A penchant for the "investment grade," available money and quick closure allows Equity Office to make the most of every opportunity.
What do you call a company that buys seven "trophies" totaling 4.2 million sq. ft. in 1995, and fights a tough, but losing, battle for control of New York's Rockefeller Center? Equity Office, based in Chicago, has over the last few years amassed an impressive portfolio of office properties through a combination of timing, resources and recognition that the landscape of office building ownership has changed dramatically.
Founded in 1976, Equity Office, Equity Office Holdings and Equity Office Properties are all teathered under the Equity Group Investments entity, which is Sam Zell's private parent company.
Today, Equity Office has built itself into a national company, with six offices located in Chicago, Washington, D.C., Atlanta, Houston, Denver, and Los Angeles. Its portfolio of 32 million sq. ft. of space sits at about 92% occupied.
One of its highest profile acquisition targets last year was New York's venerable Rockefeller Center, but after three to four months of intense negotiation, Equity lost out to an investor group led by Goldman, Sachs & Co., David Rockefeller and New York developer Jerry Speyer.
"We have stayed focused and disciplined to what we have to have in quality of asset and returns, focused on markets and properties. That's the main thing that's making us successful," says E. Valjean (Val) Wheeler, Equity Office's president and chief operating officer. "If you look at our acquisitions, I'd say we're pretty consistent in buying 10-15 properties a year. Our pattern has been pretty consistent. When you get to be the eighth-biggest, I guess people pay attention to you more. There are more sellers out there today as markets have improved."
Some might say timing is everything, but Equity seems more than just lucky.
"We have been fortunate that when the markets are at their very lowest, we had the ability to have the capital to go buy those properties at that point in time and we've been able to incubate those properties as the markets improve. As the office market becomes much more financially feasible, we are now filling these buildings up and coming out, which we think is the right time to show the increasing values that we can do," says Wheeler.
If there is a commonality among Equity Office's properties, it is distress in one form or another, where the owner is motivated to move the property off of their books or the asset has fallen into a marketing black hole.
An evolution in the seller community has played right into the Equity strategy.
"In 1988 when we first started the (Zell/Merrill Lynch) funds, they were primarily developers that were in trouble and were about to lose the property. They were banks that were under scrutiny by the regulatory authorities that they needed to get rid of the assets. That trend followed into the early-'90s, and then with Fund II and with Fund III we found our-selves going from banks in trouble to insurance companies that wanted to reduce their office exposure, but were not as reluctant of an owner as in the 1988 to 1992 period. That seems to be still the trend," says Wheeler.
Being a fairly horizontal organization also has helped position Equity to ride the changing tide of sellers. "The acquisition person does a lot of up front work in positioning the asset they acquire. But once that's done the entire team of asset management, property management, leasing and marketing all participate in that due diligence process. So when the investment committee approves the acquisition, we're all part of that acquisition. That acquisition was not made by a small group somewhere off on the floor. We all take ownership, so we're actually hitting the ground running prior to closing. Everybody knows what their role's going to be, we know how we're going to manage the building, we know if we're going to use third-party brokers, or how we're going to do it. None of us gets compensated on how many buildings we buy," says Wheeler. Instead, management's compensation is based on performance.
So how does Equity's team find those properties to buy?
Its four acquisition officers have split up the country into regional territories, and use an extensive database of every office building in every major market and secondary market throughout the country that they would like to own if the opportunity presented itself. "And since there has not been any building since we started the opportunity funds in 1988, that list is extremely extensive and is a list that they continually work from," says Wheeler. "So we identified buildings. We know where they are, who owns them, and it's constantly working that list of buildings. You know what its financial condition is, what the condition of the owner is, and you're constantly working those people to find out if the situations have changed."
And it's not always an overnight process. "It's taken the acquisitions group two to three years to bring some of these to fruition, from when they first identified it and first talked to the owner. The owner was not ready to sell, couldn't sell, didn't think he needed to sell, a lot of different reasons. As time has gone by and markets and their returns continue to dwindle, their attitude changed," says Wheeler.
Certainly Equity's credibility in not only doing deals but closing on them quickly has been an asset.
