Europe's New Money Players - Investment Outlook - March 2006

Powerful Lehman Brothers and Colony Capital are trawling Europe for new opportunities alongside niche players such as The Stein Group. What they share: opportunism and a belief that Europe is the place to be.

By Staff -- HOTELS Magazine, 3/1/2006

Partners in a recent InterContinental acquisition include (l. to r.): Gerald Parkes, Lehman Brothers; Chris Morrish, Government of Singapore Investment Corp. (GIC Real Estate); Amanda Jean-Baptiste, Lehman Brothers; Petra Ekas, Lehman Brothers; Anne Lemonnier, Lehman Brothers; Andy Fish, Government of Singapore Investment Corp. (GIC Real Estate); Ryan Prince, Realstar Group; and Mark Newman, Lehman Brothers.

Mark Newman is not one to equivocate. "I think we are at the beginning of a strong multi-year expansion and transformation of the hotel business in Europe," says Newman, managing director and global chief investment officer for real estate private equity for Lehman Brothers Real Estate Equity Group, London. "I expect the landscape will look markedly different in five to seven years, with plenty of ups and downs along the way. However, the potential for the hotel business is enormous as borders continue to fall and Europe becomes an even more mobile community."

Although Newman terms Europe's transformation nothing less than "remarkable," it remains a work in progress. Germany and France are just starting up the curve of recovery. Europe, as a whole, is only beginning "to embrace the challenges of expansion and unification and confront the roadblocks to growth." Like any turning point, this one is forging a full spectrum of potential-not only for property players and capital providers such as Lehman Brothers but also for ownership/ management models such as Realstar Group, opportunity funds such as Colony Capital that are evolving from growing asset value to growing companies and entrepreneurial niche players such as The Stein Group. Europe's prismatic upside will test these strategies as the market determines whether one model works best, or whether there is room for different views.

THE PROPERTY PLAYER

Looked at from the property perspective, "Europe has opportunities across all geographies and asset categories at the appropriate price and within a suitably balanced structure," Newman says. His statement flies in the face of conventional wisdom about this being a seller's market. But, then again, there is little that is conventional about Newman's read on markets, assets or deals.

Eight years' worth of deal-hunting in Europe has given Newman a conceptual view far from the hit-and-run mentality of many U.S.-based funds. That is why he sees this as a good time to be shopping Europe. Newman allows that liquidity has strengthened in Europe over the last three years, particularly for hotel assets, and that increased activity has led to increased prices. But equating that with a seller's market is missing the point- and missing investment opportunities.

"It is important to remember that increased activity has drawn more attention to the hotel sector, broadened the pool of buyers, diversified the choice of management and franchise options and enhanced financing alternatives," says Newman, who was a managing director and principal with Fortress Investment Group in the late 1990s before joining Lehman Brothers in 2000. "More liquidity over the long term benefits both buyers and sellers. It is worthwhile to see both sides of the recent upsurge in investment and related activity, not merely the apparent increase in price in certain transactions."

Newman's conceptual style of analysis is one reason why a healthy portion of Lehman Brothers Real Estate Partners' recently closed US$2.4 billion fund for global investment will be earmarked for Europe and why hotel assets will continue to represent "well over" 20% of the assets the fund acquires. Like all opportunistic buyers, Newman is open to anything from single assets to portfolio deals such as last year's purchase of 12,800 UK hotels rooms from InterContinental Hotels Group (IHG), alongside Realstar Group and Government of Singapore Investment Corp. (GIC Real Estate)-a deal with cascading benefits that flowed into the issuance of Europe's largest CMBS hotel offerings last December.

Further downloads from hotel companies separating bricks from brains should keep the product pipeline flowing because of its bottom line benefits. "The strategy of selling assets to focus on core management and franchise operations appears to have paid dividends for certain companies," Newman says.

For 2006, Newman predicts "significant activity in Europe's luxury sector, much as there was in 2005." But, Lehman Brothers may not be one of the main contenders. "Personally, I am interested in budget hotels, extended-stay products and well-priced full-service offerings focused on the business traveler," he says.

Newman also is interested in brands. "Branding appears to be growing in importance, and we will be paying attention to this aspect of the market," he says.

"Many strategies remain available in Europe. That is reflected in the strong buying activity all the way from the budget to the luxury sector." - Mark Newman, Lehman Brothers Real Estate Private Equity

THE "MIXED MODEL" PLAYER

Realstar Group's strategy for Europe grows from a history that has bridged ownership of brands such as Canada's Delta Hotels (which it sold to Fairmont Hotels & Resorts in 1998), master franchising, asset management and ownership. Its chameleon-like flexibility clears the way for less traditional, more complex deals.

