Euromoney Liquid real estate March 2007: Full contents
Samuel Zell: A life in and out of real estate
Sam Zell lives the vision
Ten years ago, Sam Zell, the Chicago-based billionaire investor and real estate entrepreneur, wrote an article reflecting on the dramatic collapse of the US commercial property market in the early 1990s and the subsequent revolution in funding and ownership of the asset class.
The piece was published by the Wharton School at the University of Pennsylvania and outlined what Zell saw as a dramatic and permanent change for the real estate industry: a shift from dependence for funding on a lightly regulated, opaque group of banks fixated on lending for speculative development, towards public equity market investment in Reits based less on bets on rising or falling property prices and more on valuation of existing properties as cash-flow producing assets to be managed like any other corporate assets.
He gave it the headline "liquid real estate". Thankfully, he didn’t copyright the phrase, so Euromoney has adopted it for this new magazine on real estate investment and financing. But have we got our timing wrong? After all, Zell is once again back in the headlines, this time for selling the biggest commercial office landlord in the US and the biggest publicly traded Reit, Equity Office Properties Trust, to private equity group Blackstone in the largest LBO in history.
Blackstone paid $23 billion for the company and assumed $16 billion of debt in a $39 billion transaction that eclipses the $25.7 billion plus $6 billion in assumed debt KKR shelled out for RJR Nabisco back in 1989 and the $21.3 billion plus £11.7 billion in debt that a consortium of private equity funds including KKR, Bain Capital and Merrill Lynch Global Private Equity paid for HCA last year.
Zell founded Equity Office Property Trust back in 1976 – nine years before Peter Peterson and Stephen Schwarzman opened the four-man office of a niche investment and advisory boutique called Blackstone – as an integrated real estate management and acquisition vehicle. He took it public in 1997, the same year he published his visionary article. It became the first real estate company to be included in the S&P500 and grew into the biggest office building owner and manager in the country with 590 buildings in 28 cities spread across America from Seattle to San Diego, from Boston to Miami.
Zell has been one of the great proponents of the Reit sector and a champion of indirect stock market ownership on a global basis. "Car companies are as capital intensive as real estate and yet you can easily buy and sell shares in auto companies in the US, Japan and Europe," he tells Liquid Real Estate. "Why shouldn’t you be able to do exactly the same for property?"
Well, now that EOP, which used to enjoy average daily trading volume of 2.4 million shares on the NYSE, has had its shares de-listed, it makes that all the more difficult for investors to do. Blackstone’s huge LBO of the company is the culmination of a series of take-private bids for once publicly traded Reits. In the past 18 months private investors have taken over Trizec (in an $8.9 billion deal), Carramerica ($5.6 billion), Arden Realty ($3.2 billion), Meristar Hospitality ($2.6 billion), Glenborough Realty ($1.78 billion).
Private equity investors are snapping up publicly traded assets in many industry sectors, so there’s no reason why real estate should be any different. Yet Blackstone and others have carved such a swathe through this young sector of the public stock markets that it raises the question whether this is a wholesale retreat of real estate ownership back into private hands, perhaps revealing indirect public share ownership to have been a brief phase, even a failure.
Zell vehemently disagrees with this. "If anything, the recent [take private] activity that’s occurred has validated the public markets’ ownership." It seems an almost perverse conclusion. But Zell insists on it. "The whole real estate business is very different today compared to 15 years ago. You have much greater transparency, you have Reits in the S&P500. And that transparency equates to lower risk. There’s a lot of talk about yield compression, but it’s because the real estate industry has created liquid vehicles that have dramatically lowered risks and so investors are willing to accept lower yields."
Plausible argument
It’s a plausible line of argument but one that seems to jar slightly with Zell’s own experience and behaviour as chairman of Equity Office Properties, especially in the past two and a half years.
The whole background to the takeover of EOP, which culminated in a dramatic contested bid between Blackstone offering all cash right now and another publicly owned Reit, Vornado Realty, offering a mix of cash and shares with a theoretically higher value but dependent on its own shareholders’ approval, is laid out in EOP’s proxy statement published last December.
It doesn’t take much reading between the lines to sense the growing frustration of Zell and EOP’s senior management at the stock market’s failure to upgrade the company’s valuation and stock price, even as the net underlying asset value of many of its commercial offices in prime locations was clearly rising. Does this not show a failure of the public markets to value real estate accurately and to price and allocate capital efficiently to the users with the best track record?
Zell suggests that there may have been a particular issue, rather than a general failure. "If you compare EOP’s with the multiples for say Boston Properties or Vornado Realty, there was a very significant and inexplicable discount for EOP."
