Ask anyone in the real estate investment world to name the most influential icon in the business and you'll likely hear the same name:
. As chairman of two of the largest real estate investment trusts --
Equity Office Properties Trust
Equity Residential Properties Trust
, his actions and those of his companies are closely watched. And as chairman of the
National Association of Real Estate Investment Trusts
, or NAREIT, his stamp is on recent legislative changes to REIT regulations as well as the continuing attempt to standardize the often confusing accounting standards of REITs.
But Zell's multibillion dollar empire transcends the real estate world, with interests as diverse as
Chart House Enterprises
, a chain of seafood restaurants across the U.S., to
American Classic Voyages
, the leading purveyor of passenger cruises along the Mississippi River and throughout Hawaii. And his eclectic holdings reveal plenty about his personality.
If you're lucky enough to catch him in his midtown Chicago office, you'll find him in blue jeans and an open collar, equally content to survey the Chicago landscape from his working outdoor patio and the lay of the land on Wall Street from his real-time terminal. And since he likely will have arrived at work on one of his motorcycles, you'll get the sense that Zell thrives on a sense of exploration and adventure -- traits he proudly says are largely responsible for his success.
Zell's opinions are widely sought and influential, both inside and outside the real estate world. We sat down recently to discuss the state of real estate and REITs, as well as a host of other subjects -- from the impact of technology and valuations of many of the dot-coms to his future in an ever-changing world.
What became clear in the hour or so we spent together is that Zell is clever, articulate and opinionated -- likely contributors to his investing success.
Christopher Edmonds: Let me begin somewhat philosophically. You have built quite an empire in the real estate business and, along the way, you have learned a lot from your successes and failures. Provide me a vision of what the "new Sam Zell" real estate company might look like, if you could start over.
I think that Equity Office Properties Trust and Equity Residential Properties Trust embody what I thought would be nirvana. They both are very large, very diverse and very professionally managed companies. Scale is key because ultimately I believe that the success of these companies will emanate from the ability to mix providing space and providing services to tenants.
That's a little different than it was say 10 or 20 years ago when the name of the game was simply providing space?
Absolutely, but was it providing space or was it betting on inflation? The real estate business -- certainly prior to 1986 -- was driven by the fact that in the leveraged portfolio, a 3% or 4% inflationary uptick per annum translated into outsized gains. I think that's the original basis of real estate before it became democratized. And that led to oversupply.
What do you mean when you say real estate was "democratized"?
Effectively the sources of capital for real estate expanded. In the 1980s we had public limited partnerships that raised billions of dollars that created competition that ultimately killed the golden goose. We had all kinds of institutions -- savings and loans, insurance companies and pension funds -- expanding their allocation to real estate all at the same time. So it, in effect, became a total access business as opposed to a barrier-to-entry business. The result was a pretty big disaster for everybody.
Then came the REIT structure, and the capital markets through the early 1990s seemed infatuated with public real estate companies. Yet today it looks like REITs redemocratized the business and now they've hit a brick wall. Why?
I think if you look at the real estate industry from roughly 1992 to 1997, there was a period of enormous recovery. Whether you call it an infatuation with real estate or recognition of an enormous recovery, either way the attraction was extreme. But, what we are all dealing with today and what really represents the challenge in the real estate industry is that we are now right smack-dab in the center of the whole economy and competing for capital with everybody else. That's something the real estate industry has historically not had to deal with. Historically we have had allocations from insurance companies, we had savings and loans that were basically created to finance real estate and we had pension funds that adopted the philosophy of asset allocation, thereby allocating a percentage of a very rapidly growing pot to real estate.
Now, the real estate industry has become part of the mainstream and has to compete for capital with everybody else. Therefore, at times such as now -- in a very speculative environment -- the prospects of 15% return and stability aren't as enticing as the multiples in dot-com land.
I gather from the tenor of your comment that you don't think that's sustainable.
I don't think I'd be the
if I suggested that wasn't sustainable. All you have to do is try to apply any kind of a present value to all the dot-com valuation and you can't get there. So something has to give.