In the IHG transaction, Realstar Group stepped in as both a co-investor and also the operating partner/owner's representative for the consortium with IHG. "This kind of role will be increasingly important in all hotel investing, but particularly in Europe where the market is just developing," says Ryan Prince, vice chairman, Realstar Hotels Ltd., London.

Assessed with Realstar Group's blended macro/micro approach, Western Europe and the "more developed" Eastern European Union countries will be prime targets. Pioneering will fall to someone else.

"We get nervous about developing markets where freehold/leasehold systems of ownership are not yet well embedded or where there is political risk-for example, Russia and some of the former Soviet States," Prince says. That does not mean Realstar Group would rule out buying in Eastern Europe "in a unique situation with special circumstance." Nor does it mean it would do a deal in London or Paris just to have a pin on the map. "Investments always come back to terms and price. Returns, especially in Europe, tend to vary depending on the market and on the deal's dynamics. There does not tend to be a one-size-fits-all answer," Prince adds.

The fundamentals look best in Europe's upper mid-tier (3- and 4-star) hotel market and in the 2-star sector. Simple, straight-line deals are not Realstar Group's style, Prince says. To tap Europe's potential Realstar Group will continue its focus on deals that are too complex for the general investment market-think distressed sellers, deals with tax issues, sellers who prefer confidentiality. That puts some idiosyncratic assets and portfolios high on the priority list: resorts, golf courses, marinas-"businesses with operations similar to pure hotels, but with a twist."

Like Newman, Prince repudiates the idea of overheated pricing. His rationale comes from a different base. "It would seem hotel asset prices have increased in Europe over the past several years. However, in Europe, benchmarking this increase is a real challenge due to lack of meaningful trades," he says. That is particularly true in the case of hotels encumbered with "North American-style management agreements" as opposed to leases or owner-operator sales. "The most appropriate benchmarking would be to other classes of commercial real estate. In the UK, for example, retail, office or industrial assets are trading at sub-6%, sometimes sub-5% yields. So by comparison, hotels are reasonably priced at the moment," Prince says.

Will that view still hold up when Realstar Group considers exiting? Prince believes it will. The rollout of real estate investment trusts and the entrance of institutional investors should drive even greater liquidity in Europe. "You have to have an exit strategy. But, if you buy well and deliver on the investment hypothesis, the exit will take care of itself," he says.

OPPORTUNITY FUND PLAYER

While Realstar Group can analyze opportunities from the longer term view of an investor who can adjust its hold window within the context of the deal, Colony Capital LLC has to be fast on its feet to meet the short-term, high IRR hurdles of one of the world's most visible opportunity funds. "In Europe, we are looking for opportunities for 20%-plus returns in a pricey, liquid market. The two things usually do not go together. So, we have to think outside the box" says Sébastien Bazin, principal, managing director Europe and CEO of Colony Capital SAS, Paris.

Single hotel assets in Europe are currently "too expensive" to get that kind of return. "We need volatility. Real estate cannot provide that (at today's prices). That is why we are looking at real estate/operating companies," Bazin says.

It is also why Colony Capital LLC continues to focus on the hotel sector with deals ranging from its buyup of Raffles, its US$1.2 billion investment in Accor and more recently to its purchase of Fairmont Hotels & Resorts alongside Kingdom Hotel Investments. Of the US$6 billion Colony invested in Europe last year, 40% was devoted to hotel deals. Given the sector's potential, Bazin is unlikely to change his strategy.

The luxury sector is always seductive. "It is particularly strong right now because of increasing room rates. Eighty percent of those gains go directly to the bottom line," Bazin points out. But, the future is all about 2- and 3-star product for Bazin. "Consider all the new travelers coming to Europe from Russia, India and China. Not all of them can afford to stay in a 4- or 5-star hotel," he says. Nor can they afford them in their home markets. "A brand that can deliver clean, attractive and well-maintained rooms would be scaleable in many different countries."

Well known for his cerebral brand of contrarianism, Bazin is shopping for stand-alone concepts in fragmented hotel markets such as southern Europe. The first push would be toward companies with portfolios of urban hotels and "those that need equity to grow." Though these regions have frustrated the savviest of brands, Bazin sees a new attitude toward succession planning in familyowned- and-operated chains, and even in public companies. One thing that would block any deal: hostility. "We depend on management for its expertise. We would not do a hostile takeover," he says. (He dismisses the idea that Colony instigated the change-over at the CEO level of Accor, where it has board representation. "We help with strategy; we do not interfere in the business. The new management will come back to the board and tell us what the plans are," he says.)

To grow the resort side of the portfolio, Bazin likes the prospects for Morocco, Tunisia, Turkey and Greece. Colony has learned a great deal from its Costa Smeralda acquisition, which could lead to "significant" resort development along the Mediterranean basin.

