.

The Next Hurdles
That selectivity is the reason Bortz cites for LHO’s industry-leading asset quality. According to company reports based on ADR comparisons, LHO’s asset quality edges out even industry giant Host Marriott—at US$142.97 (given a couple of selective acquisitions and sales during the year, this number is expected to blow through US$150 by year-end) versus US$140.86. The next closest contender is MeriStar Hospitality with ADR at US$100.76. Bloomberg reports that LHO’s five-year total return reached 236% by the close of the first half of 2004—a heady premium over the RMS Index, which came in at 98% and the BBG Hotel REIT Index, at 46%.

Industry insiders say Bortz’s hands-on approach plays a key role in delivering those numbers. Martz agrees. “Because we are small, we can have a chairman/CEO who gets involved in every aspect of the company’s operations, Martz says. “He is at every budget meeting at every property. If you want to know why we can get the deals we get, why we have one of the lowest debt/equity costs in the industry, and why our operating and EBITDA margins lead the industry average, that is why.”

LHO’s ability to leverage its size with operators and financiers has produced a conservative balance sheet and FFO/share outperformance that averaged 24% to 77% ahead of its competitors from 1997 to 2004 (based on a mean of analysts’ estimates). The REIT has one of the lowest levels of debt and equity cost in the industry. Its total debt to EBITDA ratio of 3.4x.

LHO’s homework, analysts say, should focus on RevPAR growth and operating margins. They would like to see tighter cost controls on utilities and in general accounting areas. Bortz counters that LHO has done “a good job” at capping expenses. The problem areas are an 11% decline in telephone revenues—something hard to stem or offset—and pressures from continued rises in areas such as insurance costs.

Bortz counters RevPAR complaints with the fact that fewer of LHO’s rooms are selling at discounts and that EBITDA is up 152 basis points. Tax expenditures have also come under fire from Wall Street. “Taxes are based on rent paid versus income. In 2001, the tax leakage would have been less. In good years, it will be higher,” Bortz says.

Rising rates in 2005 should push flow through. Resorts will see “purely demographic growth,” while urban hotels should enjoy “more substantial improvement.” On the group side, he sees improvement for 2005; more substantial recovery in 2006.