Does it worry you at all that once that gives, it will have an impact on the real estate markets?
I don't think there is any question it will have an impact on real estate. To some extent the tremendous demand on the office side -- especially in certain areas of the country -- is very much dot-com driven. Yet the companies signing those leases really have no creditworthiness. And so, clearly that is a risk to the real estate industry.
If dot-com land were short-term phenomena then I would suggest to you that was a really big risk. But I believe that the technology is extraordinary and that the network it creates will change how we all do business. Consequently, I think there will continue to be lots of demand although maybe we will have a "musical chairs" kind of environment. That still represents risk to real estate.
Say we have residential tenants in our apartment building that are employed by dot-com companies that don't make any profits. They have relatively low salaries and high option plays, which means when they lose their jobs they have no safety nets. Therefore, it isn't like renting to an autoworker who has supplementary employment insurance or other people. These companies have no safety nets therefore their employees have no safety nets. So, for sure, it's changing the risk. Hopefully, we are extracting additional revenue to cover the risk.
The Tech Effect on REITs
You say this is long-term technology that will change the way we do business. How will that impact companies like Equity Office?
It affects companies like Equity Office by first and foremost pushing us to provide excessive broadband capacity to all of our building. We recognize that broadband capacity -- far beyond where anyone thinks is necessary today -- will be in demand tomorrow. So, step one is to make sure our customers have access.
Step two is to understand what parts of our business might be more easily adaptable to the existence of the Web, whether it be billing procedures or sourcing suppliers and various other things in which the disintermediation impact of the Web is a relevant issue. So we have to be aware of that.
On the other hand, we don't see any diminution in the need for office space. We don't think there is some kind of virtual office in everybody's future. We believe a critical part of a business's success is the interaction of people.
As the technology grows, so too does the need of early-stage technology companies for office space. The acquisition of Cornerstone along with some personal holdings gives you insight into the leasing patters in technology hotbeds like Silicon Valley. What are your impressions of the creditworthiness of these companies? What kind of guarantees do you need to feel comfortable leasing to these New Economy players?
First and foremost is that the landlord does not provide capital improvements. So, the space the landlord has on day one is replicable on day 10 if there is default.
When you have creditworthy tenants, you effectively provide tenant improvements that are amortized over the term of the lease and you have the creditworthiness of the lease to cover your expenditure and your exposure. In the case of embryonic companies, we have no reason to risk that kind of a scenario. So, therefore, you start by saying the tenant improvement problem is yours, not ours.
Second of all, we tend to get one-year letters of credit so if there is a default, we have a period of time to extract the tenant and to resecure tenants for the property.
There has been a trend among private property owners and some REITs with New Economy tenant exposure of accepting warrants and pre-IPO stock in lieu of cash rent. What are your thoughts of riding the wave of some of these early-stage companies?
I believe to the extent anyone does, they are venture capital investors, plain and simple. A company the size and scale of Equity Office could, in fact, allocate funds each year to venture capital investment through bartering of space for stock. I can't emphasize enough that the decision to take anything less than cash would reflect an investment decision in the idea. And, consequently, I would expect that to the extent that Equity Office ever did that they would do it in the context of having really done significant due diligence -- or would have gotten someone else to do so -- and they had accepted the idea.
Where Have the Good Times Gone?
Let's return to the performance of REITs over the past two years. You indicate that one reason for the decline is more competition for capital from traditional real estate investors. However, all REITs have significantly underperformed in the past two years. Are there other reasons that account for the declines?
have significantly underperformed in the past couple of years. The companies, generally, have performed quite well. And I think if you "believe" in ultimate recognition of value to the extent that the companies continue to perform as well as they are performing, I would argue that there will be a catch-up.
Would you care to predict when the catch-up will occur?
More likely sooner than later and more likely in the next year than two or three years out.
Back to the reasons for the decline in share prices, are there others?
If you accept my thesis that the excitement over the REITs was very much the function of the recognition of a sorely underperforming sector about to become an overperforming sector, I think you also have to not forget about history. The real estate industry as a whole has not conducted itself with great acclaim in the public markets in the last 15 years.
