Power Hitter - Investment Outlook - December 2006

RLJ Companies always swings for the seats. In its sweet spot are upscale, focusedservice hotels that can power bottom-line returns in the high teens to mid-20s. Look for more home-run power from a new US$743 million fund.

By Staff -- HOTELS Magazine, 12/1/2006

Many investors see the hotel industry's cycle moving into late innings. Robert L. Johnson (far left) and Thomas J. Baltimore have a different read. "We believe it is more like the third or fourth inning. We are very bullish on the lodging space," says Johnson, the visionary who launched the Black Entertainment Network before moving into sports and real estate. They are backing that conviction with the better part of US$743 million in capital raised for their newly closed RLJ Lodging Fund II. As always, they will be swinging for the seats. Johnson and Baltimore are not just playing the contrarian. Their criteria for evaluating markets change the cyclical profile. "It can be misleading to look on the macro level. Each market has its own cycle," says Baltimore, RLJ's co-founder and president. That is why RLJ Development is targeting deals in markets with accelerating demand, including Chicago, Denver, San Antonio and Austin, Texas, Indianapolis, the Carolinas and "strategic areas on the East Coast." And that is why it is avoiding areas such as South Florida. It is also one of the catalysts behind RLJ Development's decision to acquire 100 hotels from White Lodging Services last August. "More than three-quarters of White's portfolio is in recovering markets," says Baltimore, a veteran on the development side for both Host Marriott and Hilton Hotels Corp. "The properties are young. In fact, most are under three years old. They are still ramping up. Many are in clusters so we have more synergies to tap." Despite aggressive pricing for most assets, readily available debt and equity continue to make further acquisitions appealing-particularly large deals. "Stephen Bollenbach (Hilton Hotels Corp.'s co-chairman and CEO) once told me the guy with the lowest cost of capital wins," says Johnson, chairman and CEO of RLJ Companies and co-founder of RLJ Development, a privately held hotel real estate investment company. "We got into the lodging sector when the cost of capital was at historic lows, so we were buying at the right price. We can continue to leverage that now when some sellers are cashing out." Johnson says the financial markets are "still friendly" on the debt side and it is unlikely interest rates "will run ahead of us." Maturities are not a problem since RLJ's are structured with provisions for early opt-outs without penalties. Add to that the continuing supply/demand imbalance and, Baltimore says, the net result is that, "It is time to be buying again in the hotel industry."

The Taj Mahal Palace and Tower in Mumbai, built in 1903, is a pillar of strength and flagship for the company now with global aspirations.

WHAT'S HOT

In RLJ's sweet spot are underperforming upscale, focused-service hotels in major metropolitan areas. "These kinds of assets have a lot of advantages over larger hotels," says Johnson, who contends these properties attract business people who travel more, stay longer and "create less wear and tear." He likes the fact that focused service means less of a fiscal "unknown" for spaces that frequently under-perform: restaurants, meeting and function rooms. With less public space to maintain and more rooms to sell, there is less cost erosion on the bottom line. Like most fund managers, Johnson and Baltimore are in the turnaround business. They are opportunistic enough to take on select development projects, such as a convention center hotel being developed with Marriott International in Washington, D.C., and a "downtown" Hilton in Norfolk, Virginia, which may have a residential component. But, greenfield projects generally carry too much risk. "More and more we are looking at deep turns and conversions," Baltimore says. It's all a part of RLJ's "all-weather strategy." "Bob and Tom have a knack for buying the right assets," says Norman Jenkins, Marriott International's vice president of owner and franchise services. "They look for opportunities to drive value. They do not waste money-either their own or their investors'. They are a formidable pair at the negotiating table." The latest opportunity for RLJ came in mid-November when Johnson joined Las Vegas-based Pinnacle Entertainment as an equity partner in a venture seeking a gaming facility license in Philadelphia. If successful, RLJ would own about one-third of the US$300-$400 million multi-use casino project. The initial phase would include a gaming entertainment complex with options ranging from a multi-screen movie theater, premier eateries and an ice skating rink.

The Hilton Garden Inn in Washington, D.C., fits both the brand and market preferences of RLJ Development.

BUY, THEN MONETIZE

An important component in that comfort factor is RLJ's do-it-yourself approach to investing. In-house departments give them an expert view of everything from operations to asset management and underwriting. "Many funds are allocators. We are operators," Baltimore says. What that means is that deals are not just about asset value growth. Johnson adds, "Once we acquire a hotel, we focus on how to monetize it." RLJ's approach to asset management is aggressive, but not adversarial. Baltimore sees it as simply holding management companies accountable.

