1998 Stocks for Mom
May 07, 1998

To Mom from Michael*
*But Not for the Average Boy's Mom
by Michael Dowd ([email protected])

NorthStar Capital Investment Corp.
(No ticker symbol yet -- but soon.)
527 Madison Avenue, New York, NY 10022
212-319-3400
Trading privately in the $22 to $23 per share range

I really should suggest a nice, safe real estate investment trust (REIT) for Mother. Something that is conservatively managed -- low debt -- nice folks running it -- safe dividend -- not much excitement. There's my problem. My 94-year-old mother invests long term. She wants long-term capital gains.

How can I describe Marguerite Dowd, née Marguerite McCann? She ran Lowell Massachusetts' most successful bookstore in 1923 when she was only nineteen. Better yet, when she was fifteen she talked her Uncle Bob out of $15 for the one thing she really wanted that her mother would not buy her. Was it a flapper dress? Nope. It was a ride in an open cockpit biplane. She took off from Hampton Beach, New Hampshire in the warm spring of 1919. Imagine how mad my Grandmother would have been if she'd found that Uncle Bob gave my mother money for that?

NorthStar Capital is a bit of an adventure, so picture this. It is 1919. You are looking down from an open cockpit to white sandy beach, woody green New Hampshire coast, and sparkling blue Atlantic Ocean. The prop wash from a radial engine is blowing through your hair. Tiny bathers an incredible one thousand feet below are waving gaily up at you. You're fifteen years old and anything is possible. Want to take a flyer?

Maggie is a complex woman. Appropriately, NorthStar Capital Investment Corp. ("NCIC") is a complex stock. Not exactly an IPO, it was a "blind pool" REIT that raised $300 million from Qualified Institutional Buyers (QUIBs) in December of 1997. (QUIBs are what you need to be to buy Rule 144a stock.) NCIC's QUIBs included Morgan Guaranty, Harvard Private Capital, Walt Disney Corp., and Northwestern Mutual Life. The company filed an S-11 on March 20, 1998 to enable trading in the shares. The SEC staff has 30 days to comment. Until they do, no one can tell you (or Mom) when you might be able to buy some. It depends on how extensive those comments are. Probably it will be a few weeks. You can browse the S-11 here: NorthStar's S-11.

Maggie is intrigued by the people running the company. The combined age of David Hamamoto and Edward Scheetz is only 70, so she's already got them by 24 years. She won't have to take any backchat if things don't work out. The S-11 says:

"Mr. Hamamoto was the co-founder and…. Co-head of the Whitehall Funds at Goldman, Sachs & Co., as well as a partner at Goldman, Sachs. Until co-founding NorthStar, Mr. Scheetz was a partner at Apollo Real Estate Advisors. The Company believes that, at their previous firms, Mr. Hamamoto and Mr. Scheetz were responsible for a significant portion of all investments by opportunistic real estate investment funds investing since 1992. Mr. Hamamoto and Mr. Scheetz collectively…. were instrumental in the origination, structuring, and closing of approximately 190 distinct property, portfolio, and corporate transactions representing a total investment of approximately $16 billion..."

They were busy boys, but even in their mellow middle years Hamamoto and Scheetz still can move swiftly. NCIC planned to leverage its $300 million 1 for 1 with debt so there was $600 million to invest. So far the company has already committed well over $335 million in ten transactions, and also announced its intention to purchase seven hotels and a billion dollar development company not included in that total. NCIC's investment style is complex. Each transaction needs explanation, but here are four outlines.

Ian Schrager Hotels. NCIC owns a controlling interest in the trendiest hotel concept since César Ritz and Escoffier started serving high-cholesterol meals to Edward VII. The new concept was invented by Ian Schrager, former co-creator of the celebrated Studio 54 discotheque. Studio 54 was so famous Vanity Fair is still writing about it 20 years after its demise, and Miramax is releasing a movie about it this summer called 54. More important to investors, Schrager's undeniable taste and personal contacts have enabled him to decorate originally and fit out upscale hotels at far lower-than-Ritz-Carlton costs, while still attracting very upscale rock star and gorgeous fashion model guests. Look at these occupancies and room rates.

