In this one-on-one exclusive interview with NREI during the Building Owners and Managers Association convention, mega-real estate guru Sam Zell talks about life in the REIT lane and why bigger is better.

Sam Zell is a true American character. He speaks his mind, whether you want him to or not. And he doesn't always say what people want to hear, which is rather refreshing. Still, the commercial real estate industry puts great stock in what the man says because success talks and paupers listen.

After his keynote speech at the recent Building Owner and Managers Association (BOMA) convention in Boston, I had an exclusive, one-on-one chat with Zell about the state of the real estate industry, his thoughts on being a major REIT player and where the industry is going.

Q: Let's start with office buildings. Most of your acquisitions have been financially distressed A or B properties in A locations. What is going to happen to all of the B, C and D building stock in this country?

Zell: I had a conversation with Mayor Daley (of Chicago) about this recently. Almostany way you out it, I don't know. We live in a 1927 building in Chicago as our home office. And we've spent millions making it work for us. But for us, it's like a build-to-suit. We own the building. But if this was a quote `commercially owned' building, it'd be half empty now because it makes no sense.

I'm buying a brand new office building in downtown Los Angeles for $75 a foot. It costs me $75 a foot to rehab old space. You don't have to be a rocket scientist to figure out there's a problem. And I'm talking about a B building. If you go on to the Cs and the Ds, they are just gargantuan dinosaurs. New York, Chicago, San Francisco. But it's not just them. It's Dallas, too.

Remember part of what's happened is that the '80s redefined the definition of an old building. I bought the LaSalle Bank Building in 1978. It's 1.2 million sq. ft. and it was built in 1935. I sold it in 1982 because I saw what was happening. Th building isn't going to fall down, investor point to view. The real issue is how can you justify investing the kind of capital into the building that it requires just to bring in a new tenant.

Q: You've said that there won't be a lot of new speculative building in the office sector, but there is an awful lot of capital available for investment out there now. Why won't the industry repeat its past mistakes?

Zell: We bought a building in San Francisco called One Market for $220 million. We went out to finance it and we got eight bids from lending institutions and all eight of them competed on price. Nobody competed on amount. All eight of them offered me mortgages of somewhere between $135 and $145 million. But nobody pushed the limit. You go back to your Thursday night parties in Dallas and look around the room and tell me who in the room had 40 % equity. Without other people's equity money, you can't do it.

If you go back and study all of the oversupplies, all are a result of excessive loan-to-value, thereby reducing the developer's risk. When you reduce the developer's risk he becomes insensitive to building. If you don't have to put up real money -- your money -- and you don't have to take risk, then your ability to be an optimist is unlimited. It's an edifice complex.

Q: A lot of office tenants are going to face sticker shock in a few years when their low-cost leases come due. But we've seen that the incubator growth companies are now a major market factor today, taking little chunks of space at a time.

Zell: It reminds me of all the little oil companies in the '70s. Remember all of the little oil companies that filled all of the office space in Dallas and Houston?

Q: What's going to happen to the tenants that come due here pretty soon?

Zell: Many of them moved into the space because it was cheap, but I think part of what will happen is they will renew in half the space. If they took space at $12 a foot and now it's $24, they've got to find a way to get there. I think a lot of them are going to move out because they can't afford it. If you've got one of these copper and marble downtown mausoleums and the guy's paying $12 a sq. ft., there are lots of options still in new buildings where his cost of occupancy will be less. So I think you're going to see some of that. I think you're going to see some downsizing in response to that. And as they start getting near the end of their leases, instead of taking more space as they grow they're going to reconfigure their own space and start taking that square foot per employee down. And frankly, some of these companies could afford to pay $24 a foot to begin with but they got a free ride.

Q: I'm sure you remember when everyone was denigrating the so-called vulture funds and you won your nickname "the grave-dancer." Are you a long-term player?

Zell: I don't know anybody in the country who's a more long-term real estate investor that I am. I graduated from law school in 1966, I bought an apartment complex in Toledo, Ohio in 1966, I paid off the mortgage in 25 years. I own it. There aren't very many people who can say that.

