We have all been peregrinatiously seeking a scintilla of insight on the current crisis from the greatest minds in the world. Global statesmen, Nobel laureates, captains of industry, Wall Street wizards, financial pundits, and economic astrologists. The most brilliant minds have all weighed in with a myriad of GPS coordinates attempting to map a way through the global economic crosscurrents. However, the most salient and timeless answer echoes from the soft and timid voice of Chance the Gardener, Peter Sellers' character in the famous movie "Being There."
Chance is a gardener who has grown to middle age living in a solitary room in a rich man's mansion. Bereft of contact with other human beings, all he knows of the world he learned from television, his sole passion outside of his garden. When the mansion's owner dies, Chance wanders out on his first foray into the world and is immediately struck down by the limousine of an adviser to the President.
The President has his hands full. The economy is slumping, America's blue-chip corporations are under stress, and the stock market is crashing. Chance is introduced to the President who, mistaking the lowly gardener for an upper-crust business owner (Chauncey Gardiner), asks for his advice about stimulating growth. Not used to being around people, Chance shrank. Finally, he spoke: "Yes. In the garden, growth has it seasons. First comes spring and summer, but then we have fall and winter. And then we get spring and summer again. As long as the roots are not severed, all is well and all will be well." Thinking this is brilliantly insightful the advisor says, "I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature, but we're upset by the seasons of our economy."
In all the confusion lies the true answer!
It is time that we come to the realization that what we are experiencing is a cycle, a normal cycle...not a crisis. The only crisis is one of our own unfulfilled, unreasonable expectations of continuous, effortless, infinite prosperity. Let's snap out of our economic Alzheimer'sand take a look at where we've been.
Cycle #1
In 1997 the Asian Contagion spread across the world with the speed and determination of a frenzied dragon. Due to a currency scare in Thailand investors suddenly abandoned all Asian currencies and within weeks the contagion caused Russia to default on its sovereign debt. The volatile Russian market signaled the next domino to fall and Long-Term Capital Management (a major player in high risk derivatives) collapsed and Wall Street cowered as the Dow collapsed and the largest international banks in the realm were left exposed and shaken. (Sound familiar?)
The Solution
The Fed opened the money valve full bore and quieted the frenzy. Investors, then flush with cheap and plentiful cash and needing an asset class to arbitrage, jumped into dot.coms and speculative technology IPOs. The NASDAQ doubled in one year and day traders were compiling huge gains.
The Consensus
The Fed had been prudent. Problems were behind us. All would be great. They were dead wrong!
Cycle #2
The Tech Bubble of the late 1990s turned into the Tech Wreck of 2000. Normal households and retiree accounts became investors in overvalued dot.coms. When trouble arose they dumped their overvalued stocks and within weeks the contagion had spread through the entire economy. The losers were primarily households via stocks, mutual funds, life insurance companies and pension funds. Total Tech Wreck losses were over $6 trillion.
The Solution
This time, the Fed responded with even greater power. Chairman Greenspan dropped interest rates to historic lows and kept them there for an extended period of time. The Fed flushed the economy with cheap money and force-fed tens of trillions of borrowed dollars into the housing market.
The Consensus
Again, the enlightened swore the worst of the crisis had passed. Again, the government claimed it had scored a victory. Again, they were dead wrong.
Current Cycle
The Fed's response to the Tech Wreck created the Housing Bubble, which in turn propelled the Housing Bust. The losses resulting from the Housing Bust of 2007-2009 have so far been 2.5 times greater than the losses from the Tech Wreck of 2000-2002. The collapse of Bear Stearns, Lehman Brothers and AIG sent the markets into turmoil. Now, in addition to losses in stocks, mutual funds, lifecos, pension plans - real estate has entered the loser's circle. Total Housing Bust losses: Nearly $16 trillion. Combined losses suffered during the Tech Wreck and Housing Bust: $22.1 trillion.
Current Solution
For a third time, easy money and zero interest rates in conjunction with bailouts and stimulus adding up to nearly a third of GDP.
The only real beneficiaries of the current bailout have been banks. They were the engines driving the debt bubble that popped. It is bizarre that the exact institutions that were the problem have reaped the incredible windfalls of the solution. This will continue to cause populist outrage and with 15 million people jobless and a sluggish GDP, more issues will arise.
Current Consensus
We are out of the woods!
On the Horizon - Cycle #4
Sovereign debt in Europe and around the world is under severe pressure and another bubble burst may present its ugly head. The age-old American solution of printing more pounds, drachma, pesetas or escudos evaporated with the onset of the euro and the new global currency of choice is a "credit default swap." (Take a look at the Markit Credit Wrap).
The Solution Nothing is going to happen so quickly that there won't be time to adapt. We are going to creep and crawl along for a while and expectations, returns, and opportunities are going to be less than we would like. The opportunities will go to those who narrowly focus, don't wait for global re-ordering, and can create operational uplift.
Globalization We need to think globally and execute locally. This is becoming more and more difficult. The story is a bit different on each continent and each area code. Current businesses will be built in tiny micro brush strokes building value by operational improvements over longer periods of time. Financial arbitrage, cap rate contraction and leverage loading are not seasonally available today in most parts of the world. Let's take a look at generic world markets as it relates to real estate.