HOTEL     LOC ROOMS 1997 ADR %Occupancy  RevPAR 
 Paramount NY  591  $179.95   80.9%       $145.58 
 Royalton  NY  168  $294.84   85.8%       $252.97 
 Mondrian  LA  238  $223.11   76.1%       $169.79 
 

Since filing the S-11, Schrager has agreed to acquire Morgan's hotel in New York and the Delano in Miami Beach, Florida. Schrager had been managing both. Industry sources report that the Delano is one of the most profitable hotels in the world on a per-room basis. The purchase price has not been announced, but I hear its 208 rooms yield an astonishing $12.8 million -- or over $61,000 a year per room in net operating income (NOI).

Between its innovative design and marketing and NorthStar's access to capital, Ian Schrager Hotels' chances for growth look good. Since last July it has expanded three original hotels with 997 rooms to more than 3,200 rooms by the year 2000 (plus the UK properties). Putting a pencil to the financials in the S-11, the ingoing cap-rate on the first three Schrager properties seems in the 13% range. That's some 200 to 300 basis points better than most hotel REITs are buying at today. Schrager's announced deals should make it a billion dollar plus company (in assets) by the year 2000.

The latest Schrager hotel will particularly amuse Mom. When I was about 12 my father would take us all to the theater. Afterwards he treated us to an ice cream soda at Rumplemayer's in the St Moritz Hotel. It's on Central Park South, about two blocks from The Plaza. On February 17, Donald Trump announced he was about to destroy the classic 1926, 700 room, grande dame hotel and convert it to a bronze and glass condominium. But Schrager's concept and NorthStar's ready capital let them scoop The Donald. On May 5 they bought what is the best remaining hotel site on Central Park South for about $250,000 a room. The St. Moritz needs a lot of work and some of the smallest old rooms may have to be combined to make fewer, larger ones. Still, on a street where upscale properties trade at over $500,000 a room, that price leaves a large margin for profit and error.

About two weeks from the date Schrager starting to look at the hotel, its Australian insurance company owner announced, "FAI has received (and cleared) two cheques: US$70 million (A$106 million) and US$7.8 million (A$12 million) thereby receiving in total A$118 million and through the granting of a long term lease we have effectively placed US$115 million (A$174 million) in a fixed interest type security." The $115 million is at 5% for ten years, is in place for 40 years, and carries a staged kicker to a maximum of 10% of the equity. I should note that NorthStar didn't put up all the $77.8 million, it has some major partners in the deal. Mom respects acting decisively, buying cheaply, spreading risk, and borrowing efficiently. She hopes they put Rumplemayer's back though.

USFS Development Fund. NCIC committed $35 million to help capitalize a company that will fund the mortgages on 25 to 30 of U.S. Franchise Systems' <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: USFS)") else Response.Write("(Nasdaq: USFS)") end if %> budget Microtels and its higher-end Hawthorn Suites. If the strategy works, as USFS grows NorthStar will also profit. NCIC has the right to buy $4.9 million of USFS' stock at $11.25 a share. USFS has just announced that it will add a third brand by acquiring the mid-priced "Best Inns" franchise.

The exact terms of the NCIC/USFS structure are not yet public. We do know the pool will be 50% financed by third party first tranche debt. Mr. Hamamoto believes the USFS properties will generate "12% to 16% returns on cost." Put those two numbers together and NCIC should achieve returns well into the 20% range. There are real over-building risks in today's low-priced hotel market, but USFS has taken the first-loss $10 million risk position in the pool. It's hard to think a public company with good management will lightly risk reporting to the financial world that it just blew off a $10 million investment in its flagship hotel brands. USFS' Michael Leven is reputed to be among the very best executives in that business, and he knows what that would do to his stock.

