Sam Zell and the Art of Motorcycle Maintenance

Real Estate Tycoon examines the Market's Past, Present and Future

by Michael Krivan, MBA1

U of M alumnus Sam Zell addresses the Business School

Sam Zell, the renegade equity management mogul who earned his BA and JD from U-M during the 1960s, returned to Ann Arbor last Thursday to share his insights on the real estate industry with a crowd of B-school students and local developers. The man ranked 96th on Forbes' list of the wealthiest Americans offered his version of the history of the U.S. real estate industry, his views on its future, and glimpses of the business philosophy that made him a near-billionaire.

Until the late `60s, according to Zell, the U.S. real estate industry was the domain of a small, exclusive club of entrepreneurs who used tremendous leverage and long-term, fixed-rate, non-recourse, self-amortizing debt to create massive amounts of wealth. As the value of this circle's real estate increased, the present value of their debt instrument decreased, resulting in extraordinary gains. In 1969, Wall Street tried to grab a piece of the pie by creating the Real Estate Investment Trust, which was designed to finance short-term mortgages. What ensued was a major building boom, as investors tried to replicate the early developers' success.

Zell, who had bought an apartment complex in Orlando, FL, found himself in the middle of the maelstrom. By 1973, a dozen competing apartment projects were erected in the neighborhood: occupancy in his building dropped from 100 percent to 68; revenues of $10,000 a month became losses of $10,000 a month. But rather than throwing in the towel, Zell turned the situation into an opportunity.

That year, Zell put his immediate property business on hold. "I spent nine months preparing for what I thought was the single greatest opportunity in history to buy real estate," he said. "What I saw was a scenario where the banks and the insurance companies would be very amenable to restructuring troubled deals." He and his partner, TK Lurie, set a goal of $50 million in five years -- and due in part to the inflation created during Jimmy Carter's presidency, they greatly exceeded their target.

Industry analysts called Zell and Lurie geniuses at picking real estate investments; Zell sees it differently. In effect, he explained, "we created a massive arbitrage. We went out and we bought $3 billion of real estate; we financed it by restructuring the existing debt with an average interest rate of 5 percent in an environment where inflation was 9 percent. So what we really accomplished was this 4 percent spread on $3 billion over an extended period of time." As a result, Zell's company came out of the `70s as one of the largest owners of property in America.

In 1980, Zell reevaluated the then-overpopulated real estate market and concluded it was time to move on. He and Lurie spent the next seven or eight years "doing corporate deals and watching the real estate market." What they witnessed was "an orgy of overdevelopment truly unparalleled at this time in our history." Zell identified three factors that caused the glut.

First, a slew of new players entered the real estate market hoping to capitalize on the seemingly inexorably increasing value of property. Pension funds, insurance companies, and S&Ls shifted huge amounts of capital into the market -- somewhere in the neighborhood of $100 billion a year. In the mid-80s, Japanese investors, buoyed by the resurgent yen, poured $200-300 billion more into the already bloated market. It was, according to Zell, "a classic case of oversupply, of much too much money chasing too few opportunities."

A second factor contributing to the oversupply was a new way of thinking about real estate development: Investors dreamt up the concept of "segmentation" in order to justify new construction in an already saturated market. Developers would build a non-smoking hotel, for instance, Zell said, in an area where existing hotels were struggling to maintain high enough occupancy rates to stay in business.

The third reason for the overdevelopment, Zell said, was the advent of the HP 12 -- "one of the most wicked instruments that has ever been created in the real estate world." The revolutionary new calculator allowed aspiring developers to "do projections, on pretty paper with pretty lines," Zell said. The machine created "a world full of MBAs in windowless rooms on Wall Street playing with their HP 12s and coming up with economic justifications for what they were suggesting somebody else do with somebody else's money. This was truly a disaster. (For those of you who don't know what an MBA is: an MBA is somebody who knows how to do the numbers but doesn't know what they mean.)"

What resulted was "the substitution of an understanding of real estate for a set of numbers," or, in other words, "the extraordinary commoditization of what is in itself a truly unique business," he added. "Every single piece of property is unique. Every single piece of property has individual characteristics. The key to understanding real estate is to understand that it is a local business. And that commoditization of real estate was another way of shoving risk under the table."

When the 1990s arrived, the real estate industry entered a "period of despair," Zell said. Unused properties were ubiquitous: Zell calculated that all the vacant real estate space in America had a value "larger than what [the country] had borrowed offshore that year to fund the deficit.... We as an industry had literally committed hundreds of billions of dollars to nonproductive usages. And we had done so because the promise was: build it today because it will cost more tomorrow... not because there's any economic justification."

The effects on the economy were devastating. The greatest losses occurred among the banking institutions. Every major lender in the U.S. was on the ropes in 1990; Citibank almost went broke, while Bank of New England and Bank of Boston went under.

"[The real estate industry] reached a secular top in 1980 or 1981," Zell said. "Since 1981, we have been, and will continue to be through the beginning of the next century, in a secular deflationary trend."

What does this mean for the future? The way Zell sees it, there will be a major shift away from wild speculation. "We have to go from building for future demand to building for pent-up demand," he explained. "I think we're going to see a reintroduction of discipline, of supply and demand really governing what's going on.

"I think we're going to see the real estate industry no longer being treated as non-correletary. And as a result, real estate is going to have to compete for capital with all other forms of investment," added Zell, whose Equity Financial and Management Company is the largest owner of office space in America. "Ultimately, real estate is a business that revolves around access to capital, and access to capital in the future is going to be much more disciplined.... The industry is likely to be more stable, have fewer players, have lower velocity, and look a lot more like commercial real estate everywhere else in the [world]."

The industry also promises to be less entrepreneurial. "I view myself as somewhat of a dinosaur," he said, "having been around at perhaps some of the most unique times, where enormous leverage was available on a non-recourse basis.... Those days are over and are unlikely to return."

There are opportunities available in the real estate market these days, Zell said, but they are "lower-leveraged opportunities, less on the building side and much more on intelligent management and figuring out ways that the owner of real estate could benefit, particularly from the telecommunications revolution that's going on.... Some of you out there will even be more creative in the future and find ways to develop auxiliary income and leverage the position of the owner."

"Real estate is a fascinating field; it's challenging intellectually, it's creative, and it's very fulfilling.... The future is bright," he said. "But it's a field that requires that everybody everyday recognizes the fact that they need to be afraid, they need to be concerned, they need to not believe what comes out of a computer."

As for the secret to his success, Zell said there was "no substitute for working your ass off, understanding risk, understanding reward, being honorable and consistent, which means that people always want to do a second transaction with you." He attributed some of the success to luck and good timing, and some to his natural ability "to understand and observe my circumstances and the world I live in relatively without emotions."

When asked the value of his U-M legal education, Zell said that although he "didn't remember shit from law school," the experience was "an extraordinary asset" because "it taught me to think, it taught me how to deal with problems."

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