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Better REIT than wrong?

Host Marriott has made significant changes during the past five years. The company has exited the limited service segment in favor of upscale hotels and has restructured as a REIT. Now Host Marriott is making the best of the dismal REIT environment by buying back shares and managing its blue-chip portfolio of high-end properties.

Simply put by Chris Nassetta, "We are the largest hospitality REIT with the highest quality properties." Nassetta, currently Host's executive vice president and COO, was recently named successor to president and CEO Terence Golden when Golden retires in May 2000.

Host Marriott is a relatively new entrant into the REIT market. The company has restructured many times in its history to improve its position in the market. By 1998, the company prepared to restructure once again. Host Marriott Corp. spun off Crestline Capital Corp. as an entity charged with owning retirement properties and holding leases of existing hotel properties in preparation for conversion to REIT status in 1999.

Buckled in during REIT turbulence Lodging REITs plunged almost 50% during 1998, so, to some, the timing of the conversion was odd. "What some people forget is that we were a large, public real estate company," says Nassetta. "The biggest motivation for our REIT restructuring was taxes. Our taxes as a percentage of cash flow were reaching remarkably high levels. Instead of paying all of that out in taxes, we believed it would be better for investors to receive that pay out in the form of dividends."

The company estimates that without the REIT conversion Host Marriott would be paying 29% of net cash flow in taxes during 1999 with that share rising to 44% in 2000, and to over 50% in 2001.

Years before its REIT conversion, Host had begun a striking overhaul of its portfolio and began pulling out of limited service. "We didn't like the look of that business," says Nassetta. "We could see that [limited service] was going to overbuild."

In 1995 Host Marriott's total portfolio consisted of 53% limited service hotels. The sale-leaseback of 18 Residence Inns and 16 Courtyard hotels to Hospitality Properties Trust in 1996 marked Host Marriott's exit from the limited service business. Host's exposure to the segment has shrunk to around 1%. "Since 1995, we have sold virtually all of those assets and redeployed the capital to reposition our portfolio."

Host went on a buying spree during 1998, acquiring 36 properties. A $1.55 billion portfolio acquisition from New York-based Blackstone Group accounted for a big chunk of 1998's acquisition activity. The largest deal in Host Marriott's history added 12 luxury hotels and more than 5,000 rooms to the portfolio.

The deal also launched a multi-branding effort that added premier brands to the portfolio: two Ritz-Carltons, two Four Seasons, three Hyatt Regency hotels, four Swissotels, and a Grand Hyatt. Host Marriott now owns one-third of the entire Marriott system of hotels and one-half of Ritz-Carlton's.

Host Marriott will stick to its strategy of disciplined growth within the upscale market while the REIT market is on the mend. "Going forward, we will continue to target the upper upscale segment, concentrating on strong markets with barriers to entry.

"Over time, we believe we will be a logical consolidator of this segment," adds Nassetta. "We have a solid foundation of properties to build on and a strong balance sheet."

Host Marriott employs the same disciplined acquisition strategy to its international business. "Our acquisitions - domestic or international - are driven by yield. We don't enter a market just for the sake of establishing a presence. Internationally, we just haven't seen the yields that make sense on a risk-adjusted basis."

Host Marriott does have international exposure. The company owns assets in Canada and Mexico, and is searching for opportunities in Southeast Asia. "We will do more international," says Nassetta, "but that business will rely on achieving yields that create value for the shareholder."

Growing from within The public market has largely forced the hand of lodging REITs like Host Marriott. They have been pushed off of the acquisition treadmill and now must create value internally. "Over the long term we are a logical consolidator and buyer of upper upscale lodging assets," says Nassetta. "In the short term, we are focusing more on what we have."

Acquisitions have given way to asset management and a stock buyback program. The company plans to buy back $100 million of its own stock by the end of 2000. "We still pursue good acquisition opportunities, but with our multiples down, our focus has shifted to the purchase of our own stock. Our stock is trading at a multiple of five times FFO compared to thirteen times FFO at the peak. This gives us a great opportunity to buy stock at a premium to most acquisition opportunities."

Host Marriott is also fine-tuning its existing portfolio. "We will be releasing many of what we consider non-core assets," says Nassetta. "This usually means assets located in suburban or secondary markets. Basically, assets where the prospects for growth are not as strong." Over the next five years, the company expects to winnow its suburban allocation to 8% from its present level of 15%.

Host Marriott will also sell assets where there is compelling opportunity, including a recent sale of its Boston Ritz-Carlton. "This falls into the category of 'unique opportunity,'" says Nassetta. "The buyer was interested in using the Ritz-Carlton name and was willing to pay for it. We believe we traded that property at a significant premium to the asset value."

REIT outlook So what will shake the funk that Host Marriott and other lodging REITs are in? For one, says Nassetta, is the passage of the REIT Modernization Act. "The passing of the RMA would provide some momentum.

For Host it would mean that we could buy back some of the leases from Crestline."

The all-important gross domestic product may also provide some lift to the slumping lodging sector. "The correlation between GDP and hotel demand is so strong. Strong growth in GDP may also help get the lodging stocks moving again. The most likely scenario, however, is more moderate growth in GDP."

The most important dynamic for the weak lodging REIT market, according to Nassetta, is supply and demand. "Ultimately, supply will slow and demand will begin to rise, and we will reach the inflection point where RevPAR will begin growing strongly again. This will be the most important dynamic with regard to improving lodging REIT stock performance."

The laws of supply and demand will be the industry's most important dynamic over the next two years, says Nassetta. "When you look at the data, it is clear that there is increasing supply, and this is having an effect. Our strategy of focusing on urban locations and markets with barriers to entry protects us more than others, but the new supply is having some effect on us, too. We expectto see a peak of the supply curve in 2000 with it turning down during 2001. By 2002, we expect demand to outpace supply.

"Between now and then," he adds, "we need to remain disciplined in deploying capital and concentrate on internal growth."

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