What might have caused this? Could it be that stock market investors harboured their doubts about Zell’s acumen. He had famously expanded into prime office space in California at the start of the decade amid the excitement over the internet and had got caught out when the dot com bubble burst and internet companies started closing down and laying people off. It may be that the largest Reit on the market was beginning to suffer from diseconomies of scale. As prices for office buildings and rents boomed in certain cities – New York for example – its very diversification, supposedly a strength, diluted exposure to the hottest markets.
Zell himself offers a more prosaic explanation and one that finally admits of deficiencies in the public market for real estate securities. "Part of the problem in the US is that we don’t have chartered surveyors and so there are no good, independent net asset value appraisals. A lot of the analysis for the buyside is questionable and so you might have a certain net asset value ascribed to a Reit which eventually gets bought for two times that net asset value. Now, in the end even independent valuations are only valuations. The market is the market. But in some cases the public markets aren’t valuing what’s in a Reit and that’s creating an opportunity for others."
Zell and his colleagues, in the end, did a great job of closing that valuation gap for EOP. Do, please, go and read the history, the background of the mergers section in the December proxy statement. It’s a gripping tale.
In 2004 we find the board worrying that the significant appreciation in private market values of offices in southern California, Washington DC and New York, is not being reflected commensurately in EOP’s cash flow or stock price. In November 2005, the company receives an informal expression of interest from a mysterious company A, acting on behalf of company B. Subsequent speculation has been that company B might have been Calpers. Pension funds have been keen buyers of Reits which supply steady bond-like income streams because their negligible tax rate is based on paying out 90% of earnings as dividends to shareholders.
In January 2006, a possible acquisition is discussed. Sam Zell says he won’t support any bid lower than $45 a share. That is pretty damn bold of him, given that EOP’s shares are trading at $31.23.
EOP opens its books to the prospective bidder, which at this stage is mentioning $40 per share. More frustration for EOP: having looked through the books the bidder suggests it will make a written offer of only $37-$38.
During the first half of 2006, EOP takes advantage of what it calls "extraordinary market conditions to dispose of assets at high valuations" and to "acquire additional assets in certain core markets." The stock price starts to nudge up. The long game is playing into EOP’s hands. In July, Vornado emerges as a potential bidder, followed in August by Blackstone talking about a bid of between $40 and $42 per share. The market price is now up to $37. In September, yet another unnamed potential bidder comes sniffing. And by October 2006, EOP is telling Blackstone that any bid will have to exceed $45 per share and probably have to be closer to $50.
In November, Blackstone splits the difference and offers $47.50. The actual shares are now at $43. Over the next three months, EOP skilfully plays Vornado and Blackstone off against each other. Blackstone twice raises its offer and eventually Zell sells the company for $55.50 all in cash, right up front. That’s a valuation 78% higher than where the shares were trading a year earlier when the possibility of being acquired was first raised. Zell and his team have scared up and delivered an extra $10 billion in market value for EOP shareholders in just 12 months.
Surely even the most modest man would describe that as a huge success. Investors might be forgiven for assuming that if anyone got out-negotiated here, it is probably Blackstone. So what Zell says next falls rather like a bombshell.
"If I had owned 100% of EOP, I probably would not have been a seller."
Zell, presumably, had been watching Blackstone’s swift deal-making in the two weeks since the purchase closed. From the old EOP portfolio, the private equity group sold eight office buildings in New York to private landlord Macklowe Properties on the very day it bought EOP itself. Maguire Properties, a Los-Angeles based Reit announced in late February it would be buying from Blackstone 24 properties in Los Angeles and Orange County for $2.88 billion. Beacon Capital Partners, the Boston-based private equity group, paid Blackstone up to $6.35 billion for 36 properties in Seattle and Washington, DC from the old EOP portfolio.
It’s the kind of wheeler-dealing Zell himself would no doubt love still to be in the middle of. Before getting drawn into takeover discussions in 2006, Zell had certainly considered a go-it-alone strategy for EOP including a leveraged re-capitalization to repurchase shares and boost the stock price and a further pruning and adjustment of the portfolio. But Blackstone’s barnstorming programme of disposals in the first weeks of ownership has been simply breathtaking.
Is this the kind of thing only a private owner can do and that trustees of a public real estate company could never undertake so quickly? As Blackstone was allowed by EOP to enter negotiations with potential buyers for individual buildings within its portfolio before consummating the acquisition, it raises the tantalizing suggestion that Blackstone might have found a smarter way to trade on its knowledge of private market valuations for properties than EOP itself could have done.
Is Zell regretting the sale?