Debt is Today's Equity "Extend and Pretend" is the resolution of choice. The CMBS and banking purgatory has slowed the velocity of transactions and owners and lenders co-exist in the fog, hoping tenants will find the "Kool-Aid" in the next couple of years and bail them out. The secondary debt markets everywhere are focused on YIELD, not RESIDUAL. Zero interest rates and bank borrowings are fueling leveraged returns to financial buyers on fixed income instruments at values which are solely focused on some positive cash flow fortified with zero interest rate borrowings and purchasers are unfazed by maturity date residual short falls.
The banking CRE loan market is zombisized, with over $1.5 trillion of maturities coming due through 2013 but few foreclosures or realizations. Commercial values have deteriorated by 40 percent from their high in 2007. Vacancy rates across all asset classes have soared, rental rates across all asset classes have deteriorated, and in spite of all this, real estate cap rates are historically low when measured against spreads over long-term treasuries. This means investors are willing to accept lower yields in an environment with dramatically more risk. Any yield when interest rates are zero appears attractive.
The long awaited macro meltdown of the commercial real estate mortgage market has not happened and may not ever happen (that's also what they said in 1987, three years prior to the onset of the RTC). It may simply limp along as everyone tries to buy time. For instance:
Real estate debt spreads on CMBS have narrowed as a result of TALF and a modification of the REMIC tax provisions, which allow special servicers more flexibility in loan modifications.
New bank regulations allow banks to not take diminished residual value into consideration in the mark-to-market process if a borrower otherwise appears able to make the current payment. In other words, since interest rates are at zero, if a loan is current at some small spread, it will be considered to be unimpaired even though the current value may be 40% less than the loan balance at maturity.
The market is in a craze for yield, buyers are not concerned with residuals, the wave of distress has turned into a trickle of stress and the opportunity is one of special situations rather than a systemic restructuring.
Fundamentals stink. Real rental rates today for most office product are the same as 1994. The upward future value for un-let buildings today will go to the tenants. Tenants have become Ninja killers and they now will only sign leases for much longer terms at fixed rents. As a consequence the upward lift when the cycle reverses will be a windfall gain to them rather than the landlord.
More than likely, interest rates will remain modest, smaller banks will continue to be purged but the assets digested by the bigger banks or sold in small bunches by the FDIC, whose reserves will eventually outweigh the mark-to-market losses and as a result of very limited new demand and construction financing, supply demand will stay basically in parity as to where it is.
Real estate returns in the future will be driven by re-employment, GDP growth and expansion, which also will be slow to come and volatile in its presentation. Lenders will be forced to actually lend at some point. They will start conservatively as always but will no doubt end badly once again. However, this will take awhile.
Deferred capex on most existing real estate will be a future tax to successor buyers and leasing commissions and tenant improvement costs will force existing owners and lenders to find a third party solutionby dilution. Many owners know they have lost their equity value and are just hanging on for optionality. As such they simply want to fill the space and create enough cash flow to pay the current low interest rate. In order to attract that tenant, however, fresh cash is needed for tenant improvements and leasing commissions. Neither the owner nor the lender want to put more cash in. New equity will enter these transactions by being last money in and first money out. They will simply dilute both owner and lender.
Equities - Very Little Velocity of Equity Property Trades Anywhere
In North America, cap rates on good real estate are historically high; new acquisition financing is limited and the purchase of secondary debt is competitive and expensive on any risk adjusted matrix for the most part. Too much money - too few assets. Some deals are possible but bargains are hard to find. Real, inflation-adjusted rental rates in most real estate asset classes have not changed for 15 years. Real estate is for trading not really for holding. Real estate returns have been driven by leverage and deleveraging. In North America, without re-employment, business revenue growth and consumer spending, real estate fundamentals will continue to limp along.
China is in the midst of its always booming and busting real estate cycle, which is about to bust once again.
Japan is still in denial through its second decade of zombie-like behavior and the Japanese continue to express their concern through increased savings not spending, which furthers the downward cycle.
Brazil is booming, growth is exponential, development projects are massive and infrastructure requirements are unquenchable. Exits and currencies are issues. Argentina is in a freefall but resource rich and Colombia is looking up.
India is a three-Tylenol headache of no infrastructure and weighty bureaucracies while the Middle East is flush with cash and plenty of entrepreneurs who very rarely need our help.
UK is pushing off the bottom but don't expect much growth anywhere in Britain.
Europe will see little growth and will go through waves of social manifestations and increased volatility this year - sovereign debt to GDPs in most European countries is well beyond 100 percent.
Pressure from the sovereign debt dilemma of Greece, Portugal, Ireland and Spain will reverberate through Euroland where not much growth is expected.
France - property values are still quite strong and distress is handled in a quiet and refined manner amongst the banks and borrowers. French do not traditionally lever their residential real estate and commercial real estate within the golden triangle is the object of most foreigner's desire.
Germany - struggling back and has an orderly legal and bankruptcy process for resolving troubled real estate loans. Foreign capital didn't do well there and the large residential deals are still in restructuring.
Spain - opportunities for distress although maneuvering is quite painstaking.
There is still a flight to quality - in spite of the tremendous inflationary pressures of our multiple deficits and non-stop monopoly money printing press, the dollar continues to climb against competitive currencies. If the archaic and cumbersome FIRPTA withholding tax is repealed by congress the flood of global capital will seek capital preservation within the quality and reliable assets of America. A 30 percent withholding tax is punitive.