"One of the things we've been very good at is taking an organized approach to going through the due diligence process and very quickly coming back to the seller with a decision to move forward or reject the deal," says Michael Steele, president of management and leasing. "If we have made the decision to move forward, over the years we have developed a strong credibility with many of the large institutional sellers that we can move forward very quickly as a buyer and complete the deals. It gives us opportunities to see deals where possibly others have not seen them."
Wheeler agrees. "We have acquired buildings that we were not the high bidder on. We are very thorough in our due diligence, we do not re-trade deals unless some physical aspect shows up in due diligence. Most sellers know that about us, and most sellers are more motivated to strike a deal with a buyer that has a reputation for having the money to do the deal, the sophistication of understanding the asset, and closes. You find a lot of people out there today bidding properties up thinking people are going to pay more for them, and at the end of the day they sit down and re-trade the deal. We have a reputation for not doing that because we do our homework on the front end. It's also well known that we've got the capital to make things happen."
What is Equity looking for in an acquisition target? Wheeler says he looks at the quality of the asset itself. Then it comes down to location and market conditions.
"We're not afraid of vacancy. We're not afraid of normal physical deterioration. We're not afraid to redo lobbies. They're basically institutional grade properties. We have return hurdles we want to hit, but you move those around to some extent depending on what you think the asset's going to do short term and long term," says Wheeler.
They refer to their properties as investment grade. "Over the test of time they will not be duplicated. The functionality of the floor plates, the lobbies, the architecture is basically timeless, it's not going to get outmoded. Those are features we look for. And location for sure. We have bought what would typically be in some markets B buildings, but they are in fact in AAA locations."
But here again, more assets are simply lacking the touch that is often needed by a focused team of real estate experts.
"In the late-'80s and early-'90s when we made an acquisition, it was apparent that we had a reluctant owner on our hands. He just simply did not have the capital to keep it up, lease it, etc. Those issues are a little more subtle today because you're now dealing with another tier of seller," says Wheeler.
"Sometimes it's an asset that has been in their portfolio for some time and they've moved on to other investments and maybe they haven't focused as sharply on the asset, given the changing market out there and the changing opportunities that are there if you aggressively go after them," says Steele.
To do its deals, Equity uses a variety of financing tools at its disposal. "A general rule is that leverage is 45%-65% of acquisition price, not value," says Wheeler. "We have, as you can imagine through Sam Zell's long history in the real estate business, a lot of lender relationships. Roughly 40% of the deals we did last year were seller-financed. The other is financing we received at or shortly after closing, when there may be one or two that we put all cash into and elected not to put any debt on it."
Overall the goal is a balanced mix of unencumbered assets, those with fixed-rate debt and those with floatingrate debt. "Those ratios move around, and there are a lot of variables to them, but the financing is an integral part of the acquisition process, and what kind of debt will we or won't we put on it," says Wheeler.
As part and parcel of its deal-making, Equity relies heavily on market research, especially considering the highly volatile nature of today's office markets.
Size makes a difference. "One of the real advantages we have is that we go from our corporate staff of about 150 down to six regions spread across the country and now operate properties in 27 states at a little bit over 30 million sq. ft. of space," says Steele. "At this point, with the exception of the Pacific Northwest, we're actually in most major markets and with our in-house leasing and management teams we're requiring them as part of their normal work to stay on top of what's happening in the submarkets and in the overall markets so that information is always available to us in our databases. One of the real advantages we have is our ability to very quickly mobilize a due diligence team which not only looks at the physical aspects of the property but also looks at the macro and micro market trends and competitive environment that the building's in. So you not only have to know a particular city and submarket, but how that building fits into the niche market and who it competes with and what its advantages are."
Once an acquisition is made, Equity tries to keep the people who are already at the property employed, assuming that they're doing a good job. "In today's market in many cases that in fact is the case. In years gone by, you oftentimes had a property just because of a reluctant ownership that had been really stripped bare. Just as there's been a transition of sellers, there's been a transition at the property level and what exists there," says Steele.
"Part of the due diligence process is putting together a strategic plan for the asset should we buy it so that the day that we close, which is one of the days in the life of a property when it gets a fair bit of press coverage and also interest from the brokerage community, we're already able to move forward with a plan for positioning that property and leasing it up," says Steele.