The three brands would appear to give NorthStar and USFS lots of opportunities to invest mortgage funds. If Leven is successful, it is not hard to imagine NorthStar continuing to do $35 million slices of high-yield debt (and $5 million in USFS stock options) for some time to come.

350 Washington Street, Boston, Massachusetts. NorthStar has invested in a joint venture that owns probably the best remaining office site in Boston's financial district. It includes an existing 888 space garage and an opportunity for first rate ground level retail space in the city's prime retail district. Most of the planning and zoning approvals are already in place from a prior developer, and Mayor Menino (who ran unopposed last time) is publicly and enthusiastically pushing fast-tracking the remaining issues.

Boston is a scalding Class A office market that has averaged 726,000 square feet of absorption over the last five years. Class A vacancy is below 2%. The last office building "opened" was the renovated 28 State Street, about two blocks from NCIC's site. On that site another REIT, Equity Office Properties, just blew away its pro forma both in speed of leasing and rental rates. In 1997, the 40-story 580,000 square foot office building leased approximately 407,000 square feet, achieving rents in the high $30s to low $40s per square foot with strong credit tenants (including one of Yorick's lawyers).

NCIC can probably break ground this year on its site. As Spaulding & Slye note, the next bunch of office developments likely to occur will be much more distant from the financial district. Many are months or years further away from breaking ground. NCIC has a first rate architect, a strong builder, a well-respected leasing agent, and it is in at a very good land price.

Yorick himself is a Boston resident. He has a hard time seeing anything likely much short of a total collapse of the Boston financial community that would jeopardize this project becoming a major success. Again, it's hard to forecast the exact returns, but at about $65 per developable square foot of land cost you can make a guess. NCIC's total, fairly secure equity exposure in the tens of millions of dollars should pro forma somewhere well up in the mid-20% range. If it wants to step up the leverage, it could be a whole lot higher.

Emmes & Company. On April 9, NCIC announced that it had teamed with Andrew Davidoff and Emmes' senior management to acquire a controlling interest in Emmes & Co. LLC for $55 million. Emmes is a privately owned, hands-on asset manager and turnaround specialist formed in 1992. It does publish an annual review of its operations. From 1992 through 1996, Emmes reports that it earned an average internal rate of return (IRR) of 42.8% on its portfolios, building initial investments from $44.5 million to over $575 million.

To give you an idea what it does, consider the "Ginsberg Portfolio," which includes mortgage loans and property, all in some 10,800 "class B and C" apartments located in New York, New Jersey, Pennsylvania, and Florida. Many of the notes had been in a securitized mortgage "REMIC" underwritten by Donaldson, Lufkin & Jenrette and rated investment grade by Moody's. DLJ's (and Moody's) due diligence had been sadly lacking. There was substantial deferred maintenance and the reserves were totally inadequate for properties of their age and condition. Within about a year of the underwriting so many tenants were on a rent strike that the bonds were in default. DLJ stepped up to the plate and repurchased the notes from the investors and began to manage the asset. DLJ invested significant capital expenditures, but lots of work remained to do -- and a long, ugly lawsuit looms before it can foreclose many of the properties.

In October 1997, Emmes brought NorthStar and another venture capital group (Blackacre) in to help buy out DLJ's notes. The outstanding indebtedness (original DLJ underwriting plus accrued interest) had been $412 million. 2,200 of the total 10,800 apartment units have now been foreclosed. The total purchase price (including expenses and working capital) is a shade over $270 million, or 65% of the face value of the notes. Current reported NOI by property managers, receivers, and bankruptcy trustees is around $30 million. That works out to be a (very rough) 11% return on assets, and an even higher return on equity if they leveraged it a bit.