Hotel Cala di Volpe, Sardegna, Italy, is an example of the resort development that Colony Capital may further expand along the Mediterranean basin.

One asset class that will not be on the menu is condo-hotels. Although some have projected a strong growth market in Europe, Bazin argues that the 4.5% to 5.5% yields at entry and inability to leverage debt mean there is not discount on the buy side. "We cannot buy 10% to 15% below market," he adds. Add to that the need for "a substantial team" and pricing radicals based on unit positioning and the option is even less appealing. "You may be able to sell the top-floor units at a better price, but you also may be stuck with ground floor units no one wants. If you miss your underwriting by 18% to 22%, you could find yourself with a 12% IRR," he cautions.

Bazin is equally unlikely to go on a buying spree in Eastern Europe unless an unusual deal surfaces. Too many buyers, too much open land, few barriers to entry in some key markets and yields that are sinking below those of Paris hardly constitute a compelling reason for Bazin to break new ground.

He likes the prospects for France overall, especially a France that has turned its attention to its economy after the culture shock of losing its Olympic bid. "It was probably good France did not get the Olympics," Bazin says. "The government would have been talking Olympics, not looking at what needs to be done. France needs something that impacts the economy for more than 18 months."

NICHE PLAYER

"Two years ago, I was a voice in the wilderness saying that continental Europe would revive," says David Stein, CEO of The Stein Group, Barcelona. Playing the prophet, the pioneer or the outsider is a role that suits an entrepreneur such as Stein.

"Clients do not care what you paid for the building. They want value for money. If you paid twice what the building was worth, will the guest pay double the rate? We want to grow, but we can wait for deals. We do not need to be inter-galactic." - David Stein, The Stein Group

A transplanted American who "fell in love" with Europe, he opened his hotel company just a month after September 11, 2001. In the shadow of what would become one of the hotel industry's worse troughs, he promised 25 hotels by the end of this decade. With the freedom to cherry pick opportunities across Europe, he will reach that goal late this year or early in 2007.

A veteran entrepreneur whose "first career" culminated with completion of the expansive Monarch Beach resort project in Orange County, California, Stein sees the niche luxury market as the best vehicle for riding the wave of European recovery. Competition is fiercer than ever for projects at the top of the range, and will only get more intense as brands such as Starwood Capital's newly launched Crillon Hotels enter the market. But Stein's ability to mine for projects under the big brand's radar should keep the group on track-a strategy that is likely to see the group making a move onto "a second continent" shortly.

He does not share other investors' ambivalence about Eastern Europe. The group already is adding its first hotel in Russia. "You can get product relatively cheaply and operate it relatively cheaply. Occupancy and rate should go up faster than operating costs," Stein says. Any project has to pass his "paranoia test:" the market cannot have too much capital chasing too few deals; it cannot have an artificial supply side and the group has to be able to add value to the operation. Cities such as Amsterdam, with its moratorium on new city center hotel development, pass the test. Rome and Madrid rank high on his wish list.

"We want to be in these markets, but we will not invest until the deal pencils out," Stein says. He recently looked at a hotel in Barcelona but declined because of the price. "The owner told me this is what the hotel was selling for 10 years ago. That is not what matters. I just could not pay that multiple regardless of what the owner paid a decade ago," Stein says.

Stein's goals are different because his targets are different. He sees a rich vein of opportunity in the form of small, ultra-luxury hotels-most under 100 rooms. While mass travel builds the budget sector, Stein wants to tap the top of the market coming from the major growth engines in Eastern Europe, Russia, China and India. "These people have lived without certain amenities for too long. They want great hotel rooms and great food. They are not into adventure travel," Stein says. A "rebirth" of travel from the United States should also help.

Gran Hotel Son Net Mallorca in Spain was The Stein Group's first hotel in a group that now includes 13 open and another four under development.

This is a good time for an opportunistic, 5-star strategy, Stein contends. Individual, iconic hotels are going on the block-usually via networking rather than marketing-as third-, fourth- or fifthgeneration owners seek to diversify or find partners. "These families have to live in their communities. They do not always want to sell to the highest bidder," says Stein. "They may want someone who will protect their reputation and improve the asset. There is more to the terms of this kind of deal than just money."

The best profit potential lies in irreplaceable assets and landmarks that can benefit from an infusion of cash and operational sophistication, according to Stein. His goal is 20% return on investment.

Stein's hold window is shaped by the individual asset. Generally, it extends out between seven and 10 years. "I would rather say 10 years and sell early than say seven and have to get lucky," he adds. In fact, Stein foresees no problem with a decade-long hold. "Europe's recovery is sustainable, based on the growth in travel and tourism. The future for Europe is very strong," he says.