More than 500 industry professionals gathered at the historic Millennium Biltmore Hotel in downtown Los Angeles on Nov. 7 for the 2001 Annual Real Estate Finance & Investment Conference. The theme of this year’s event, organized by UCLA Extension and sponsored by National Real Estate Investor, fit the mood of the country: "Tough times, tough questions, tough answers."
Panel discussions focused on a variety of finance topics, including the changing capital markets, construction financing, mezzanine financing and 1031 Exchanges, as well as opportunity and pension funds. In addition, two panels focused on technology: the digital revolution and how it’s reshaping the American landscape, and the future of California’s economy in the aftermath of the dot-com wreck coupled with an energy shortage.
The main event was a "Town Hall Meeting with Sam Zell," billionaire and chairman of the board of Chicago-based Equity Group Investments LLC. Zell 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.
Zell kicked off the day’s events with some prepared remarks. The self-proclaimed "grave dancer" stated that the current recession began at the end of third-quarter 2000 and is a reflection of the excesses of the past four to five years, a period he describes as one of irrational exuberance in large part because of the technology craze. According to Zell, the liquidity the government has injected into the economy in the form of tax cuts and airline bailouts will lead to inflation. Nevertheless, he foresees economic recovery taking shape in the second half of 2002.
As part of the town hall meeting, the always outspoken and sometimes irreverent Zell sat down with NREI Editor Matt Valley to answer questions about building insurance and security, investment strategy, the technology revolution, the future of REITs and other timely issues.
NREI: Sam, in the wake of Sept. 11, terrorism insurance has become a critical topic for the commercial real estate industry. What impact might this issue have on new development, and what efforts are NAREIT [National Association of Real Estate Investment Trusts]and other organizations undertaking 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 depending on how the insurance companies react. If I were betting, I’d bet that before it’s over the insurance companies will figure out a way to cover this risk without federal government involvement, maybe through a pooled approach or something like that. 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: How long will it take for the insurance industry to sort this problem out?
Zell: I wish I knew. I don’t think it will be long, but I can’t answer that question.
NREI: In the wake of Sept. 11, how much money has Equity Office invested in building security measures?
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 on dramatically increasing security and the costs thereof.
NREI: What does the future hold for high-rise buildings?
Zell: I think that everybody is overreacting. 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. And they were 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: Let’s talk about strategy. Given that we’re in an economic period that you describe as 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, and we have a five-and-a-half year average exposure to them, and our job is to make the optimum out of that five-and-a-half years. Clearly in today’s environment, contact, interface and responsiveness to the needs or fears of our tenants is a critical element to creating long-term confidence. There is little doubt in my mind that on a national basis that 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. And I think that in this environment, service and attention to your existing tenants is the most valuable effort you can make.
On the question of acquiring new tenants, I think that to some extent you have a Gulf War scenario going on right now. You have a giant strike [delay] by decision-makers. But just like in the Gulf War, you can delay the decisions for just so long. Two years ago, everybody was anticipating what their [space] needs might be. Now everybody is saying, "If I absolutely have to do that I’ll do it, but I’m certainly not going to anticipate it, and I assume that you’ll always be available to me when and if I need it." That is the classic conundrum of somebody who’s making that assumption until they find out that it’s not available.
NREI: You mention branding. In the apartment sector, Post Properties certainly comes to mind. Are there any other companies that reflect that branding capability?
Zell: Well, I think Post Properties, Equity Office, Boston Properties, Equity Residential, Archstone-Smith. The field of companies are focused on understanding that what they really have is a potential franchise. And the question is: How do they execute? And how they execute will ultimately determine the winners and the losers.
NREI: I’m going to read you a comment written by David Shulman, managing director of REIT equity research for Lehman Brothers, following the annual NAREIT convention in early October and the events of Sept. 11. Shulman writes: "We would characterize many of the CEOs that we met with [at NAREIT] as more reactive than proactive in the current environment." His analysis goes on to say that 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. Do you agree with his assessment?
Zell: Meaning that REITs are reactive as opposed to proactive? I know David very well. I’ve disagreed with him in the past. And I have no problem disagreeing with him now. It’s very hard to call REITs reactive when in the last nine years they’ve gone from $6 billion to $150 billion of equity, when they’ve in effect created Equity Office, Boston Properties and Equity Residential and Archstone — huge, sophisticated companies really making a contribution. The fact that the S&P 500 now includes EOP, and I think will include other companies in the near future, reflects that the real estate industry today is dramatically different than it was in the past. And in fact the industry is being run by probably the best group of executives this industry has ever supported, certainly in the last 50 years.
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 that the industry appears to be in a holding pattern at the moment?
Zell: I think you have an environment right now where perhaps the perception of the unknown is far greater than the reality of the unknown. The people who are waiting to sign the lease until the last possible minute have the same mentality as the buyer and the seller in a consolidation situation. 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? What a stupid decision to make to go into Silicon NREI and San Francisco just when everybody knew there was no future to it."
We went out there when Spieker approached us and we said, "Here’s the basis upon which we can explore doing a transaction, and that means we can’t accept $80 rents per sq. ft., even though you’ve got them someplace, and if you’re willing to go forward on that basis we’re prepared to underwrite and see how we do."
Interestingly enough, that deal was announced in February of 2001. Yesterday, on the plane coming out here I reviewed an update on the Spieker transaction. The funny part about is that both revenue, cash flow and everything are pretty much where we thought they’d be when we underwrote the deal in February 2001. Obviously, in the early part of that period it looked like we were going to get a huge windfall. Then everyone was afraid we were going to get killed. The reality is we did the underwriting correctly and we had the guts to go forward and close the deal.