So what does all this mean? Most of the real estate private equity funds of the 2006-2007 vintages will generate returns substantially below the levels of their historic returns. As a result, many of them have disappeared already and more are vanishing due to ailing legacy assets and no go-forward plan. In accordance with the laws of natural selection those that survive will be stronger and will be able to compete in a less frenzied atmosphere.
Changes in the Engines of Value Legacy returns for the past 15 years were driven by (in order of importance):
Improved or expanded exit valuations
Cheap and plentiful debt
Aggressive revenue growth expectations
Deleveraging
New vintage opportunities will primarily be based on (in order of importance):
Operational improvements
Restructuring and recapitalization
It is interesting to note that real revenue growth for the last 15 years has been totally illusory. Gains have really been realized by leverage and cap rate contraction. The chart below graphically displays that there is virtually no real growth, on an inflation-adjusted basis, in rents since 1994.
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Return Expectations Real estate private equity sponsors targeted 20% plus IRRs and 2x plus equity multiples within a 3-5 year period. Private equity's cost of capital today cannot compete with newly recapitalized REIT's in the acquisitions of single assets. REIT's availed themselves of a window in the capital markets that allowed them to mend their wounded balance sheets and they are in a rush to prove that they can redeploy that capital requiring far more modest yields and bidding up asset sales.
Historically, opportunity funds have performed most admirably in a cyclical pattern of economic turbulence. The difficulty today is there is no velocity in transactions and there is very little acquisition debt. Both owners and lenders are happy and sanguine as zombies for the time being.
The Seasons will Change Equity opportunities have not properly re-priced for market risk. There is no hurry to be an equity owner. These markets will not turn quickly but they will turn in their own season. There are plenty of opportunities but they are in debt microclimates and require surgical focus and longer and lower expectations.
The answer is to farm and harvest definable and smaller opportunities until we see the harvest moon hanging high in the sky. As Chauncey said "The roots are not severed so all will be well in its own time."
When we speak of luxury hotels and other upscale hospitality assets, prospective owners daydream of heel-clicking maître d's in silk-lapelled tuxedos, cork-sniffing sommeliers decanting Château Lafite, bowing waiters gliding across the floor in crisp white linen jackets, beds adorned with 1,200 thread-count Frette sheets, Bernardaud dishware, antique Henin & Cie cutlery, and Alberto Pinto furnishings upholstered in Chyangra cashmere. Unfortunately, that is simply an illusion. Owners instead have to wake up to the realities of housekeeping, crisis management and daily CPR for their CFOs.
The economic characteristics luxury hotel ownership are thought to encompass three asset classes - fixed income, equities, and commodities. In actuality that is an illusion as well. It is the commodity, rather than income and equity, where value is most often harvested. Scarcity and timing are everything. When the clouds are the most plentiful and visibility the darkest, it is the best time to acquire "a view with a room."
Luxury hospitality assets are large, heterogeneous, and characterized by labor, marketing and management attributes of a service business. Operating leverage is high, financial performance is volatile, and earnings visibility is typically limited as booking cycles become shorter and shorter for groups, conventions and frequent business travelers. The worst news about hospitality is that in a downturn, the revenue stream is marked-to-market every hour. The best news about hospitality is that in an upswing, the revenue stream is marked-to-market every hour.
In addition to normal debt and equity financing challenges, hospitality cash flows are usually impacted by long-term contractual agreements with management companies who participate significantly in the profits and traditionally limit their exposure to capital contributions required for ongoing operations. These management contracts can be a tremendous complement or terrible impediment to the liquidity of the assets during cyclical upturns and downturns. Managing the manager becomes an art form and, after buying at the right price, the most important attribute of a successful hotel investment.
As Colony goes back to the future, we find the hospitality sector displaying symptoms very similar to those that occurred in the last cycles. The industry is once more following a pattern consistent with past trends, demonstrating a high correlation with the macro economy. In the last 24 months of economic turndown, the lodging sector has been hit hard, and the luxury sector in particular has reached cyclical lows in occupancy, ADR and RevPAR. Due to negative operating leverage of these assets, they are the least liquid lodging assets on the ride down, which is the exact reason that a properly timed arbitrage can be so dramatic. We also find the universe of qualified competitors to acquire these assets to be much smaller than the universe of buyers for other types of income-producing properties.
Bricks
The deterioration of fundamentals in 2009 will surely continue in 2010. In spite of minuscule signs of recovery, the next 24 months will mandate that distressed owners and lenders seek capital solutions for their ailing assets and loans. The current climate is highlighted by the following:
It is important to note that this downturn in hospitality has been caused by decreasing ADRs and occupancy levels; trauma caused by deterioration of demand, not necessarily the oversupply of product.
2009 occupancy averaged 55% (lowest level since the Great Depression) and expected to have only a slight uptick during 2010, still well below the 20-year average of 62%. Generally, occupancy levels below 60% signal excellent buying opportunities.
2009 ADR dropped 9% and is forecast to decline 2% in 2010, with growth returning in 2011.
The combination of ADR and occupancy deterioration pushed RevPAR down 17% during the year. Luxury and upper-upscale were hit hardest due to the nature of their business model, but have historically recovered better than other hospitality asset classes.