Significant opportunities remain to reduce excessive fees, cut out payroll padding, improve buying goods and services, and eliminate the "leakage" that goes on when management thinks the capital is asleep. How much more can good asset managers save, and how much will it have to invest in the apartments and lawyers? Not easy for an outsider to tell, but it is making money now, so any extra NOI is all gravy. Assuming the foreclosures go forward, Emmes and NCIC are buying the portfolio at about $25,000 an apartment unit. With good management and a continuing strong economy in the mid-Atlantic markets, this could be another major win, though litigation is always risky.

Emmes' share of the Ginsberg portfolio is only a part of the $1 billion plus in real estate and related assets Emmes controls. There are New York office properties and a fair amount of retail as well. In addition to Emmes' share of these assets, the Emmes stake gives NorthStar access to its very high quality asset management SWAT team. Since management already owns 50% of its stock, they are probably better incentivized than NorthStar could do if it built its own group.

Emmes' website isn't up yet, but here's the website for its lending subsidiary, Emmes Capital (ECAP). ECAP's track record has also been pretty impressive. Using nominal leverage and almost no economies of scale, it has earned over 20% a year over the past 3 years. With NorthStar's capital access and deal flow, it is fairly easy to believe ECAP will continue growing earnings in the 20% plus range, and that it will grow the size of that pool even faster.

In addition to these deals and the others noted in the S-11, Koll Real Estate Group, whose subsidiary Koll Resorts International has already involved NorthStar in two of its golf ventures, has just announced that it is selling its development company to NorthStar for $30 million (plus liabilities). The subsidiary is a leading developer of office space in Southern California, and reports it has $1.2 billion of work in the development pipeline.

So here's Mike Dowd's deal for his Mom, but make up your own mind for yours. Starting with $300 million in capital in January, NorthStar has already secured majority control of two companies with billion-dollar-plus asset bases and extraordinary growth prospects. (It has three if you count the Koll development pipeline.)

Certain of NCIC's investment characteristics are already clear. Scheetz and Hamamoto are making maximum use of the company's easy availability of capital to get good deals at good prices. At the same time, it is leaving enough on the table to attract some first rate folks to run the deals. Partners in their ventures include Schrager, Davidoff, Levin, and other respected names like Koll and Soros.

The upside is that you and my Mom end up owning pieces of a diversified, multi-billion dollar real estate empire within two years or so. The downside is that NCIC is in some pretty risky, development-oriented deals. Some partners -- notably Schrager and Koll -- have had recent, very substantial financial problems. So far Hamamoto, Scheetz, and company have looked for edges to cushion those risks. So far they appear to have have been finding those edges. There seems to be someone smart and knowledgeable whose oxen will be gored before NCIC's oxen start bleeding.

A sure thing? Not hardly. The incentive fees to NCIC's manager are very generous. NCIC will be more leveraged than most other REITs, and its outside management and outside advisory company offer more chances for conflicts of interest. You still do not know what management is going to do with almost half its capital. All this is cause for both concern and taking care. Your friend Yorick has written a fair amount in scholarly journals about the risks of REIT IPOs, but we are not talking about a stock for me. It is for my Mom. What other real estate stock would you buy for a mother who's been a high-flyer since she was fifteen?

And now, if I may, Happy Mother's Day Maggie. Your children and grandchildren love you. Stick around for another 94 years while we see how well Mr. Scheetz and Mr. Hamamoto do with your money. It should at almost as much fun as watching the Red Sox this spring.

Gossipy Footnote:

It is fun to use AOL, Yahoo or some other engine for a quick net search on "ian schrager" or "studio 54," or the late "steve rubell." It gives one a sense of some important things, though. The first is how powerful Schrager's style and marketing presence is today. The second is how quickly stylish places like Studio 54 (and Morgan's) can fade from favor. I particularly noted these:

Letter from L.A. | New York Post: Gossip | New York Post: Business

Next: TMF Runkle gives Pfizer

* A Stock for Mom represents the opinion of one Fool and in no way should be taken as the opinion of either the Motley Fool, Inc., the company in question or representative of anyone or anything else other than that specific Fool's thoughts.