He returns to his theme of public market transparency. "I’m running a public company, one that has taken money from the public and I have said all along I would have no anti-takeover provisions or any of that bullshit. So if someone comes along and makes us an offer higher than our own internal valuation of the company, it’s a no brainer. You have to accept."
High on its publicly stated reasons for recommending the bid to shareholders, EOP declared "the high multiples of funds from operations at which shares of Reits, including our common shares, have been trading and the risk that those multiples might not be sustained".
But does Zell in fact see still greater value to be extracted from real estate?
While some private client brokers were advising individuals to sell Reit shares in February, interpreting Zell’s decision to sell EOP as a sign of the smart money starting to get out after a long run of fabulous returns, there’s plenty of reasons to stick with real estate a while longer. One technical support is the sheer prevalence of buyers, including pension funds seeking yielding assets, though Reit yields are now dipping below those on 10-year treasuries. Another is lack of new supply in constrained downtown areas, especially for cities on the coast, amid a booming economy with low unemployment. Typically, commercial property managers are in the business of rolling over five-year lease deals while managing the margin between maintenance capex and rental income. Five-year deals struck in 2002, amid the downturn that followed the dot com collapse, disclosure of the Enron and other corporate scandals and the terrorist attacks, might be up for re-negotiation this year on terms that favour property-owners over tenants.
"You can even be in markets that aren’t growing, but if there’s no supply you do great," points out Zell. "And in New York, for example, there’s a little bit of a panic going on for space, so there the landlords have the upper hand," though he concedes "in other markets it can be different."
And he points to another key factor supporting real estate and Reit values. "It’s all a function of the financing and right now financing is available in amounts and at rates that have not been seen before. So, when they sold the GM building, on the day after they put it up for sale, Wachovia and Bank of America each made $1.1 billion of financing available to any buyer of that building: and the buyers just lined up to bid above that level."
Right now, private equity firms are the bravest advance scouts forging ahead into the debt market jungle. Of course, eventually some people will get lost in that jungle, it will turn hostile, liquidity will dry up, asset prices will stop rising. Perhaps then, the defensive qualities of Reits will come back into favour.
Zell says: "Publicly owned Reits have been very disciplined about holding their leverage at around 50%, which is comparatively modest. So in 2000 through 2003, when we had a significant drop in rents and capital values, not one public Reit company got into trouble. Now if the same thing happens again, then some of the guys who have been buying recently from us and others in highly leveraged form could be in trouble."
If it sounds like that’s not his problem, in fact partly it is. Zell’s private equity investments range across a broad array of industry sectors and assets – from barges to internet cables – but real estate has always been a significant component. If it made up 35% of his exposures at the start of February 2007, it was down to about 25% by the start of March. His challenge, rather like that facing all private equity fund managers, is where to re-deploy those hundreds of millions of dollars in cash, some reports suggest as much as $900 million, that he has just realized.
Zell says: "I just laugh when people ask me if I’m going to spend more time on the beach. Nothing could be further from the truth. We’re just going to carry on doing what we’ve always been doing."
Of course, he’s far too canny to tell a journalist – even one who asks the same question three different ways inside the first 15 minutes – where he’s going to put his money next. But he clearly shares an interest in real estate investment in emerging markets. "We have been expanding very aggressively outside the US," he says, "in Brazil and Mexico, for example." In those countries Zell has been a keen investor in affordable housing businesses. "We’re also in China and Egypt, also in affordable housing," he says.
Zell retains a close interest in US real estate. Having given up his position at the country’s largest office landlord, he is still the chairman of the largest apartment owner, Equity Residential.
Looking back on his career so far, he sees a process, especially over the past 15 years, in which property investing has been brought into the mainstream, away from being the preserve of an inner group of real estate magnets and their favoured financiers. Right now, that involves some public traded real estate companies being LBO’d by the same private equity firms making leveraged bids for other corporate assets. Eventually, he sees a return to public markets.
He says: "Prior to 1992, this was a private market with dedicated lenders who made loans to real estate people and no-one else. Today, the biggest mortgage lender is TIAA-CREFF. Its lenders sit in a big room and trade between mortgages, treasuries and corporate bonds. If real estate doesn’t pay their required rate, then that capital will flow somewhere else.
"On the back of that, we have taken an industry in the US from a stock market capitalization 12 years ago of about $6 billion to one of over $500 billion. And in fact, every day we’re getting more and more real estate entities entering the public markets and allowing people to invest in real estate. That success here has spawned the Reits in Asia and Europe and the UK.
"Believe me," Zell says, "this isn’t over." LRE
Euromoney Liquid real estate March 2007: Contents