Overall lodging NOI decline was over 35% during 2009 and valuations hovered significantly below replacement cost. Lodging NOI growth is forecasted to reach 9% in 2011, compared to a decline of 1% in the other real estate sectors.
EBITDA in luxury hospitality has decreased by up to 50% in the past 24 months.
Demand fluctuations can create substantial volatility in ADR pricing. Hotel development typically takes 3-7 years from planning to completion (up to 10 years in luxury segment), challenging the ability to quickly cease development as demand is abruptly altered.
The lack of available financing for new construction, coupled with the severe decline in cash flows, will likely subdue supply growth below long-term averages for the next several years. Currently, there are historically low levels of new construction, especially in the high-end segments through 2010. The supply surge in the recent upswing was just over three years compared to the nearly six-year cycles seen in the mid-to-late 1990s and early 2000s.
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The magnitude of the current market downturn, together with the realities of high leverage and weak capital markets, is testing owners' staying power, and an asset shakeout is likely to ensue. Intense pricing pressure and low occupancies, in combination with high operating leverage, have created "negative carry" situations for many owners of under-performing properties even in our zero-interest rate environment. The signs of stress have already begun within the highly levered capital structures. Lodging CMBS delinquencies catapulted to nearly 14% at the end of last year, compared to the overall market rate of 6%. Hotel delinquencies are up 900% from prior years. Of the $48 billion of outstanding lodging CMBS, over $22 billion is due to mature over the next three years. Without a near-term rebound, lenders may be forced to terminate forbearance agreements and push for resolutions despite unaccommodating capital markets. Overall, these undercurrents are expected to narrow the current bid/ask spread in favor of buyers and increase transaction volume, which has been sporadic to date - only $2.5 billion worth of hotel assets transactions during 2009, versus $43 billion during the peak.
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During previous down market cycles, room starts stayed low for extended periods of time, followed by periods of above-average growth in ADR in parallel with an economic expansion. Part of the reason for this accelerated ADR growth is the long lead time required to add new product in response to an uptick in demand. Historically, the long window of supply restraint has been one of the main catalysts in securing the subsequent recovery phase, often affording owners of existing properties - particularly in the luxury segmentóthe opportunity to earn oligopolistic returns during that period.
The periods following the lulls in hotel construction during the early 1990s and early 2000s, witnessed the highest annual growth in ADR and a marked return of development activity. Contrarian investors, such as Colony, who acquired hospitality assets during the dark hours of the early 1990s at significant discounts to replacement cost, were rewarded in 1996-1998 when fundamentals improved sufficiently to warrant new construction and asset values ballooned industry-wide. This was also the case following the 2001 downturn.
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Mortar - (Management Companies)
In the midst of a downturn, issues arise between owners and managers, and misalignment of interests becomes ever more apparent. Owners want to spend the least amount of money for the largest return on the project. The owner's primary concern is putting heads in their own beds. They care about the brand only as it relates to the premium they will get on their property. Owners want to be aligned with a rewards program for the benefit of their customers but do not want to be a redeemer of rewards earned from real cash spent on other properties managed by the same brand. The owners argue that they are the ones fronting all the costs and expenses while managers reap the upside of net profit when times are good and the security of a percentage of gross profit and a myriad of centralized service fees even if the business is managed poorly. Managers have learned through past cycles that maintaining brand integrity is essential but that holding owners to that task alongside them can be quite difficult.
Additionally, large public hospitality companies have mostly adopted an "asset-lite" operating structure, finding it more advantageous to separate the net cash flow characteristics of the operating company from the heavy capital burden of the bricks and mortar.
This was an easy execution during good times and a seller's market but those "asset-lite" managers will find it difficult to expand in the next cycle without making significant investments in ownership and will have to take advantage of a scarcity of capital in this asset class. Managers will have to acquire equity interests and/or make key money payments to owners in order to expand and essentially buy future management contracts.
The more stable and uninterrupted the stream of income, the greater the value Wall Street placed on these management companies. Consequently, management agreements became more favorable to the hotel companies and the lumpy annual capital burden was placed on the owner. Capital markets encouraged longer-term management agreements and owner/lender unfriendly provisions such as the requirement of an SNDA that prevented the termination of the management agreement even after a foreclosure or deed-in lieu.
Air - (Online Travel Agencies)
The Internet has caused a shift in the balance of power from the hotel managers to their customers. Across most segments of the hospitality business, brand loyalty has all but disappeared as both business and leisure customers search for the best available deals online. The proliferation of OTAs available to the general public has made comparison-shopping simple. It has also compressed booking lead times, reducing the window of accuracy in forecasting (and pricing) future business. Hotels require OTA services primarily during a recessionary environment to improve sales due to their wider reach and customer base but there is a growing discomfort between the hoteliers and OTAs due the terms and conditions demanded by OTAs.
Generally, merchant programs run by OTAs purchase hotel inventory at steep discounts. The OTAs will insist that in return for listing the particular property it receive the "best available rate" at any given hotel. Although it requires painfully deep reductions on the part of the hotel, OTA distribution provides access to brand indifferent consumers that are difficult for some hotel brands to access.
During the last two downturns, many hospitality companies turned to OTAs to address decreasing occupancy levels. Owners and managers have been willing to offer OTAs larger reductions and distinctive promotions, in turn endangering their own direct distribution channels and eliminating past success in rate parity, lowest rate guarantees and more. However, much of the luxury segment has remained insulated from the onslaught of common denominator OTA marketing.
