Sam Zell's Bet on Silicon Valley Leaves Investors Footing the Bill
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Aug. 20 (Bloomberg) -- In February 2001, 11 months after the Nasdaq Composite Index peaked, Sam Zell made a $7.2 billion bet on the future of Silicon Valley.
Zell, 62, who calls himself "the Grave Dancer," announced that he was buying Spieker Properties Inc., a Menlo Park, California-based real estate company with half of its 28.3 million square feet of office space and 10.1 million square feet of industrial space located in Northern California, where many of the technology companies with shares traded on the Nasdaq Stock Market are located.
So far, Zell's bet has been a loser. The Nasdaq index continued to plummet, shaving another 51 percent off its value by October 2002, and Silicon Valley rents sank to an average of $25 a square foot in the first quarter of 2004 from $55 in the fourth quarter of 2000, according to Boston-based Torto Wheaton Research.
More important, Zell's Silicon Valley venture has clouded the long-term vision he has pitched to investors. Spieker was the third multibillion-dollar acquisition in five years by Zell's Equity Office Properties Trust, a company that buys and manages office buildings.
The purchases, for stock and cash, were part of Zell's plan to build a real estate investment trust that would be national in scope. Zell said the large size would let the REIT hire top managers and save money on everything from carpeting to financing. Those cost savings are only beginning to materialize.
Confidence
Zell, who is chairman of three Chicago-based REITs, says his bet will still pay off because Silicon Valley remains the headquarters of U.S. innovation and will eventually rebound.
"As ill-timed as the Spieker transaction might appear, I don't think you necessarily get to pick the time that you get to dominate the intellectual capital of the United States," Zell says in his Chicago headquarters, an art deco office building that formerly housed the now defunct Chicago Daily News.
Meanwhile, the pain continues. Office occupancy in Equity Office-owned buildings fell to 86.3 percent at the end of June from 94.6 percent at the end of 2000. Last year, the average gross rental rate for expiring leases was $28.77 per square foot while the average for new tenants or renewals was $24.91 -- a 13.4 percent decline.
That so-called rolldown in rents will continue at 10 percent this year and 15 percent in 2005, says David Fick, a REIT analyst at Legg Mason Wood Walker Inc., a Baltimore-based securities firm.
May Cut Dividend
Equity Office Chief Executive Officer Richard Kincaid says he doesn't rule out cutting the $2 a share the company pays in dividends each year. One of the attractions of REITs is that, by law, the trusts must pay 90 percent of their taxable income to shareholders, excluding capital gains, as cash dividends.
Last year, Equity Office's operating cash flow wasn't enough to cover the dividend. The company has sold a net $1.73 billion worth of properties since 2001, allowing it to maintain the payout. David Loeb, a REIT analyst at Friedman, Billings, Ramsey Group Inc., an Arlington, Virginia-based investment bank, says Equity Office will fall short by about $225 million both this year and in 2005.
On July 22, Moody's Investors Service downgraded the long- term debt rating of the partnership through which Equity Office holds its properties, EOP Operating LP, to Baa2 -- two levels above junk -- from Baa1, citing the eroding performance and the dividend coverage shortfall.
Shares Sink
Shares of Equity Office traded at $26.54 on Aug. 19, below the $26.875 price on July 8, 1997, their first day of trading. They have closed as low as $20.75 and as high as $34.69 since the company's initial public offering.
Equity Office's income from continuing operations excluding gains on derivatives and securities fell 17.2 percent to $189.5 million in the first half, while revenue increased 1.5 percent to $1.59 billion.
Equity Office is by far the largest U.S. office REIT, with 124.1 million square feet of office space -- more than in the entire city of San Francisco, according to CoStar Group Inc., a Bethesda, Maryland-based, real estate research firm. Equity Office's network of buildings in 27 cities, with an average age of 11 years, will eventually provide cost savings and higher profits, Zell says.