Whether it's the old real estate investment trusts that were created in the early 1970s that basically took $24 billion and turned it into $11 billion in 24 months, or the public sale of limited partnerships in the 1980s, or the flurry of new activity in the mid-1980s where large private owners took their least desirable properties and foisted them on the public. I think that, combined with a very historically wild and cyclical nature of the business, certainly create ample basis for trepidation.
Having said that, I would say to you that the transparency of the public markets has in fact created a governor on the cyclicality. If you go back to the beginning of 1998 when the real estate industry looked like it was just going to explode from oversupply, there has been, in effect, a real tempering of new development since then, combined with the lowering of stock prices. That proves that where you have transparency, you really have a much higher level of knowledge and a greater level of discipline. I think the real estate industry as a whole is much more disciplined today than it ever has been.
In the same manner, the financial sources to the real estate industry -- because the real estate industry has moved into the mainstream -- have options and therefore you don't get the overallocation of capital to the industry that in the past has led to the cyclical downturns from oversupply.
Accounting for Accounting
I would like to extend the transparency conversation. You commented that, from a supply standpoint, the real estate industry is more disciplined than ever. There is another transparency issue -- financial and reporting transparency -- that you have been very involved with as chairman of the
National Association of Real Estate Investment Trusts
. There are many -- both inside and outside the industry -- that have been critical of REITs and stayed away from investing in REITs because of accounting issues. Is that as significant a problem as those who level the criticisms suggest?
I would think not. I think that further clarity is everybody's goal. Uniformity is everybody's goal. And I suspect that over the next few years you will see additional changes.
Having said that, the accounting "boogey man" is certainly a wonderful whipping boy for what in reality is a less attractive alternative in a very speculative market.
We didn't hear a lot of talk about accounting issues in 1996 and 1997 when the going was good. Are you suggesting that "when you're down, you're an easier target?"
Of course, of course, of course, by definition. It takes a lot less reasoning to buy a stock than to sell a stock. But you can also talk to what I call long-term players in the stock markets and they'll tell you their biggest hits have come from accumulating "out of favor industries" that were performing extraordinarily well. And right now that is what the real estate industry is.
Along those value lines, I'd like your thoughts on perhaps the most famous value investor:
. In the last 18 months Mr. Buffett has been buying REITs. Do you think his entrance into REITs is interesting?
Not really. I have nothing but admiration for his extraordinary investment prowess. I haven't really understood, however, why he was investing in the REIT industry. He certainly hasn't made his reasons clear. And based on his choices of REITs to invest in, particularly the first two --
Town & Country
-- there may be something there I am missing that makes them extraordinarily attractive. But certainly Warren Buffett's reasons for involvement in the real estate industry to date have not been transparent.
As far as
is concerned, they are much more of a Buffett type of investment as they are a leader in their industry and they have a thesis that may in fact prove correct. I can see where you pick one of the major players. The other two are more minor players in the industry.
Were you surprised that either Equity Office or Equity Residential weren't on his shopping list?
Only because I don't know what his criteria were. And based on his first two choices, I wouldn't want EOP and EQR to be in the same genre. But I've never used Warren Buffett as a basis for my decision-making process and I can assure you that I'm unlikely to do so in the future.
Let's explore the big picture in real estate and peer into the future -- say five years at the various property types. We can begin with the office sector. What's likely going to happen with office REITs in the next five years?
I think we will see the emergence of two or three major players that represent the most significant parts of the market. Some of the smaller ones will be gobbled up and some of the other smaller ones will simply disappear into the sunset.
Does that mean they become private?
They may still be public, but they will seem private. I think that the definition of success will be quite different than it is today. I think there will be a lot more focus on auxiliary income and synergies and networking and brands. And, in fact, as opposed to looking at them as just real estate companies, they will be looked upon as service companies. That's what I see five years from now in the office market.
For part 2 of the Streetside Chat, click here.
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback at