BLUEPRINT: When the music stops

Sam Zell is biding his time until he puts on his dancing shoes.

The billionaire, nicknamed the “Grave Dancer” for buying cheap real estate from distressed owners, is unsure of the exact cause or timing of the coming real estate downturn he is predicting. But, when it comes, he is prepared once again to live up to his moniker.

“Basically I think we’re near the end of the cycle,” Zell says. “We started to see significant new construction and we’re starting to see resistance to the parade of rising rents, particularly on the residential side. How this current cycle will end will be very much a function of how much supply is being added.”

Zell keeps a close eye on the residential side through one of his real estate investment trusts, Equity Residential, one of the largest apartment owners in the US. Last year, the REIT sold over 23,000 apartments, about a quarter of its portfolio, to Starwood Capital Group for $5.4 billion. Many industry observers read the deal as Zell calling the top of the market, though Equity Residential executives counter that the REIT was selling its suburban and secondary city assets to focus on its core urban markets.

With that price tag, though, comparisons have inevitably been made to the blockbuster Equity Office Properties Trust transaction in 2007. The REIT was the largest owner of office buildings in the US before Zell sold the portfolio to The Blackstone Group in February 2007 for $39 billion. Zell hiked up that price tag by initiating a bidding war among several leading public and private real estate firms, leading to one of the largest leveraged buyouts in history in a deal that came to represent the boom and bust in the US commercial real estate market.

If industry observers were not convinced by decades of Zell’s real estate prescience before 2007, the Equity Office deal crystallized his reputation, which he began building decades before in Ann Arbor, Michigan.

Zell got his start in real estate by managing and owning student housing with Robert Lurie, an undergraduate friend turned lifelong business partner, during law school at the University of Michigan. By graduation in 1966, the duo managed over 4,000 apartments and owned around 200 units outright before Zell sold his stake and moved to Chicago.

After working less than a week at a law firm in the Windy City, Zell struck out on his own to build on the success of his law school real estate ventures. He impressed local billionaire – and Hyatt Hotel chain founder – Jay Pritzker so much that even after Zell turned down a job with Pritzker, he agreed to back a Lake Tahoe condominium development deal Zell planned in 1969.

It was in 1968 when the newly-minted lawyer founded Equity Group Investments, which Lurie helped build and run alongside Zell until his death in 1990. The private investment firm now has holdings spanning multiple industries and asset classes, but it started as a partnership to buy distressed apartment buildings in small to mid-sized cities. As the economic downturn of the 1970s spread from multifamily to retail and office assets, Zell and Lurie likewise expanded their real estate investments. In the 1980s, the company broadened outside of real estate to purchase distressed companies ranging from a plastics packaging company to a passenger cruise line.

Zell was one of the first investors to raise an institutional opportunistic real estate fund, launching his first vehicle in the late 1980s when many of the institutions he asked for capital had no allocation to real estate. At the time, he said the institutional community was discussing if real estate even merited its own asset class designation. Despite the debate, he successfully partnered with Wall Street to raise $2.1 billion for four Zell/Merrill funds in the late 1980s/early 1990s.

When you’re not selling, you’re buying

After decades of amassing institutional capital, Zell invests across major and niche asset classes, from malls in the 1990s to a Latin American hotel operator recently. Whether purchasing mobile home parks or prime gateway city offices, the real estate magnate’s often-repeated investment mantra has held steady.

“Every day you don’t sell an asset, you’re choosing to buy it,” he says. “When we use that kind of analysis, generally speaking, we’ve been much bigger sellers than buyers lately.”

Zell branched into emerging markets real estate by co-founding Equity International in 1999. The private equity real estate firm has about $1.2 billion in assets under management, according to a year-end filing with the US Securities and Exchange Commission, and focuses on income-producing, asset-backed investments, with holdings in 21 emerging markets ranging from Peru to China to Egypt.

Zell prefers to operate as chairman of his various businesses and stays out of day-to-day operations, leaving Equity International chief executive Tom Heneghan, who has been with Zell’s various platforms for nearly the entirety of his career, in charge.
Equity International declined to comment on fundraising. The firm is currently in the market with this latest opportunistic vehicle, Zell Equity International Fund VI.

Investors include the Teacher Retirement System of Texas (TRS), which allocated $125 million, and Zell’s alma mater, the University of Michigan, which committed $40 million, according to PERE Research & Analytics. TRS has invested with Equity International for five years, and a spokeswoman for the pension system notes the firm’s good track record in emerging markets as rationale for the continued investment.

“A legend in the real estate world, Zell has been extremely successful, has invested through several cycles, and has notable longevity in the business,” the TRS spokeswoman says.

Investments using capital from the predecessor fund, which launched in March 2010 and closed on $650 million in September 2011, include an Indian hotel operator, a Mexican industrial real estate company and an Asian logistics real estate firm.

“We look for those opportunities to bring asset classes that are not seen as institutional into an institutional format, be it self-storage or cell towers,” Heneghan says. “In many of these emerging markets, these asset classes have never been developed.”

No matter the destination for his capital, Zell’s primary indicator of growth comes from asking a simple question.

“If you had to zero in on one critical question, it would be ‘where is the money coming from to pay the rent?’ Is it coming from profits and margins, or is it coming from equity contributions?” he says. “Obviously the answer to that question will have enormous implications for how this cycle ends. I raised that question because I’m worried about the answer.”

Zell notes that demand, the basic driver of growth, is the scarcest commodity. He says technology is starting to alter demand in unprecedented ways, and adds that the traditional drivers of the need for real estate are shifting as “we’re in a world of very significant disruption.” Zell cites driverless cars, Internet-based home-sharing platforms such as Airbnb and the rise in e-commerce as some of the myriad technology-driven trends reshaping how consumers access and use real estate across asset classes.
However, he cautions that firms should avoid immediately embracing all of the aforementioned changes without due diligence. Airbnb, for example, has approached Zell and other major multifamily operators about a revenue-sharing program, but the firm declined to negotiate a deal before it sorts out the myriad legal and operational problems involved with peer-to-peer lodging.

“Our world is changing,” he says. “As it changes, so too does real estate have to change.”

Heneghan adds Equity Group’s various platforms have made use of mobile-based applications and other platforms to streamline how users interact with the company.

These upgraded processes save time for both consumers and companies, and can reduce the headcount needed to operate various parts of the business. For example, Equity LifeStyle Properties, a REIT that operates in the manufactured homes and RV spaces, now allows RV site reservations through smartphones, an upgrade from many campgrounds’ archaic websites or first come, first serve approach.

“It’s a mistake if you think you can resist the change that’s coming because of technology. If you understand what’s going on, you can leverage many parts of your business to benefit,” Heneghan says.

Macroeconomic headwinds

While demand is the primary challenge Zell grapples with, he listed a host of other macroeconomic and geopolitical headwinds confronting the real estate industry, the most pressing of which is currency.

“There’s no question that the US dollar strength is a significant headwind all over the place,” Zell says.

To be sure, a robust US dollar could be advantageous for some in the industry, but Zell thinks globally. A strong dollar can depress profits for tenants, leading companies to re-evaluate their global real estate needs. Returns in emerging markets in particular have been lower for many real estate firms due to foreign exchange fluctuations, and hedging can be difficult at best.

Zell is also thinking critically about the consequences of central bank policies and the impact of normalized interest rates on debt that is coming due in the next few years.

And without diving into details on the US presidential candidates themselves, he has general concerns about the country’s unstable political environment, which affects real estate domestically and internationally. No matter who is elected in November, Zell notes the federal government is operating at a financial deficit, and may look to industries including private equity and real estate for revenue sources.

“As an observer of what’s going on, I think that the country is having a populist revolution,” he says. “I think there is a real challenge in the political system to the kind of capitalistic methodologies that we’ve undertaken in the past. The tea leaves suggest that capital is at risk. If you think Bill Clinton equated to an era of deregulation, I think right now we’re in an era of over-regulation. So far, nothing in this political environment suggests we’re likely to go in the other direction.”

Despite these and other significant macroeconomic and geopolitical headwinds, Zell is confident about institutional capital’s pursuit of real estate.

“Right now, the real estate allocation in the institutional world is less aggressive than it was, say, two years ago,” he said. “I think real estate allocations are likely to increase because more than anything else, I think real estate has shown a much more vigorous ability to respond to volatility than a lot of the other asset classes.”

Notes of approval

After decades in the industry, Zell’s calls are generally met with approval – even from those who have faced off against him.