Greg Brooks, a senior vice president at New York-based Cohen & Steers Inc., which held 3.7 percent of Equity Office stock on March 30, disagrees. ``The strategy has not worked,'' he says. ``At some point you say, `You know, I was wrong. Let's break up the company and create three or four regional REITs.'''
Zuckerman's Strategy
Zell's national strategy has been shunned by competitors such as Boston Properties Inc., which focuses on the most expensive buildings in four markets where factors such as regulations and lack of space make new construction difficult: Boston, New York, San Francisco and Washington.
"When the market picks up, you get some new supply -- but you get big price increases," says Boston Properties Chairman Mortimer Zuckerman, 67, who is also chairman of the New York Daily News and U.S. News & World Report. "Per dollar of invested capital, we do better using this model."
In the five years ended on July 31, Boston-based Boston Properties returned an average of 15.4 percent a year, double Equity Office's 7.7 percent average return. The average return, based on dividend payout plus stock price appreciation, was 11.8 percent for the 25-member Bloomberg REIT Office Property Index.
"Third Inning"
Zell, dressed in an open-collared, cream-colored shirt and faded blue jeans, says time will prove him right. "Part of being who I am is following my own convictions as to what the right directions are," he says. "Maybe we're in the third or fourth inning." The outcome of the game won't be decided until later innings, probably not before 2007 or 2008, he says.
Zell, personally and through affiliated partnerships, owns 4.1 percent of Equity Office, valued at more than $400 million, according to the most recent proxy statement.
He doesn't apologize for subpar returns. "If that's the price I have to pay to invest and build what I think is the superior engine, then I'm a very happy camper," he says.
Zell's two other publicly traded Chicago REITs have fared better. Equity Residential, which owns and manages 203,012 apartments, returned an average of 14.5 percent for the five years ended on July 31 compared with 13.7 percent for the 22- member Bloomberg REIT Apartment Index. Zell owns 2.99 percent of Equity Residential.
Manufactured Home Communities Inc., an owner of mobile-home parks in which Zell and affiliates own a 14.4 percent stake, returned an average of 16.0 percent compared with 11.2 percent for the Bloomberg REIT Manufactured Homes Index.
Mixed Holdings
Zell is also chairman of five other publicly traded companies, including Anixter International Inc., a Glenview, Illinois-based distributor of communications cable, of which he and his affiliates own 14.2 percent; Danielson Holding Corp., a Chicago-based energy and financial-services company in which he owns an 18.03 percent stake; and Capital Trust Inc., a New York-based company that provides real estate financing, of which he owns 12.3 percent.
Zell plays hard. He rides a yellow ST4s Ducati motorcycle in a club with 10 to 20 other bikers who call themselves Zell's Angels.
Zell, who is married to his third wife, Helen, owns a house in Sun Valley, Idaho, where he frequently skis with mostly male colleagues. "He says he brings along a copy of `War and Peace' to read while he waits for us at the bottom the hill," says David Helfand, 40, a former executive vice president at Equity Office.
Birthday Bash
For Zell's 60th birthday in 2001, a barge took 600 guests from his headquarters on the Chicago River to a warehouse that had been renovated for the party. "The bands, the champagne, the wine were all fabulous," recalls Louis Masotti, 70, a consultant who once worked with Zell. There were fireworks, and Bette Midler performed.
Zell, the child of Polish Jewish immigrants, was born in September 1941 in Chicago. His father, Bernard, who changed his name to Zell from Zielonka, was a jewelry wholesaler and real estate investor. As a teenager in the 1950s, Zell says, he bought Playboy magazines for the newsstand price of 50 cents and resold them to classmates for $2.00.
Zell majored in political science at the University of Michigan in Ann Arbor, graduating in 1963. He received a law degree there in 1966. In the summer of 1962, Zell says, he sold Suave shampoo to drugstores for Helene Curtis Industries Inc. "It's a spectacular experience -- you learn rejection at an early age," Zell says of being a salesman.