So is Equity in its acquisitions for the long-term hold? The answer is, it depends.
"For the four Merrill Lynch funds that have been raised, the investors have been told that our holding horizon is from 10-15 years," says Wheeler. "So the investors who have put their money with ours understand that in some of these cases, these are long-term holds, but then by the same token every year when we prepare our annual plans and budgets, one of the things we spend a great deal of time discussing it exit strategy because markets can improve very rapidly and it may behoove us to dispose or sell an asset sooner than later and we have that flexibility."
At this point in time, there isn't much thought being given to getting into the third-party fee management or development businesses.
"The fee side would distract us from what our goal is, and that is to create value in 30 million+ sq. ft. of offices that we own," says Wheeler. "The development side would be ancillary to what we do. We have acquired some properties that have some vacant zoned land to them. So we do have that opportunity when and if they come up."
A good example is 28 State Street in downtown Boston. Equity is repositioning the property in the market with a complete renovation. "Taking an urban building like that and completely refitting it even to the point of repairing the building's skin, is in some ways more difficult than starting off a new development with raw dirt," says Steele. Equity has just signed its first major tenant, SmithBarney, to 47,000 sq. ft. to kick off the building's leasing program.
"Within the management and leasing group, we not only have the management and leasing people looking at the asset in terms of evaluating it within their own areas of discipline, but we also have engineering and architectural people who are looking at these assets too. Internally, we can move very quickly to make those types of judgments," says Steele.
Like a lot of other real estate companies big and small, Equity Office has invested heavily in technology.
"We saw the real advantage of getting into not only the acquisition of these properties but also putting the monies into maintaining and marketing and also building an information system. We were well ahead of the curve in staying right up with technology," says Steele.
Equity has set up a distributed information system, whereby its individual properties have a general ledger and can produce statements onsite. The properties are then tied into the corporate office in Chicago for consolidation and portfolio information purposes.
"We have continued to stay up with modern technology and are now putting in place a fully integrated Lotus Notes system and we also work off of a Windows platform now. The objective we hope to achieve by the end of the year is, whether somebody is in their hotel room, in the office here at the corporate level, in the region or at a property, they'll be able to call up and get not only operating, but leasing and market information on any property we have in our portfolio," says Steele.
Of course, information technology is also having an impact on office space utilization by Equity's tenants. But don't tell Mssrs. Wheeler and Steele that tenants won't need office space anymore, as some industry pundits are quick to surmise.
"If you look at the very practical side of things, and to us the practical side is how are we doing leasing property, that theory does not hold water," says Wheeler. "We have been extremely successful in leasing space. We still find that companies continue to want to downsize, but what a lot of people are not focusing on is the fact of new business growth. New companies starting up, whether they're information systems companies or whatever they are, the gazelle companies, start out small and just grow by huge leaps and bounds. There is corporate downsizing, but we have been able to back-fill a lot of that space with these small incubator companies that simple grow."
"Also, there are very few businesses that can benefit from hoteling. At the end of the day, people are going to have to communicate among themselves. If you look at any people who are really studying space use, they're actually finding that companies are doing away with a lot of private offices, but they're going to conference centers where people come in and work in group situations, and in fact sometimes that takes more space than your typical office space," says Wheeler.
Steele agrees. "There is truth in the fact that a lot of the large companies have adopted a hoteling concept. Having come from that business myself some years ago, back in the '60s you operated pretty much in the same way, it just didn't have a name attached to it. As their space needs have shrunk somewhat, you see tremendous growth in areas of software and telecommunications, businesses that didn't exist five years ago and they're growing dramatically."
One example is an Equity Office tenant, a service provider that performs outsourcing functions, which has grown from 120 employees to 300 in just the last two years. "Companies are growing and shrinking, but the fact is that the work hasn't gone away," says Wheeler.
As Wheeler sees it, the bottom line is keeping those tenants happy. "Our success has also been taking care of our tenants. It's one thing to lease a building up. That's a lot of hard work and it costs an awful lot of money to put those tenant improvement dollars in there. The challenge is to take care of those tenants and keep them."