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Zell: Still the Contrarian

Remember a year ago, when economic pundits predicted a V-shaped recession with a dramatic rebound in the first half of 2002? Well, Sam Zell didn't put much stock in that forecast. He went on record saying a turnaround wasn't likely until 2003.

Frequently a contrarian and always irreverent, the chairman of Equity Office Properties Trust (EOP) and Equity Residential Properties Trust (EQR) — two bellwether real estate investment trusts — was correct. Hopes for a quick recovery fizzled in the second quarter of this year.

It wouldn't be the first time the 61-year-old real estate mogul hit the nail on the head. When commercial real estate tanked in the early 1990s, his mantra was “stay alive till '95.” Indeed, that turned out to be the year in which commercial real estate came out of hibernation following a severe industry-wide recession caused by overbuilding.

Zell, who began his real estate career in the 1960s, vaulted into the top tier of real estate moguls in the 1980s and early 1990s by buying distressed properties and selling them when the markets recovered. In the process, he became a billionaire and was dubbed the “grave dancer.” Forbes estimates his net worth at $1.8 billion.

NREI sat down with Zell recently in his Chicago headquarters to talk about his business and how he sees the industry shaping up in the coming year. The current glut of space in the office market is an inevitable result of the 1990s boom, according to Zell. The industry forgot the lesson of “Jack and the Beanstalk,” he says: “The beanstalk doesn't grow to the sky, and the market doesn't grow to the sky. When we saw the kind of leasing frenzy that existed, I think it was pretty obvious that it couldn't last and that we were going to end up with excess supply.”

That kept Zell from betting on recovery in 2002. But now he's predicting that by this time next year, vacancy rates will be lower and the commercial real estate market on balance will be materially healthier. In short, Zell believes that industry experts are “exceedingly pessimistic.”

“I think a year from now we'll be talking about inflation instead of deflation,” says Zell. “In the end, a little inflation never hurt the real estate business. I think people will be surprised a year from now that things will be a lot better than they had expected.”

Gross Domestic Product grew by 4% in the third quarter, offering evidence that recovery is indeed under way, says Zell. “If you combine that positive economic growth with no new [office] supply, the real estate industry is going to get better.”

Across his many businesses, including EOP and EQR, Zell believes the rate of deterioration has begun to level off. “That indicates to me that we've absorbed the adjustment that's required, and now we have to build new momentum. The first thing that you have to do is stop it [momentum] from going down, and I think we have.”

The national office vacancy rate climbed to 15.1% in the third quarter, according to Los Angeles-based CB Richard Ellis, up from 12% a year earlier but was only slightly higher than the 14.6% recorded in the second quarter.

Meanwhile, rental rates in the apartment sector continue to experience downward pressure as concessions abound. In Dallas/Fort Worth, for example, effective rents dropped 1.8% in the year ending Sept. 30, 2002, according to Dallas-based M/PF Research.

New CEO to Take the Reins

Against that rocky economic backdrop, EOP has taken some blows. EOP's share price tumbled from its 52-week high of $31.36 on April 12 to $25.94 as of Dec. 3, a 17% drop. Management is quick to point out, however, that EOP's dividend, which currently is $2 per share, has increased by 67% since the company's IPO in July 1997.

In April, CEO Timothy Callahan resigned. Zell temporarily assumed the dual role of chairman and CEO while searching for a replacement. Meanwhile, EOP embarked on what Zell describes as a massive restructuring of its business. Since 1997, EOP's portfolio has grown dramatically from 32 million sq. ft. to 126 million sq. ft. In 2001, the company recorded revenues of $3.1 billion. Now, after digesting three major mergers, EOP is making the transition from an aggressive acquirer of real estate to a top-notch operating company.

Management has identified 20 top markets in which it wants to own a high concentration of office product in order to become the low-cost provider in each market while maintaining high levels of service. “We've gone from a building- centric model to an area-centric model where density becomes much more important and relevant,” says Zell. “Making that happen, making it smooth is the biggest challenge facing the company today.”

Ultimately, the person picked to lead the charge was an insider, Richard Kincaid — the former CFO and most recently COO of the company — who was named president effective immediately and will officially take over the helm as CEO in April 2003. “The next stage of growth for the company will be predicated on how well we've done as an operating company,” says Kincaid, who began working for Zell in 1990.

The ability to wring out excess costs is a prerequisite to becoming a low-cost provider. In the Boston market, where the company owns more than 50 office properties, EOP has consolidated 18 separate property-management teams into one centralized operation over the past two years. Kincaid estimates the cost savings will total $6.6 million. The company also is increasingly recruiting specialists to improve delivery methods and lower costs, and this fall hired a vice president of procurement.

Bears Still Out in Force

While Zell foresees a gradual recovery in the office sector over the next 12 months, analysts don't seem to share that optimism. On Oct. 30, the day after EOP announced its third-quarter net income had fallen 16% over the same period a year ago, dropping from $201.8 million to $168 million, Lehman Brothers Equity Research downgraded the stock to “underweight” from “equal weight.” The firm cut its price target on EOP shares by $4 to $22 per share. It also reduced its funds from operations (FFO) per share estimate by five cents to $2.75.