By virtue of necessity in order to 'raise the money' and create a fund, the fund has to have a terminal date, so 10 years was the terminal date. But when I went out and I personally raised all the money I looked everybody in the eye and said there is a 10-year terminus here and if in 10 years you want us to liquidate we will. But the reality is that I believe that over the next 10 years the shortage of streams of income eminating from brick and mortar is going to make those assets that we've acquired extraordinarily valuable. I believe that one partner will buy out the other or we'll roll the whole thing up and take it public. And that's what we're going to do, roll the thing up and take it public. That's going to basically mean that we're perpetual owners.

Q: You've said that bricks and mortar will outperform any other asset class. So what will it take for the funds to come back to the investment table?

Zell: A lot of the funds that got burned badly have come back into the real estate world through Zell/Merril, through the slice-and-dice funds. This whole issue of direct versus indirect financing is a huge issue. Every insurance company in the country is dealing with this issue. The reality is that you can't make a case for direct versus indirect. It's not then core business number one. Number two, in the old days, you couldn't buy Sam Zell. But now CalPERS can buy Manufactured Homes, Equity Residential and EOP (Equity Office Properties) and they can see them for free. And they get Mel Simon for free. And they get Smith in Washington, D.C. for free. And they get Beacon here in Boston for free. And they get Don Bren for free. The justification for direct was that the real estate industry per se didn't have a mechanism whereby you could invest in Sam. We all had to go public and now can have me for free. Now instead of you putting up all of the money getting a preference, you buy it and sell it, mark to market, that is the single major issue.

The European story is fascinating because they're way behind us in equitization, but they are obsessed with it. ABP and Rodamco are taking positions in all these REITs. They took a major position in Zell/Merrill Four. Why? Because we're going to take it public. Whereas normally they're the lagard, in this particular arena, they're just the opposite.

Q: You've said there are too many REITs. Is consolidation really ever going to take place?

Zell: Slowly but surely it's becoming irrelevant. Why? Let's take FOR (Zell's apartment REIT Equity Residential). EQR's got 70,000 apartments. We bought a portfolio from Balcor a few weeks ago that's bigger than half of the REIT in existence in the apartment arena. Whereas in the early stages of consolidation we would say, 'We'll pay a premium to get this one or that one,' now all of these 10,000 and 45,000-unit REITs are nonexistent. EQR's G&A is 2%. Ninety percent of all the other apartment REITs, their G&A is 5 1/2% to 6%. When EOP (Equity Office Properties) goes public, it's going to put enormous pressure on Bearcon, on Carr and Cali and all of these guys because we're so much bigger. The point is, if they're at 6 million sq. ft. and we're at 32 million sq. ft., we're going to go to 45 million and they're going to 8 million. Now let's talk about economies of scale. Let's talk about G&A. Let's talk about public company costs. Let's talk about financing costs. The idea that EQR can go into the public market and do spot secondaries, and sell unsecured paper. All of these things are available to us because we're so big and we have such economy of scale. So little by little, the consolidation issue becomes irrelevant.

Q: You don't strike me as a person who worries about your stock price on a daily basis. Do you wish the market would do a better job of valuing you shares?

Zell: Sure I wish they would. But it comes down to do I really care what my share price is in the next 30 days or the next 12 months. No. We have done 11 or 12 secondaries in EQR in three years. That means we have almost perpetually been in the market. And people complain, "How is the share price going to go up if there is an unlimited supply of new capital)?" My answer is I'm not real worried about my share price tomorrow. I'm worried about taking advantage of what I believe is a unique opportunity where there are still an enormous number of apartments in what I call 'involuntary hands.' And I've got to be there with a bushel-basket and if that means that my stock price doesn't do good or I keep raising new money for two or three years so be it. But what I'm going to own is going to be irreplaceable and unique, and I'll have the economy of scale to run them more efficiently than anybody else.

Let's assume that EQR probably has a 50-basis-point advantage over anybody else. So now you put your apartment building up for sale. If I paid exactly the same as somebody else, I'd get a 9% return and he gets 8 1/2%. That's what's going on.