Using a football metaphor, billionaire Sam Zell told a crowd of more than 500 commercial real estate executives gathered in Los Angeles that the focus of owners should be on blocking and tackling. In other words, tenant retention.
“The real estate industry historically has not focused enough on the importance of customer relationships and customer service. Responsiveness to the needs and fears of our tenants is a critical element of long-term confidence,” explained Zell. His comments came during the 2001 Annual Real Estate Finance & Investment Conference held at the Millennium Biltmore Hotel on Nov. 7.
In a spirited interview conducted by NREI Editor Matt Valley, Zell also chastised venture capitalists for letting the technology boom in the late 1990s get out of control.
The “Town Hall Meeting with Sam Zell” was the main event at the UCLA Extension program. The conference focused on a variety of finance topics including the changing capital markets, construction financing, mezzanine financing and 1031 Exchanges. In addition, two panels focused on technology, including the dot-com fallout in California and its effects on the state's economy.
Zell, chairman of the board of Chicago-based Equity Group Investments LLC, also serves as chairman of both Equity Office Properties, the nation's largest REIT with a market capitalization of $12 billion, and Equity Residential, the largest publicly traded owner of apartments in the U.S.
Following the delivery of some prepared remarks, Zell answered questions about building insurance and security investment strategy, his own experience with venture capitalists and other timely issues. What follows is an edited transcript of that exchange.
NREI: Sam, in the wake of Sept. 11, terrorism insurance has become a critical topic. What steps are being taken by NAREIT [National Association of Real Estate Investment Trusts] and other organizations to combat that problem?
Zell: I think that the basic insurance capability is there to insure except for spectacular, catastrophic-type events. NAREIT and the industry have been working with Congress to create a scenario where the federal government would become the insurer of last resort. Obviously, there are political and philosophical elements to this [approach], and I think we'll find out whether it happens or not to a large extent depending on how the insurance companies react. I'd bet that before it's over, the insurance companies will figure out a way without federal government involvement to cover this risk, maybe through a pooled approach. I think that there is a growing fear in Washington that we're over-responding to Sept. 11, and creating a scenario that we'll end up paying for in the future.
NREI: Followi ng Sept. 11, how much money has Equity Office invested in building security?
Zell: There is no question that security measures in all of our buildings have been dramatically upgraded. I can't give you a number as to direct cost, but I will tell you that most of those costs are passed on to the tenants. And whereas other examples of passing on costs created some levels of friction, I don't think we've had any friction [from tenants] whatsoever for dramatically increasing security and the costs thereof.
NREI: What's the future for high-rise office buildings?
Zell: Do I think there's going to be any more 100-story buildings? No. Do I think the country needs any 100-story buildings? No. Do I think 100-story buildings were ever economical? No. They were just phallic symbols in an environment where we lived in la-la land and thought we were never vulnerable. A construction guy once told me that the most efficient building possible is 50 stories. And my guess is that's where we'll go. I don't expect that we'll have any significant issues either renting space or running [high-rise office] buildings going forward.
NREI: Given that we're in an economic period that you predict will be difficult for the next six months, what's the best short-term strategy for commercial real estate owners?
Zell: Take care of your best assets, your tenants. When it's all said and done, the real estate industry historically has not focused enough on the importance of customer relationships and customer service. We at Equity Office Properties (EOP) like to say that our assets are our tenants. We have a five-and-a-half year average exposure to them, and our job is to make optimum use out of that five-and-a-half years.
Responsiveness to the needs or fears of our tenants is a critical element of long-term confidence. There is little doubt in my mind that on a national basis we are beginning to see the branding of real estate. Branding by definition means that you look at an asset and you have an expected level of service and attention.
NREI: David Shulman, managing director of REIT equity research for Lehman Brothers, recently wrote the following on the heels of the NAREIT convention: “We would characterize many of the CEOs that we met with [at NAREIT] as more reactive than proactive in the current environment.” Few REITs have significantly altered business models other than assuming stricter underwriting standards, going for occupancy at the expense of rents and enjoying historically low interest rates following Sept. 11, according to Shulman. Do you agree?
Zell: It's hard to call REITs reactive when in the last nine years they've gone from $6 billion to $150 billion of equity. Equity Office, Boston Properties, Equity Residential and Archstone are sophisticated companies really making a contribution. The fact that the S&P 500 now includes EOP shows that the real estate industry today is dramatically different than it was in the past.
NREI: Equity Office completed the acquisition of Spieker Properties earlier this year. How much consolidation are we likely to see over the next year, given the economic climate?
Zell: The buyer and seller in a consolidation situation have the same mentality as tenants who are waiting to sign the lease until the last possible minute. They don't want to buy the asset or the company and have it fall apart.
When we announced the Spieker transaction, everyone said: “Oh my God, how could Spieker have sold out so cheap?” Then a month later it was: “Can Zell get out of the deal? What a stupid decision to go into Silicon Valley and San Francisco just when everybody knew there was no future to it.”