The logic is simple, according to David Shulman, the REIT analyst who authored the Lehman report: More than half of EOP's net operating income is derived from two sets of customers that have been hit hard by the economic downturn — West Coast technology companies and East Coast financial services firms. Both segments, Shulman says, are likely to lag the overall recovery.

“Office rents and occupancy are likely to remain under severe pressure through 2003 and well into 2004,” wrote the analyst. EOP's overall occupancy rate in the third quarter declined 0.8% to 89.2%. The company says boosting occupancy is its top priority.

Naturally, Zell is aware of Shulman's harsh assessment of EOP's recent performance and near-term prospects. But he says that the veteran analyst also was overly pessimistic when the market bottomed out in the early 1990s. “I have the report that David wrote in 1991 where he said that there was enough office space in existence to last 14 years,” says Zell softly with a widening smile. “So, he's just full of gloom and doom today. That's OK.” Zell says he learned a long time ago not to view analyst reports as personal attacks.

The chairman also emphasizes that there is little or no risk that EOP's dividend of $2 per share will be cut. “I think it's very secure,” Zell says. “The company is committed philosophically to stability and preservation of the dividends.”

One advantage in this downturn vs. a decade ago is that the industry is far less leveraged, says Zell. “If we were sitting here in a 1980s [financing] environment with the kind of vacancy that exists today, you could be pessimistic that the banks were going to own everything. This time around the banks aren't going to own anything.”

Multifamily Market Under Pressure

The soft employment climate and the strength of the single-family home market have proved to be a big challenge for the apartment sector. Occupancy within EQR's portfolio registered 93.9% in the third quarter, virtually unchanged from 94% in the second quarter and on par with the national average, according to Lehman Brothers. Equity Residential, the nation's largest apartment REIT, owns or has investments in 1,057 properties in 36 states consisting of more than 226,000 units.

But, in a market where low interest rates continue to turn renters into homeowners, landlords have no pricing power. In the third quarter, EQR's same-store net operating income fell by 7% over the same period a year ago. However, EQR's dividend looks more secure than many others in the sector, says Shulman. Its dividend yield is approximately 7%. Since its IPO in 1993, EQR's annualized total returns have been 15.3%. EQR's share price closed at $26.70 on Dec. 2, down from its 52-week high of $30.96 on April 10.

Company Prospects

Which of his two major businesses does Zell think will do better in the year ahead? “It's an interesting question because the apartment business in the next 12 months will have new supply, but the office-building business will not,” says Zell. “The fundamentals are probably better in the apartment business, but the new supply will weaken the results. Therefore, I think both will operate much the same for different reasons.”

Concessions in the apartment market have been widespread throughout the apartment industry. A portfolio with 94% occupancy may only have an 88% economic occupancy rate by the time the concessions are factored in, Zell says. “We're sensing for the first time in 12 to 14 months that the market is getting a little firmer,” he says. “I suspect they've sold houses to everyone they can sell houses to.”

Both EOP and EQR have been net sellers of properties this year. Zell says that the pruning process never ends. “You're constantly identifying assets in your portfolio that are less attractive than ones you might acquire.”

Through the third quarter, EOP had disposed of $342 million in assets, raising the total to $566 million over the preceding 12 months, according to Lehman Brothers. Meanwhile, Equity Residential has disposed of $339 million of assets through the third quarter.

An Oligopoly Unfolding?

Zell foresees consolidation occurring among REITs. He has long held the belief that the still highly fragmented commercial real estate industry is marching toward an oligopoly as consolidation produces a handful of landlords that dominate the markets in which they operate.

Markets with huge capital expenditure requirements, such as the auto industry, tend to be oligopolies because it's a natural protective instinct, he says. Real estate is the last capital-intensive business to consolidate. “Do I think that we're going to end up with two real estate companies like two car companies? That's very unlikely. But do I think that the future of REITs will be 30 or 40 companies? That's very likely.

“This downturn would have been less painful with more consolidation,” Zell continues. “We have more than 200 REITs today, and we probably need something like 35 or 40 strong ones.”

Going forward, Zell believes smaller REITs will have a hard time getting research coverage, which will ultimately accelerate the trend toward consolidation.

Zell as Mentor

Since assuming the dual role of chairman and CEO at EOP, Zell says he has discovered that the depth of talent on his team was even greater than he previously thought. One of his biggest assets as a leader is the ability to get employees to work closely together, Zell believes.

“My own irreverence relaxes people,” says Zell of his management style. “Obviously, when a guy who owns $400 to $500 million worth of stock in the company makes a decision, that gives everyone a lot more comfort.”

Although Zell is a large investor in his own company — he owns about 3% of both EOP and EQR — Kincaid says that the chairman doesn't micro-manage the day-to-day operations. “It's a good combination,” he says. “He's going to let you know if he doesn't like what you're doing. But you also have someone there who has unparalleled real estate experience.”

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