Renowned Investor Warning That Recession Is on the Way

Sam Zell knows a thing or two about Los Angeles real estate, as head of the nation’s largest office real estate investment trust, Chicago-based Equity Office Properties Trust.

Equity owns several buildings in L.A. 550 S. Hope, 10880 Wilshire Blvd., 10960 Wilshire Blvd., Two California Plaza and the Pasadena Towers. It also owns a portion of the debt on 1999 Avenue of the Stars in Century City.

Zell wears another hat, as chairman of Equity Residential Properties Trust, largest owner of apartments in the country.

Zell was in L.A. recently to deliver the keynote address at the Real Estate 2000 Conference at the Century Plaza Hotel. He sat down with the Business Journal to discuss the local economy and real estate market.

Elizabeth Hayes

Question: The ongoing economic boom seems downright indestructible, even with interest rates rising. What’s your take?

Answer: I tend to be a little bit more pessimistic than the average person at the moment. I think the level of speculation that currently exists in the stock market, which translates down to everything, is quite significant. The fact that we’re fueling our economy by using the proceeds of IPOs to pay for advertising is something that I’m very concerned about.

The best analogy I can give you is 1984-89, when every single new building was worth less when it was finished than what it cost to build. So we had an enormous amount of capital allocated to real estate that made no contribution other than creating a period where people felt good. They were employed, buying a lot of office furniture and stuff like that. But it was all fluff. I think the depth of the 1990 recession reflected that.

You have a very similar kind of risk going on now, where the economy is being buoyed by artificial means IPO proceeds and dot-com craziness that I’m concerned will stop and stop sharply. And when it does, the impact on the economy will be much greater than everybody envisions. If I were a prognosticator, which I sometimes am, I would think the next recession will occur at the same point that the IPO window closes.

Q: Any sense of when that might be?

A: I think it’s sooner rather than later and frankly, the sooner it happens, the less painful it’s going to be for the economy and society.

Q: Have you had Internet companies that wanted to sign big leases at your buildings using IPO proceeds?

A: We have that problem all the time e-commerce companies coming to us wanting to rent space, and the only thing they have going for them is a (venture capital) burn rate. Obviously, you deal with them by getting letters of credit for (tenant improvements) and various other things to reduce your risk. But it’s risk, nonetheless. People don’t remember that in 1984 when the price of oil cracked, all kinds of flaky oil companies walked on their leases.

Q: What else are you requiring of dot-com tenants?

A: We’ve been offered stock options and warrants, and I wouldn’t preclude that as a possibility as part of the compensation in the future, but that doesn’t reduce my risk. If I sell you my $10,000 cat for your two $5,000 dogs, I don’t know what I’ve accomplished.

In terms of the real estate business generally, intelligent real estate players are keenly aware of this risk and hopefully mixing their tenant bases so that they don’t have extreme exposure to dot-com world. Obviously, depending on where you are and what kind of properties you own, your potential exposure varies. There are areas in Silicon Valley where every company is a dot-com company. And if you own the building, you’ve in effect made a big bet on e-commerce. Generally speaking, we have attempted to avoid that kind of concentration because we think it’s a risk, frankly, we’re not getting paid for. It isn’t like dot-com companies are paying 50 percent more in rent to reflect the risk they represent to the owner.

Q: L.A. is continually being left off national publications’ lists of best places to do business. Is it that hard here?

A: I think it’s just the opposite. It’s an easier environment than Northern California for sure. And I’m not just talking about real estate, I’m talking about everything. I invested (in L.A.) based on my assessment of what I thought the economic viability was. I think the economic viability of L.A. is terrific.

Q: Are you looking at buying more properties in the coming year in L.A.? What submarkets do you like?

A: I would imagine that in the next year we will add significantly to both our apartment portfolio and office portfolio. I think that is likely to come partially from direct acquisitions, more likely from acquisitions of other companies.

The consolidation theme that everybody has talked about for a long time is happening, and the pressure is particularly acute among smaller REITs, illiquid REITs, who say, “There’s no way I can ever catch up to the dominant players.”

If you really wanted to put a label on the last seven years, in particular, you’ve seen the beginnings of oligopolization of our industry.

Q: When will this be complete?

A: I don’t know, maybe 40 years from now. Everybody forgets, commercial real estate represents something like 15 percent of the GNP. It’s so big that it’s not an overnight scenario. On the other hand, you are starting to see very, very significant concentrations of ownership in cities around the country. My guess is that over time the number of those people (who control large commercial real estate portfolios) will stay the same, but what they control will significantly increase.

Q: Where do you see the L.A. market vis & #341; vis the nation?

A: There’s little doubt that L.A. has had a wonderful recovery from the overbuilding of the ’80s and there’s no question this is a major, vibrant market and I see nothing on the horizon that’s likely to change it. Furthermore, you have very, very difficult entitlement issues here that act as a natural barrier to entry.