Start in Real Estate
Zell began his real estate career while an undergraduate by managing off-campus student housing, refurbishing apartments and renting them to students in the Ann Arbor area. He hired Robert Lurie, an Alpha Epsilon Pi fraternity brother, to manage one building in 1963.
After graduation, Zell practiced law for less than a year and then set up Equity Financial & Management Co. in 1968 to invest in real estate, using his own money and that of investors to buy buildings in smaller cities such as Toledo, Ohio, and Reno, Nevada. Lurie joined him in 1969.
In 1976, Zell and his brother-in-law, Roger Baskes, were charged with conspiracy to defraud the U.S. of income and gift taxes in connection with Zell's purchase of two Reno properties years earlier, according to court documents. Baskes was convicted of conspiracy and served two years in prison.
The indictment of Zell was dropped in exchange for his testimony, according to court documents. "You can't choose not to testify," says Baskes, 69, who's married to Zell's sister. "My affection for him has never diminished."
Tax Maneuvers
As he expanded his real estate holdings, Zell used tax laws to his advantage. In 1981, Zell and Lurie acquired control of Great American Management & Investment Inc., a Chicago-based REIT that had millions of dollars of tax losses, which enabled them to buy companies and shield the profits from taxes. Lurie died of cancer in 1990.
By the mid-1980s, Zell also was gaining a reputation for buying failing companies and selling them at a profit. In 1990, Zell and Chicago investment banker David Schulte formed the $1.02 billion Zell/Chilmark Fund LP to buy control of financially distressed companies such as radio station operator Jacor Communications Inc. Zell took over Jacor in 1992 for about $79 million.
When Clear Channel Communications Inc. bought the company in 1999 for about $4.4 billion in stock and assumed debt, the fund earned a profit of more than $1 billion.
Profitable Bets
Zell also made profitable bets on real estate. In 1988, predicting that property prices were ripe for a tumble, Zell teamed up with Merrill Lynch & Co. to start what would be the first of four funds to invest in real estate. The market sank in the early 1990s. Zell and Merrill Lynch spent about $4 billion buying properties.
Vacancy rates hit 19 percent in the second quarter of 1991 compared with less than 10 percent in the early 1980s. "The real estate industry was in a depression," recalls Richard Saltzman, president of Colony Capital LLC, a Los Angeles-based investment firm, who worked as an investment banker at the funds.
As the 1990s progressed, real estate prices began to pick up. So did investor interest in real estate, aided also by changes in the laws that govern REITs.
President Dwight Eisenhower first gave investors the opportunity to own shares of commercial real estate pools in 1960, when he signed the Real Estate Investment Trust Act into law. The Tax Reform Act of 1986 let REITs begin managing real estate as well as owning it.
Manufactured Home
In 1992, tax accountants and lawyers devised the so-called umbrella partnership REIT, which permitted property holders to sell their assets to REITs while allowing them to postpone paying capital gains taxes.
A flood of REITs went public, including Zell's Manufactured Home, which raised $118.4 million in a February 1993 IPO. Six months later, Zell took Equity Residential public, raising $322 million.
By 1996, the four Merrill funds were pooling their assets to create Equity Office. Zell's timing again proved to be prescient, says CEO Kincaid, 42.
Kincaid recalls working nights and weekends to arrive at a value of the properties in the funds that would satisfy their 48 institutional investors. Exhausted, he slouched on a couch in Zell's office and talked with his boss about the timing of the IPO. "I said it would take until the fourth quarter of 1997," Kincaid recalls. "Sam said, `No, we've to get it out by the summer."
"Through the Window"
Zell, Kincaid says, was betting that the market would soon be less receptive to new REIT offerings. "Sam realized we needed to get it through the window," Kincaid says.
Zell brought Equity Office public in July 1997, raising $564.5 million. The Standard & Poor's Composite REIT Index peaked on Oct. 6, 1997, and it fell 35.6 percent by the end of 1999.