OTAs can assert power and distort the impact of market downturns. However, the long-term successful operation of luxury hotels relies upon a customer experience beyond the rate. Reputation, quality and consistency are as equally important in good times as rate. The ability to train and motivate hotel staff, maintain standards, build and protect reservation systems, plant and harvest the data obtained from customer loyalty programs can only be maintained by managing and operating a broad pool of assets in various geographic regions. The inability of individual owners to obtain cost and management efficiency will become more drastic as a result of the knee-jerk cost-cutting reactions in these downturns. Management companies will be actively sought by new owners and the management company's own equity values will increase correspondingly with the recycling of the assets they manage.
Public Hotel Companies
Public company share price performance usually telegraphs future asset level performance. Public markets appear to have hit the bottom. However, public values dissipated 85% from the peak in 2007 to trough during early 2009.
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Brand Expansion
Although the lodging sector is highly segmented, the products are managed by only a handful of hospitality corporations. Lodging companies all started with one brand and realized they could manage multiple brands because the labor intensity and synergies in purchasing, IT, etc. are so strong. The industry is largely segmented with regard to product, with an assortment of brands offered for the gamut of consumer wants and needs along the entire pricing scale. Approximately 70% of the hotels in the US have a brand affiliation, but no one flag accounts for more than 4% of the nearly 5 million total US hotel rooms. The end result is an industry comprised of a multitude of brands and controlled by a handful of operators. The top 10 US lodging corporations account for over 90 brands and nearly 3 million hotel rooms (60% of total US supply).
Throughout history, the lodging sector has pushed new boundaries, adapted to changing economic circumstances and tested various business techniques. At the end of the day, there is a constant factor that will always prevail during any economic environment. He who controls the customer, controls the revenue. Hospitality companies control the "bandwidth" in which the customer is delivered to a particular product. Additionally, the massive operating needs of running these businesses require scale. It is the management, recruitment and training of these hundreds of thousands of people that is the defining difference.
Employee headcount at various lodging companies:
Accor - 150,000
Marriott - 146,000
Starwood - 145,000
Hilton - 105,000
Fairmont - 30,000
Kerzner - 8,500
Sector Preference
Limited and budget sector hotel opportunities at first glance appear to have less volatility for an owner due to fewer employees per guest, reduced amenities and dramatically diluted service. However, the real estate itself becomes the least important aspect of demand in these economy sectors. The managers have a chokehold on owners of these hotels because it is the delivery of the "bandwidth" to customers that is the distinguishing characteristic. The people flow can easily be directed from one Motel 6 site to another or from one Days Inn to another. These types of ownership investments are best suited to family operators who function under franchise agreements and work the properties themselves.
Institutional owners possess the best negotiating power with managers in unique and iconoclastic luxury assets. Every luxury manager wants to operate Claridge's in London, Cala di Volpe in Sardinia, The Plaza in New York or The Hotel du Cap in the South of France. Their lineage demands a premium.
Current Issues Between Owners and Managers
Most management agreements of top brands are 20-30 year no-cut contracts. Contracts include a percentage of gross and percentage of net profit participation by the manager. Additionally, there are centralized service charges and various recoverables for HR training programs, sales events and trade shows in addition to sales and marketing fees. Many top owners have required performance tests that are based on budget projections of revenue and profitability. Due to the current downturn across hospitality, many of these contracts are in arbitration as owners' try to terminate or modify management agreements.
Moreover, all of the debt structured in CMBS format is subordinate to the manager's contract. This is in addition to the managers typically requiring non-disturbance agreements from lenders which, to-date, have withstood judicial scrutiny. Therefore, special servicers viewing foreclosures or liquidations of these properties will face further loss and deterioration due to their inability to terminate a manager's contract. By not delivering a luxury asset free and clear of a management contract, the available pool of purchasers is severely depleted. Strategic hotel buyers are usually the most competitive for this product and of course, a Four Seasons is not interested in buying a Mandarin Oriental.
All owners are looking to reduce FF&E reserves, are seeking cost savings, are complaining about mass premiums on insurance and are actively seeking management fee relief. These owner/manager conversations are global and transcend all brands and sectors. This added complexity creates increased drama and surgical expertise in the execution of a buy.
Specific Go Forward Opportunities
The luxury sector, in this cycle, has been the brunt of a populist backlash against groups and business meeting being conducted at resorts or five and six star luxury settings. This occurrence will fade, as will the political winds behind it and when it vanishes, businesses will return to the best of class properties.
Furthermore, six star hotel properties have always been the driving engine to large-scale resort properties. As residential and resort housing demand returns, developers will seek the top quality flags to act as anchors in their for sale projects.
The Optimal Investment Strategy: Buy Quality
Historical patterns will continue to repeat themselves, and the luxury segment will again outperform the mid-scale and budget/limited service segments in the recovery of capital values during the next up cycle. Luxury hospitality continually has the most volatility and the greatest spreads between the bottom and top providing the most potential for capital gain.
Fundamental reasoning provides an attractive opportunity for investment in the sector:
The luxury segment has historically experienced the highest ADR growth during the market recovery phase. In combination with the streamlining of unnecessary expenses during a downturn and the high operating leverage attendant to the business, luxury hotels should become a leading segment in terms of profit growth as the recovery phase takes hold.