Starwood’s founder, Barry Sternlicht, has known Zell for the majority of his career, interacting with him in various roles. Sternlicht served on the board of Equity Residential for several years, including at the time of the REIT’s initial public offering in 1993, and took part in the bidding war for Equity Office. And the blockbuster 2015 transaction with Equity Residential represented Sternlicht’s third bulk purchase of apartments from Zell.

“Sam Zell is truly a legend in our industry. Few people I know see around corners and have their finger on the pulse of the world the way Sam does,” Sternlicht tells PERE. “Sam is tough, as you’d expect, but honorable to a fault. He may ask for a lot, but if you agree on a deal, a deal is a deal. That’s not run of the mill today. His experience and global contacts are close to unparalleled in our space today and it’s a really good time to have those credentials as the world wobbles forward.”

Zell’s prediction of an upcoming downturn is far from the first wobble he has seen – and on which he has made his name. In 1976, his article for Real Estate Review entitled “The Grave Dancer” birthed his nickname and ended with words that ring true many real estate cycles later.

“Grave dancing is an art that has many potential benefits,” he wrote. “But one must be careful while prancing around not to fall into the open pit and join the cadaver. There is often a thin line between the dancer and the danced upon.”

Another industry veteran, Blackstone’s global head of real estate Jonathan Gray, was on the other side of the Equity Office transaction and most recently, his firm purchased real estate finance company Capital Trust’s investment management platform in 2012 for $21.4 million. Zell was the chairman of that public commercial mortgage REIT.

“I always love doing transactions with Sam,” Gray says. “He is so decisive and clear thinking in his approach. It really sets him apart from others in our business.”

Not all observers are quite as complimentary as these industry titans. Some real estate onlookers regard Equity International co-founder and former chief executive Gary Garrabrant’s seemingly abrupt exit from the firm in 2012 as a black mark. Garrabrant and former chief strategic officer Thomas McDonald left Equity International to set up their own private equity real estate firm, New York-based Jaguar Growth Partners, which also focuses on emerging markets.

Both parties decline to comment, continuing a policy of public silence on the matter.
Not many high-level people leave [Equity International]; their retention rate is every executive’s dream,” one Chicago area fund manager tells PERE. “I’ve always been curious if it was a clash of personalities or another reason.”

Betting on chaos

Equity International thinks Latin America’s shaky geopolitical outlook is an opportunity – with caveats.

Zell has seen Latin America’s evolution from chaos to investment grade to, depending on an investor’s definition of risk, chaos again.

Despite today’s unstable environment in Brazil and other Equity International focal points, Zell maintains a positive long-term outlook for Latin America, citing strong population growth and upward movement into the middle class.

“Even though I think it’s taken a hit right now, I think that growth is a continual trend that will make Latin America a worthwhile investment,” he says.

In Brazil, Equity International primarily focuses on Sao Paulo and its outskirts, as well as Rio de Janeiro to a lesser extent. Like Zell, chief executive Tom Heneghan is realistic about the region’s myriad political and economic challenges that can be viewed as an opportunistic investor’s chance to snap up properties at attractive prices – or a signal to run far, far away.

“Just about anything you can think of going wrong in a country, [Brazil] has experienced,” Heneghan says. “I refer to it as the biblical plague. They’ve got their unemployment, corruption, high interest rates and an oversupply of real estate. That has scared a lot of capital away, and it has made in-country capital almost non-existent.”

Because Brazil’s currency has plunged against the dollar, foreign capital goes further in the country. But volatile currency also means the firm must get paid for the risk, which it does through preferred returns when EI invests alongside a local partner.

The firm relies on these local partnerships in many emerging markets through what Heneghan deems a mutually-beneficial relationship. As Equity International gains on-the-ground expertise, local partners become more institutionalized and have better visibility through working with the US-based firm. In one such partnership, the firm invested in invested in Acosta Verde, a Mexican shopping center owner and developer.

Heneghan says Equity International looks for dislocated markets in Mexico, which has a more institutionalized real estate market than Brazil, and housing offers the right intersection of strong demographics with little supply.

While the firm sees pockets of opportunity, Zell says he is also aware that any geopolitical changes – and the list of possibilities runs long – could stop this positive sentiment toward Latin America.

“Frankly, this is probably the most unstable world that I have ever recognized,” Zell says.