Zell argued that owning buildings across the country would let the trust negotiate national deals with large tenants in multiple locations. Big REITs would get better prices from sellers of carpeting, paint and light bulbs -- and would pay less for capital in the bond and stock markets.
Zell continued to pursue expansion by acquisition, buying Beacon Properties Corp., a Boston-based owner of office buildings, for stock and cash valued at $4.3 billion in 1997. In 2000, he bought New York-based Cornerstone Properties Inc. for $4.5 billion in cash and stock.
Equity Office has only recently started to reap the promised economies of scale. In 2002, for example, the company set up regional offices to service properties rather than do so on a building-by-building basis.
Fielding Complaints
On the 12th floor of an Equity Office building at 10 & 30 South Wacker Drive in Chicago, a customer service center fields complai
nts -- about air conditioning or heating or lights -- for 35 buildings in the Chicago area.
Kincaid estimates the annual savings from these and other changes at $75 million to $100 million. The trust's annual bill for maintenance, repairs and property operating expenses was about $750 million in 2003.
Kincaid says he can't pledge to maintain the dividend at the 50-cents-a-quarter-level at which it has stood since October 2001. "That's not a remotely prudent thing for any company to promise," he says.
Kincaid says the company is confident enough to have repurchased almost $600 million of its own shares since 2002.
Zell calls Equity Office a company in transition. "Equity Office's world changed from an acquisition machine to an operating machine," he says.
Exiting Markets
The company is selling properties in markets in which Zell sees slower economic growth, such as Fort Worth, Texas, and Charlotte, North Carolina. Zell says the company will continue to sell, taking advantage of high property prices.
The change, he says, explains high executive turnover: Five of Equity Office's top seven managers in 2001 have since left. "There is only one constant in the company, and that's me," Zell says. "And Richard."
Executives who have worked with Zell say his management style is informal. "He doesn't want papers. He doesn't want reports," says Bruce Duncan, 53, CEO of Equity Residential. "Just tell him what you think, and defend it."
Investors also find him more freewheeling than most CEOs. "He is profane," Legg Mason's Fick says. "He says things that are not in the best interests of shareholders."
Two months after the terrorist attack on the World Trade Center, Zell questioned the rationale behind such tall buildings at a Los Angeles real estate conference.
"Phallic Symbols"
"They were just phallic symbols in an environment where we lived in La-La Land and thought we were never vulnerable," Zell said. Fick says Zell recently has restrained his colorful language in public speeches. "The last few times there have been fewer F-words," he says.
Zell's prognostications are closely followed. Each year, associates look forward to holiday greetings: a mechanical model of breadbox size made of polished metal, wood or other materials. One year, it was a representation of the naked emperor from the Hans Christian Andersen fable.
For 2004, it was a globe. A flick of a switch sets parts of the models in motion, and from inside comes a raspy salutation from Zell, who goes on to opine about the economy or markets. For 2000, he warned, "New technology will change our lives but will not change the basic laws of economics."
For 2004, Zell foresaw the backlash against the outsourcing of U.S. jobs and urged more training for American workers. "A dynamic capitalist society must continue to move up the food chain," he said.
Rising Rents
Now Zell predicts that office rents will rise because of a paucity of new construction. He says that the cost of replacing the kind of properties that command top-dollar rents has risen 30 percent in the past 18 months, as prices of construction materials increase. In the 18 months to July 1, for example, the price of hot-rolled sheet steel more than doubled to $646 per ton.
"Construction stops, and the market gets healthy," Zell says.
Even so, Zell says he's disappointed that the last recession did not produce the kind of real estate bargains he was able to find in the early 1990s. "Sam the Grave Dancer had nothing to dance over," he says.
Investors share his disappointment. After seven years as a public company and more than $20 billion of acquisitions, Equity Office still isn't playing a song they can dance t |
