Sam Zell visits HBS

Sam Zell, the Real Estate Guru of Michigan, recently came to campus and shared his thoughts on the industry going forward. “The real estate industry is at the end of the first inning in terms of its evolution” remarked Sam Zell, “the goal is liquid real estate and while we have come a long way, there is much more to go.” Three primary trends are taking shape in the industry: consolidation, professionalism, and securitization.

First, Zell laid out his foresight that consolidation will pick up sooner or later in real estate. Not only that operational economies of scale matter, but also that equity capital in real estate is becoming much larger than it previously have been. “Four major ‘equity forces’ are emerging,” he said, “and they are accelerating consolidation of the real estate industry…they are real estate private equity funds, public REITs, private REITs, and corporate/public pension funds.”

The first among the four enlarging capital pools is real estate private equity. Also called “opportunity funds” or “vulture funds,” Zell himself created the first investment entity in real estate with his Zell/Chilmark fund. (he occasionally called himself a “Grave Dancer” back then) “Since creating approximately 20% returns after fees for its investors, a rush in real estate private equity has occurred,” he said. Albeit strong growth in capital flows, however, he predicted that the “attractive opportunities” in previous years are diminishing due to the less leveraged properties in recent years. Zell closed his remarked “sustainability of these funds are still to be tested, but I wouldn’t say there are no bargains out there.”

Second is public Real Estate Investment Trusts, or REIT. It is well known that REITs have had major capital inflows from investors due to the consistent positive returns hovering 7% to 8% while S&P has dropped over 50% in the past two years. However, Zell reminded us that people tend to forget that this has been a long-term trend that will continue: REIT market capitalization grew from $16B in 1990 to $160B in 1999.

Zell said not only will total market capitalization will rise, but also the average size of these REITs will increase as they see benefits of larger scale operations. “Real estate will someday become a oligopoly,” he continued, “look at the evolution of oligopolies in other capital intensive industries such as the railroads, the automobiles, the steel industry. Real estate will follow the same track.”

Third is private REIT. Zell characterized these non-listed entities as a REIT created by a group of wealthy individuals, which carry little or no debt on their books. Private REITs, Zell added, are created to provide tax benefits to shareholders as well as the stable cash flow and financial flexibility due to non-transparency. Although average capitalization is smaller than the public REITs, Zell anticipated the significant equity cushion would guarantee sustainability for these funds.

The fourth that Zell predicted being a larger capital influence are public and corporate pension funds. “We live in an era which the pension fund of General Motors is larger than the market capitalization of GM itself,” he remarked, “and its influence on real estate will dramatically increase as well as any capital market in the U.S.” Also, many pension funds are increasing their allocation to real estate due to the sustainable returns.

Due to this increasing pressure, Zell predicted the real estate industry would consolidate to generate operational efficiency and increase financial horsepower.

The industry is seeing an influx of professional management practices such as predictability of cash flows, accountability, and transparency. Management is now emphasized over flipping, as development activity is no longer given credit by the public markets, regarding such gains as non-recurring. Also, more prudent capital structure practices are being used effectively lowering leverage levels. “There is more emphasis on equity yields as more equity is demanded by lenders” whereas leverage rates could be as high as 95% historically, we see loan to value levels closer to 75% today. This is a sharp contrast of the gun-slinging real estate days whereby you couldn’t find a developer that could turn down a loan.

The path towards liquid real estate is spearheaded by the growth of real estate securitization in today’s public market. The Real Estate Investment Trust (REIT) market, largely marginal in the early years since its inception in 1960, has grown tremendously in the 90’s driven by the Tax Reform Act of 1986, the Savings and Loan crisis, the overbuilding of the 80’s, and regulatory pressures on banks and insurance lenders. In one decade the market capitalization of the REIT industry has grown from $16 Billion in 1990 to $160 Billion in 2000.

When asked about the potential effects of President Bush’s proposed economic stimulus plan, which would eliminate taxes on dividends from those companies that already paid corporate taxes, thus eliminating double taxation (a benefit that would not be entitled to REITs because they already avoid double taxation by avoiding taxes at the corporate level) he said that the proposal would have no impact. First, the proposal probably won’t get passed. Second, C-corporations don’t payout, nor will not payout anything near what REITs payout to have an impact (REITs are required to payout 90% of its taxable income to its shareholders).

With regard to what’s on many of our minds, careers, he had three things to say. First, if you are looking to get into real estate you should be willing to accept less up front in order to get your foot in the industry – the rewards will follow. Second, while many wonder if an advanced degree is needed to succeed in the real estate industry, he says that the critical benefit is the ability to analyze problems, structure your thoughts, and execute on solutions. Finally, while it was once possible to start from scratch, he has a hard time imagining someone doing it now, so the best bet is to join a firm and develop your skills there rather than striking it out on your own today.