Far more significant barriers to new construction exist in the luxury segment. Lead times are typically longer and prestigious locations are scarcer, difficult to procure, and possess significant difficulties in planning and entitlement.
The luxury sector is not subject to the same pressures from OTAs as economy chains. A luxury hotel typically has specific attributes that a customer finds unique and as a result does not lend itself to OTAs.
Institutional investors typically do not possess the patience or expertise to enter joint venture partnerships with strategic managers in order to maximize distribution and yield management. Cash flows, capital expenditures and operating metrics are lumpy and current cash distributions are limited. Inexperienced buyers can easily overspend in the re-investment of bringing a property back into shape to compete.
Demand for the upper upscale sector occupancy is projected to grow by nearly 5% in each of 2010 and 2011; however, it will take a significant spike in RevPAR before new construction in this segment is justifiable. Furthermore, hospitality is a difficult asset class for lenders and they will be slow to return to construction lending in this sector.
The relative lack of supply and distinctive nature of the assets within the luxury segment are positive influences on liquidity and capital values in comparison to the more numerous and homogeneous assets within the mid-scale and economy segments. Many luxury properties have unique and potentially irreplaceable attributes that command a premium, particularly in a recovering operating environment. Furthermore, RevPAR growth during a recovery is significantly higher in luxury due to the wide range of supplemental income streams they generate in comparison to the economy sectors.
When the public hospitality companies again possess acquisition capital, they will place a substantial premium on existing first-class, well-situated, non-flagged or re-flaggable hotel properties in order to bypass the long development cycle for luxury properties. Additionally, "pride of ownership" buyers always exist in every market for first-class luxury hotels.
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Summary
The hospitality industry is currently struggling through one of its worst downturns in history. As a complex business with high operating leverage and a closely linked correlation with the economy, this sector is characterized by a recurring tendency for capital markets, Main Street markets and investors to overreact - both positively and negatively - to changes in the macroeconomic environment. Due to daily mark-to-market adjustments, hospitality was the first real estate sector to be negatively impacted by the downturn, and it will be the first to benefit from a renewed economic expansion. Nevertheless, institutional capital always flees from hospitality at the initial sign of pain, and returns to the sector only after getting back into the more easily digested, income-producing CRE asset classes. The remarkable deceleration in hotel supply additions will serve to accelerate the industry's recovery and the cost to supply new product to meet recovering demand should only increase over time. Given these conditions and the relatively low correlation with other real estate asset classes, hospitality should be both a positive and balancing force within institutional real estate investment portfolios in the medium-term.
Luxury hospitality and the hourly re-pricing of rates is the strongest hedge in an inflationary cycle. Office leases that are currently being re-negotiated are for terms of 5, 10s and 15 years and a recovery occurring in the early years will have minimal upward influence on these long contractual income streams. The retail and industrial sectors share the same long-term lease benefits and detriments. Hotel pricing in periods of recovery provide huge upside potential. Luxury hospitality possesses the most difficult and competitive market barriers for new entrants in an upturn. The lag effect from the point that acceptable yield on replacement cost justifies new construction to actual positive NOI is the longest of any asset type. Thus the ability to increase yield and take advantage of increased demand without increased supply is the most dramatic.
Bottom line - Luxury hotels are for trading, not necessarily for holding. Location, scarcity, quality and uniqueness produce outsized intrinsic value in any economic recovery far beyond the bland homogeneity of easy to understand plain vanilla commercial real estate.
Finding these unique six star arbitrage opportunities requires global reach and expertise which today resides within global management companies. Those management companies and their owners who are able to farm and harvest that information will benefit significantly from equity opportunities and from flagging or re-flagging these unique assets. Instead of agonizingly awaiting turndown service, it's time to place a wake-up call.
In 1892, my Grandpa, Joe Barak, was 8 years old and living in a village called Zahle in the Lebanese region of what was then part of the Ottoman Empire. He was the youngest of seven boys and his Maronite Christian family and all Lebanese were being crushed by the domination of a repressive Ottoman Empire. Sultan Abdülhamid II had massacred all separatists and killed hundreds of thousands of Christians across Syria and Lebanon who had not submitted to his feudal system. As a consequence, the Ottomans were harvesting the fertile valleys of the Beqaa as fuel for their global armies and foreign conquests. The frustrated men of Zahle drank Arak (an ouzo-like drink made of aniseed) and ate mezze along the edge of the Berdawni River. They would complain about the economy, life, and politics, and amused themselves with throwing competitions using a 200-pound cooking stone called a "jurn el kibbe." The women were the only ones who were allowed to work, as local village men were not allowed to have tools or implements. In the spring of 1892, the women of the village were given food by the Jesuits in return for tending to the Cinsaut vines at Chateau Ksara Vineyard. Ksara wine was distributed to Turkish armies throughout the realm so the Sultan allowed the Jesuits to continue their production, as long as they used exclusively female laborers.
The women would kneel within the hand-planted rows of budding grape leaves as the spring warmth brought hope but no relief. The women were generally clad in black, in mourning for family members lost in the course of decades of resistance. As they sat in the midst of the sun-drenched vines talking, smoking aguillis (hubbly bubblies) and sipping on mud-like Turkish coffee, these women embodied the strength of the cedars that covered the snow-capped Mount Lebanon, which rose as a pillar of hope within the tortured plateaus of the Levant. Tucked within the vineyard and safe from their oppressors' eyes, they dreamed of sending their children to a land of freedom and opportunity in the hopes of saving their lives and delivering them from the plight of life in Zahle.