My guess is it’s that kind of commitment or belief where we are that’s allowed us to go forward and do those transactions, but I think it’s real hard to do that. You need a big base so your stockholders don’t get scared.
NREI: REITs can grow through acquisition and raising revenue by offering services. What are you doing right now to boost revenues?
Zell: We’re focusing on blocking and tackling. We’re focused on the retention of our tenants. We’re focusing on being responsive to individual market opportunities. As a company, we have 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 we’re having there is going to 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. As an example, at Equity Residential I believe that our costs will be less next year than they were this year because there is such a focus on maintaining levels of profitability.
NREI: Jones Lang LaSalle, a real estate services provider, announced this week [Nov. 5] that it plan to lay off about 9% of its workforce worldwide, or 700 workers. Meanwhile, Cushman & Wakefield reportedly has already laid off 70and 80 low- to mid-level managers nationwide. Are we likely to see more layoffs during the next six months?
Zell: Well, as I said a few minutes ago, 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 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 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 lead to a closing of the gap between the bid and the asking price because sellers are now more realistic?
Zell: I think you’ve got to define the world 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: Let’s talk a little bit about technology. In your opening remarks here today, you were a bit critical about technology, but doesn’t it drive the very efficiencies you speak of.
Zell: I think technology is the ultimate definition of human capital. I have no problem with technology, just like I have no problems with real estate. But if you overbuild the real estate market, you’ll get screwed. If you overbuild the real estate market, you get screwed. If you overbuild the technology market you get screwed. The only difference is that if you overbuild the real estate market maybe you lost 20%, you overbuild the technology market you lose 100%. So, the risk/reward ratio is very different in technology. But there is little doubt in my mind … I mean 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 them where the next call is and let’s them check off the last call. Technology’s biggest impact on real estate will be to make real estate more efficient, not necessarily generating significantly greater revenue for real estate.
NREI: What’s your thinking about the ability to pay rent online? There were a number of industry players who assumed there would be great demand among tenants for that type of service. Are we seeing other instances where the anticipated demand hasn’t materialized?
Zell: I don’t know what the great benefit of being able to pay your rent online means. I don’t get it, but maybe people get a charge out of punching a button and paying their rent instead of writing a check. But that’s an example of a lot of applications for which money was raised and for which there was no real serious demand. I think a lot of that money that was just wasted. I haven’t heard this phrase in a year now, but there used to be a phrase called "Internet time," where you have a whole bunch of overeducated, inexperienced people defining the time factor as yesterday. In the case of broadband, instead of wiring one market for broadband and making the market work, the VCs (venture capitalists) said you’ve got to have a footprint across the whole country, so by definition every single one of these guys went broke because it was a model that couldn’t really work. There is nothing wrong with technology. 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 this most recent period you speak of, where were you on that curve in terms of interest?
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 VCs, 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 to make it work, they threw away $200 to $300 trying to make a national footprint that could never break even.
NREI: So, the lesson learned from that whole experience is .…..?
Zell: The lesson learned from that whole experience is don’t turn over the company to VCs. They don’t know their head from a whole in the ground.
NREI: Given the tough economic climate that we are in right now, does it require a different kind of employee today than a year or two ago?
Zell: Let me rephrase your question and back up and say that the real estate industry as we know it needs different kinds of employees going forward. We are going to be more involved in marketing, we’re going to need more sophisticated communications. We’re going to need more different kinds of people with different kinds of skills as opposed to the classic definition of real estate skills that includes your ability to influence the zoning board. I think it’s going to change the overall way the real estate industry is populated. 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. I think that these companies have truly become major operating businesses that require the kind of sophistication and knowledge from an operational point of view that are similar in major U.S and homes.
NREI: But will it require someone with a real estate background, or is that not necessarily and critical?
Zell: I think that the real estate skills are both learnable and . The guy running the company today may not necessarily have to be a real estate maven, an operational maven but not necessarily a real estate maven.
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 thing coming down the pike for commercial real estate?
Zell: In the next 10 years, rent as a percentage of operating cost is going to continue to decrease. Just like the U.S. commercial real estate market probably represents probably 15% of the GNP, I think that by the year 2010 that number will be 10%. Ten years ago, every company’s second biggest cost after employees was real estate. Today, telecoms, information technology and all that stuff dwarfs real estate in terms of its cost to business. As real estate costs become less of a factor, I think it will change our business. I think that it will promote branding. I think you will see companies in effect handle their real estate needs almost in an outsourcing fashion, where the name of the game is delivery of the product, delivery of the service and confidence in the security. It will be that approach as opposed to the classic scenario of sending somebody out on the street to get the lowest possible price.
NREI: As you look back on your career, how has the evolution of the commercial real estate industry actually evolved vs. how you thought it would evolve?
Zell: I’ve been in the real estate business for 40 years, and the first 30 were spent on the private side in a very unique scenario where we had our own dedicated lenders, and then it all came to an end in 1990. Probably the biggest single issue was the elimination of dedicated lenders, people who in effect at the start of the year said, "OK, we have $12 million to invest: $3 million in real estate, $4 million in bonds and $5 million in equities," or whatever the ratio was. And once that money was allocated, it was spent no matter what. Today, the largest mortgage lender in the country is Teacher Insurance and Annuity Association. Today, Teachers has a desk, and they sit there and look at real estate business offers, they’ll look at corporate side offers, and they look at their balances and make decisions based on that. We as an industry for the first time have to compete with everybody else for capital. The days of real estate being special, or having a specialized flow of funds, are over. And I think that’s extraordinarily healthy. That competition for capital also is a major factor in explaining how for the first time since World War II, one year after the start of the recession real estate is not in massive oversupply.