You combine that with the reality of today, which says if you want to build something, you’ve got to put up equity, cash, and the barrier gets even higher. There is absolutely nothing that has a greater impact or discipline on our industry (not to overbuild) than the requirement of equity. And (the equity requirement) is not going to go away because it’s a reflection that the real estate industry now must compete with every other industry for capital.

And certainly there’s your job-growth side of the market, with media and communications and e-commerce. Having said all that, could this area get overbuilt again? Sure. It wouldn’t take a lot because the term “equilibrium” is very fragile, and it only takes one idiot to overbuild the market.

Q: How about the still-soft downtown market?

A: I think downtown is making progress. You haven’t seen any new office buildings built in downtown (in recent years). I don’t think you’re going to see any built. I think if the city of L.A. hadn’t decided at the depths of the depression to build a whole bunch of new municipal buildings downtown, that market would have already recovered.

I’m very optimistic. When it’s all said and done, you have an infrastructure in place downtown that’s irreplaceable. You have a whole bunch of highways that all criss-cross, you have a bunch of civic facilities, whether it be a new stadium or music hall. Those are all elements that I believe contribute to the future of downtown. And by the way, given the right transaction, we’d buy something else in downtown L.A. today. We have significant confidence.

Q: The biggest obsession of local leaders is to transform downtown into a 24-hour city, where people live, shop, work, play. Is that a pipe dream?

A: Downtown Dallas is no different than downtown L.A. It’s Death Valley at night. It’s a bunch of big buildings and yet, take a look. There’s an area there called East Elm and other peripheral old areas where both new stuff is being built and they’re converting warehouse buildings into condos and loft apartments. Again, that is to some extent driven by the employment base that says, I don’t want to go out to Addison (Texas) or Ventura (California) to live. Maybe I don’t want to go downtown, but certainly downtown is a lot better than Ventura, and I can live halfway and still be on all the grids and expressways and, eventually, you may even have public transportation here. Maybe.

Q: What do you think the odds are that we’re going to attract a critical mass of residents downtown?

A: How patient are you? If you don’t put a timeframe on it, I think it’s an inexorable move, as inexorable as moving to the suburbs was in the ’50s. If you went up and down Bunker Hill and knocked on everybody’s door and asked them how they like living on Bunker Hill, I think you might be surprised at the kind of positive responses you get.

Q: Do you see the trend of office tenants moving into converted warehouses and campuses continuing? Will institutional tenants start preferring that type of space, rather than high-rises?

A: Unlikely. I don’t think there’s any evidence to suggest that’s a trend or represents an alteration in usage. I think for the last 30-40 years, there has been demand for suburban-type campuses, space where companies can provide amenities to their employees, beer parties or whatever. But that’s one kind of tenant.

Another kind of tenant, which may be a law firm or accounting firm or statistical firm, has different kinds of needs, and in many cases they need to be in urban centers where immediate access to everybody else is really important. If you look at the demographics, you’ll see that more and more jobs are being created in central business districts, and they’re for sure the strongest part of the office market today.

Q: Is converting obsolete office buildings into lofts an undertaking you would do?

A: It’s not our cup of tea. I don’t understand the risk-reward ratio of being in the development business, but we certainly might be more than willing to own the stuff under the right circumstances.

Q: On the Westside, rents have been going through the roof and certain tenants have been getting priced out of the market. Do you see that as any kind of threat to Westside landlords?

A: You are right now coming off of a whole bunch of leases that were written in ’92 and ’93 and ’94. At that time, the market was still very soft. Tenants who otherwise wouldn’t be able to afford a class-A building could afford an A building. Now their leases are expiring and they still can’t afford an A building, but they’re in it because they got in at a lower rate and now they’re going to have to move. It’s just that simple. But that’s America, that’s capitalism.

Q: And there are plenty of better-capitalized tenants capable of replacing them?

A: At the moment, there is no shortage of tenants who are prepared to do that. On the other hand, if you took the dot-coms out of the market, it might change things. If the wild speculative optimism of today became a more cautious focus tomorrow, you might have very different approaches. How much space somebody needs is a lot like, what’s a woman’s greatest asset? A man’s imagination. If you think your business is going ape, then you’re apt to jump to the conclusion that you don’t have enough space and you’ve got to do something now.

Q: Tell us about your decision to buy part of the debt on 1999 Avenue of the Stars. Since JMB is still the owner, what was the attraction of that deal?

A: Let’s start with the fact that I think it’s the best building in Los Angeles, so that’s the first, second and third reason. Second of all, it fits into the quality of our portfolio and we’re managing the building, so therefore, it’s part of our network. We have a debt position and an option in the future to own it.

Q: One of L.A.’s biggest constraints to growth has been the area’s lack of affordable housing. As a major apartment owner, what would you suggest be done?

A: If L.A. really wanted to create affordable housing, it could create the equivalent of an enterprise zone where it made the cost of land a lot cheaper in return for some kind of limitation on rental increases.

Everybody talks about affordable housing but nobody wants to afford it. The reality is, “affordable housing” is just a bull,, term. What it really comes down to is s cheap housing, OK? And the answer is, if you want cheap anything, somebody’s got to subsidize it in one form or another.