Whispers came through the valleys from Beirut to Damascus that an opportunity for freedom and prosperity was blooming in America, Brazil and Mexico. Joe's father would hear nothing of such fanciful ideas, but in June, Joe's father was killed by the Turks during a separatist insurrection in his village. In typical motherly style, Joe's mother did not miss a step and took most of her poor family's savings to buy Joe a ticket in steerage on a ship leaving for Marseilles and then New York in the late fall of 1892. This kind, loving, and selfless woman walked him from the mountains to the sea and kissed her son goodbye, surely thinking this was the last time she would ever see him. Small boats took Joe and others out to a waiting ship, where the passengers climbed a rope ladder up to the steamer. They spent several days stopping at various ports, while crossing the often rough waters of the Mediterranean Sea, until they reached the southern shore of France and the port of Marseilles. From there they rode a train to the northern shore of France and connected with another ship that would take them across the Atlantic Ocean to New York City.
Joe had one pair of pants, one shirt and one pair of socks in his possession, along with three Ottoman Lire that his mother insisted he take, though they were of course worthless where he was going. The idea was that he would go by himself to America, find work, save money and send it home to pay for the passage of other family members. There was no one else from his village on the ship and he had no friends or relatives awaiting his arrival in the new land.
In February of 1893, at the conclusion of a forty-day journey, Joe arrived at Ellis Island. Joe spoke no English, knew only the other Lebanese boys with whom he had traveled in the hull of the ship, and knew that his only order of business was to find employment.
Joe arrived at the doorstep of America hoping to find a booming and welcoming land of opportunity. As fate would have it, 1893 was the beginning of one of the largest financial panics in US history. The similarities between then and now are amazing.
The Panic of 1893 was caused by overbuilt railroads and bad railroad finances, which led to a series of bank failures. The panic became a five-year depression, which was built on asset bubbles, over-borrowing, speculation, and excessive government spending.
The 1880s experienced a period of tremendous expansion in America. Railroads were over-built, especially in the West where silver was discovered. Railroads made silver and other products more readily available to customer demands, and the items flooded the market. As the railroad bubble swelled, many companies and railroads borrowed heavily to make costly improvements and expand. Banks lent heavily to miners, speculators and new business owners. Overexpansion cut into revenues, profits dwindled, and companies were unable to pay their debts. Workers were laid off. Neither the companies nor their unemployed workers could pay their debts. On February 23, 1893, the Philadelphia and Reading Railroad went bankrupt ten days before Grover Cleveland's second inauguration. The Panic of 1893 started.
Things grew worse as farmers, particularly in the Midwest, suffered a series of droughts. The prices of wheat, cotton, and other crops soared. The farmers were in debt. The value of their land plummeted. As the economy worsened, people rushed to withdraw their money from banks. The credit crunch spread through the economy. European investors took payment only in gold. The value of the gold-backed dollar plunged. More railroad companies, including the Northern Pacific Railway and the Union Pacific Railroad, went under. Without the railroads, numerous other companies that relied on them also failed. As customers defaulted on loans, banks were forced to close.
During the 1890s, over 15,000 companies and 500 banks collapsed nationwide. Unemployment skyrocketed in one year from one million in 1893 to three million in 1894. The population at the time was about 60 million. The huge spike in unemployment combined with the loss of people's savings by failed banks meant that mortgage obligations couldn't be met. In desperation, people walked away from newly built homes.
By 1890, the New York population was about 2.5 million. After the crash, it was estimated that there were 120,000 jobless people, 20,000 of whom were also homeless. The national unemployment rate was approaching 20 percent.
The Democrats and President Cleveland were blamed for the depression. The Republicans scored a landslide victory in the 1894 state and Congressional elections. Two years later, the presidential election was bitterly fought on economic issues and was marked by a decisive victory of the Republicans led by Ohio Governor William McKinley, Jr. over Democratic Congressman William Jennings Bryan.
Despite McKinley's victory, desperate people continued to abandon their homes and moved west. Growing cities like Seattle, Portland, Salt Lake City, Denver, San Francisco and Los Angeles took in the populations, as did many smaller areas nearby. The economy finally began to recover in 1896, marking the end of the worst depression American history... until the 1930s and today.
Bottom line, when he stepped off the ferry from Ellis Island believing that he would find a paradise in the welcoming arms of the American angels, he found Hell's kitchen and bread lines. There was no food, no shelter, and there were no employment opportunities. America was in turbulence and the small Lebanese community had no power or position in the political community. One of the boys with whom he had traveled had an uncle who was a peddler in New Jersey. The uncle allowed Joe, at the age of 9, to come to his store in Newark and began to teach him the art of peddling. Joe slept on the floor of the store at night and hiked miles during the days selling his wares. This was a job that even the thousands of unemployed American workers would not attempt. Households in rural areas had little or no money, no access to transportation and no stores available for dry goods, clothing and utensils. Joe learned to collect whatever money his customers had and take the rest on credit. In turn, he would sell for only those stores who would accept his credit or allocate goods to him on consignment.