Johnson contends hotels are leaving a lot of money on the table. Building a better bottom line starts with thinking like a customer. "Dollars have to flow to the point at which they touch the guest," Johnson says. "Money should not be spent on overhead. It should go into good bedding, good customer service, not just men in suits. To succeed, hoteliers have to make guests feel they are speaking directly to them. Nothing should get between hotels and their customers-including third-party (Internet) intermediaries."

This signature mix of operational expertise and market savvy has justified Baltimore's thinking. Greg Hartmann, managing director, HVS International, Boulder, Colorado, reports strong performance for RLJ's properties. "From what we have heard, they are out performing their first year budgeted performance (on which much of the purchase parameters were based). Although RLJ paid a strong price for the assets, it seems to have been a good deal for both White Lodging and RLJ," Hartmann says.

BIGGER IS BETTER

Johnson may be a visionary, as exemplified by his pioneering Black Entertainment Network, but he is a fairly conservative one. Conceptually, both he and Baltimore often think outside the box. But, when it comes to execution, they gravitate toward proven commodities. That includes their choice of management companies for their assets. To date, Hilton and Marriott have had a lock on RLJ's managed properties. Neither Johnson nor Baltimore sees much reason to change.

"Warren Buffet said that a brand builds a moat around the mind. It will take the competition a lot of marketing dollars to broach that moat. Marriott and Hilton have that," Johnson says. Adds Baltimore, "Hilton and Marriott have great brand distribution, and they deliver significant RevPAR premiums over their competitors."

But, there is room for some new faces. RLJ Development is converting one hotel to the new Hyatt Place brand. The appeal for Baltimore is a fresh brand with critical mass backed by a mature hotel company. "With a start-up brand, it may take so long to take off that it will be beyond the cycle. I like what Hyatt is doing with Hyatt Place. The acquisition and repositioning of AmeriSuites as Hyatt Place gives them a portfolio of 80 to 90 hotels. The concept has legs," Baltimore says.

RLJ Development has a wait-and-see attitude about newly launched flags, even those backed by the giants. It also has a skeptical view of new asset classes such as condo-hotels. "The jury is still out on condo-hotels," Baltimore says. "I do not know how deep that market is."

Baltimore's ability to see the possibilities of a brand, a portfolio or an overall investment model is one reason Johnson brought him on board. His "second sight" influences his view of what makes a good deal. "We had a sleepy asset in Atlanta. We thought it could do better," Jenkins says. "Tom and his team showed us what it could be: a very cool, very hip experience. As a result of that vision, performance and guest satisfaction improved dramatically."

Seeing new opportunity is part and parcel of success. Baltimore maintains that hotels can revitalize their revenue mix by marketing to and creating services for the increasing number of people of color and women who make up more and more of the business travel market. "We need to have products and services tailored to their needs," he says.

DISCIPLINED, DIFFERENT

Johnson and Baltimore have a reputation for getting deals done. They have good access to debt, move quickly and "do what they say they are going to do." That translates to less execution risk and a larger pipeline of deals to consider.

Marriott's Residence Inn brand, like this one in Cambridge, Massachusetts, gives RLJ the distribution power it likes so much.

"RLJ Development is a relatively conservative fund," Hartmann says. "It does not get caught up in the one-off bidding or bidding wars. They get comfortable with one or more choice operators or developers and just do deals rather than compete with other buyers for fullservice or trophy assets."

Johnson likes big deals, and he likes deals with IRR in the high teens or low 20s. That is new territory for an investor coming from the entertainment business. "I cannot use the same hurdles for hotels that I applied to entertainment. We had 60%-plus margins at BET. You cannot do that in the hotel business with the heavy cost of capital, franchise fees and cap ex," he says.

But, there are similarities. "It is all about attracting people to your content, whether you are putting it on a screen or selling rooms," Johnson says. "Hotels are more than places to sleep. They are places to work, to be entertained, to go to dinner."

If there is a cloud on the horizon, it is the spectre of oversupply. But that is unlikely to have much impact on RLJ's young portfolio. The hold period for Fund I is likely to be three to five years; for Fund II it will be more like five to seven. Exit strategies are open; it all depends upon the offer, Baltimore says.