Yesterday, I reviewed an update on the Spieker transaction. Both revenue and cash flow are where we thought they'd be when we underwrote the deal in February. The reality is we did the underwriting correctly and we had the guts to go forward and close the deal. It's that kind of commitment that's allowed us to do those transactions, but I think it's real hard to do that [in this environment].
NREI: REITs can grow through acquisition and by offering services. What are you doing to boost revenues?
Zell: We're focusing on blocking and tackling, the retention of our tenants, being responsive to individual market opportunities. As a company, we have a unique advantage over most everyone else, and that is we have giant concentrations in markets. So we have the ability to move tenants and better suit their needs.
We're also using the time to really focus on what we can take out on the expense side. We're running an experiment in Boston right now where we took all the building managers out of the buildings and created a central maintenance office to service all of our properties. That experience will end up being part of an overall plan to reduce our costs. We'll continue to look for additional opportunities to take advantage of economies of scale to drive down costs.
NREI: Jones Lang LaSalle, a real estate services provider, announced this week [Nov. 5] that it plans to lay off about 9%, or 700, of its workforce worldwide. Meanwhile, Cushman & Wakefield reportedly has laid off 70 brokers and 80 low- to mid-level managers nationwide. Will we see more layoffs during the next six months?
Zell: We're in an environment of reduced velocity. Companies like Jones Lang LaSalle benefit by transactions, and they're affected by the lack thereof. You have the healthiest real estate balance sheets in history, so therefore the seller doesn't have to sell and the buyer doesn't have to buy. The net effect is we've had all kinds of transactions in the last six months where the bid and ask [price] is wide and nothing happens. In the past, the seller had to make a deal. Something had to happen. That's not the case today.
NREI: Wouldn't the events of Sept. 11 close the gap between the bid and the asking price because sellers are now more realistic?
Zell: I think you've got to define the word realistic for me. Let's say for discussion purposes that I own a building and I'm earning a 10% return on what somebody wants to pay me for it. Am I under great urgency to do anything when I'm getting five times the risk-free interest rate as cash flow? I could argue that maybe I shouldn't sell the building because interest rates are going to stay this way, and if I could refinance at 4% instead of 8%, it's even a better deal.
NREI: In your opening remarks today you were a bit critical of technology, but doesn't technology drive the very efficiencies you speak of?
Zell: Technology is the ultimate definition of human capital. I have no problem with technology. If you overbuild the technology market you'll get screwed, just like if you overbuild the real estate market, you'll get screwed. The only difference is that if you overbuild the real estate market, maybe you lose 20%, but when you overbuild the technology market, you lose 100%. So, the risk/reward ratio is very different in technology.
EOP and other companies have spent a fortune putting all their internal [operations and information] on the Internet to be efficient and responsive. We're using Palm Pilots. Every maintenance man in the country at Equity Residential has a Palm that tells him where the next call is. Technology's biggest impact on real estate will be to make real estate more efficient, not necessarily generating significantly greater revenue for real estate.
On the other hand, there was an unbelievably stupid expectation that broadband usage would just go through the sky, probably just like in 1985 there was the same kind of conviction that office rents could go to the moon and that we could keep building forever. Neither one of those expectations has proven to be the case.
NREI: And during the technology craze of the 1990s, where were you on the technology curve?
Zell: I put up the original money to create one of those broadband companies. And because I was in the real estate business, I turned it over to the venture capitalists, and they ran it into the ground doing exactly what I just described. Instead of trying to do it in one market or two markets, they threw away $200 or $300 million trying to make a national footprint that could never break even.
NREI: Given the tough economic climate that we are in right now, is a different kind of employee needed today?
Zell: We're going to need different kinds of people with different kinds of skills as opposed to the classic definition of real estate skills that include your ability to influence the zoning board. I wouldn't at all be surprised if the CEO from one of the top five REITs in the next three years comes from General Electric, Procter & Gamble or Boeing. These real estate companies have truly become major operating businesses that require the kind of sophistication and knowledge similar to [other major industries].
NREI: Sam, in the early 1990s, we had the emergence of CMBS. Then there was the re-emergence of REITs, followed late in the decade by the technology revolution. What's the next great change for commercial real estate?
Zell: In the next 10 years, rent as a percentage of operating cost is going to continue to decrease. The U.S. commercial real estate market represents probably 15% of the GNP. By 2010, that number will be 10%. Ten years ago, every company's second biggest cost after employees was real estate. Today, telecoms and information technology dwarf real estate in terms of its cost to business. As real estate costs become less of a factor, they will change our business and promote branding. Companies will handle their real estate needs in an outsourcing fashion, where the name of the game is delivery of the service. It will be that approach as opposed to the classic scenario of sending somebody out on the street to get the lowest possible price.