Joe walked from door to door and town-to-town, selling laces, dry goods, threads and pins to housewives across the country. He would buy small tools, cooking utensils, sewing machines, fabric, bed sheets and dry goods from a local store on consignment and load them on to packs on his back. He would then march through rural areas selling the goods and taking orders for goods that he did not have for his return trip. He would then return to the store with a list of what he could sell on the next trip and the circuit would renew itself. As he proved himself, the store owner would extend more goods on consignment to Joe, which allowed him to buy and sell more goods on credit to his customers.
As the economic situation worsened in the East, Joe and his 10-year old peddler pal decided they would hop on a train and head West, where the opportunities were rumored to be better. They crawled on the undercarriage of trains until they reached what they believed to be the West Coast. In actuality, it was Santa Fe, New Mexico. They found a Lebanese owner of a dry goods store and started their peddling march once again. Sometimes they would walk 400 miles in a week with all of the goods neatly stored in a back pack. Due to the remoteness of the area and little competition, business boomed and they were soon able to buy a donkey and ultimately a wagon to replace their famous packs.
After three years of peddling, at the age of 13, Joe had saved enough to send home money for his brother Richard's passage to America. Richard and Joe then teamed up and quickly came to the conclusion that the only person who consistently made and had money was the owner of the store. He concluded that the dream business was to own the real estate and clip coupons while the peddlers all bought goods from him.
Joe eventually made a deal to take most of the available goods on consignment from the owner of one particular store. He did a great job and eventually proposed to buy the store from the owner and make the owner, Mr. Maloof, his continuing partner if he could pay for the store over time. The owner consented, provided that Joe married his daughter, Mary, which he did. Thus my grandparents became proud owners of a store in Raton, New Mexico. The store was on the bottom floor of a 1000 square foot building, and Joe, Mary, Mary's parents, and Mary's brother and his wife all lived on the top floor.
Joe's business prospered because he then supplied dry goods to a herd of young Lebanese peddlers who would sell on consignment to rural areas and bring back lists of desired goods and merchandise. Joe would import all requested items from around the globe and then send them back with the peddlers to the rural customers. After a couple of years, he had only one serious competitor in town and decided it was time to buy him out. He made a proposal to buy the second store over a three year period. The owner agreed and two days after signing the deal, Joe closed the second store, sold all the inventory and turned it into a butcher shop. No more competition and his first source of passive income. Real estate was the quantum leap forward for Joe and his family.
Joe's story is not just the story of my family. It is the story of America. It is the story of all of our fathers, grandfathers and great-grandfathers. It is the story of Irish, Italians, Jews, Muslims, Buddhists, Koreans, Vietnamese, Polish, Russians and Chinese. There was no social security, no medical insurance, no welfare and no public schools. No one would give you anything except an opportunity to make something for yourself and no one was "entitled." The US was a creditor nation, set the gold standard, and was the largest manufacturer and exporter in the world; however, Joe found opportunity at a moment in which the US was being threatened and flailing in distress. It was at this moment that Joe and the millions of immigrants found the greatest of opportunities and never stopped dreaming. The American hero was the entrepreneur, the business owner, the employee who bought a house for his family - the capitalist. The government and the economy in 1893 were in as bad shape as we are now! The answer then was to work twice as hard, expect nothing, ask for nothing, give 200% and dream the dream. Crisis was the norm for these men and women, and there was no expectation that anyone other than themselves was going to make things better for them.
Today, the dream has turned into a nightmare and our children and our children's children will inherit tens of trillions of dollars in debt. We are not concerned with dreaming the dream and working to get there -- we are concerned with "living the life" and making sure someone gives it to us. We are in the midst of a populist revolution, which is shifting incentive from opportunity to entitlement. We are having a hard time separating heroes from villains. Yet through it all, the underlying foundation stone of everyone's dream - be it opportunity or entitlement - revolves around the dream or hope of prosperity, self-fulfillment and ownership. Real estate has always been an inherent part of the American Dream - the dream to own a home, a house, a gas station, a bakery, an office, a store. Through good times or bad times, the pureness of the desire has remained steadfast. Only the belief and conviction in how to get it and preserve it has faltered.
There is no doubt that real estate is a cyclical industry and I promise in future Chairman's Corners we will deal with our specific points of view in this regard. However, the American Dream should not be cyclical. This is our real ability and power as individuals. The enormity of the economic and political woes across our country weigh heavily on our shoulders and the solutions vanish in the horizon. Residential foreclosures are an epidemic, household wealth has diminished, household debt is overwhelming, and meteoric unemployment, lack of availability of credit, and a confusing political situation have dampened our enthusiasm and dimmed our dream. The real solution is for us to embrace, embellish and replenish the dream.
One individual can make a difference, can defy the odds, can work harder, imagine more, and create more. There is no need for bailouts, subsidies, supports and more entitlement programs. Our children already owe $53 trillion for our own debts, social security and healthcare. We adults will limp along, having had the benefit of the good times. However, our children's dreams will be put to sunder unless we all embrace individual responsibility to "make it happen" ourselves.
We need to restore the American Dream before it becomes a Global Nightmare. That can only be done one dreamer at a time. Joe found opportunity in the midst of the worst financial panic of our country's history to that point. Why?? Because he and your fathers, grandfathers and great-grandfathers took absolute accountability and responsibility for their own actions and held on to the belief that in America, all things are possible if you make it happen. Don't rely and expect, just do! And do it now!!!!!
