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Supply and demand form foundation of Zell's principles

Sam Zell
File photo/Bloomberg News

San Diego has the opportunity to benefit from Sam Zell in the form of an investment in a footbridge that will allow the city to park in the United States and “walk across the bridge, get on a plane and fly away.”

“All my life I’ve been telling people, ‘I’ve got a bridge to sell ya’ — now I’m going to have a f---ing bridge,” Zell said.

The bridge will connect San Diego to Tijuana’s international airport, and Zell said he hopes construction will start this year.

“I don’t know if it will make a lot of money, but it’s going to be fun,” Zell said.

Zell, founder and chairman of Equity Group Investments, was the keynote speaker at the 18th annual Real Estate Conference on Thursday hosted by the Burnham-Moores Center for Real Estate at the University of San Diego.

Zell is known for his work with real estate investment trusts. He recognized his success in the industry and applied the principles of supply and demand and economics to execute similar strategies outside real estate.

“If you looked at what were the decision-making issues — how and why did we do what we do — I think you’d find that the criteria we used to make real estate decisions were exactly the same criteria we used in non-real estate,” Zell said.

The importance of supply and demand hasn’t changed in the 40 years since Zell first saw those three words written on the wall in his Econ 101 class.

“Supply and demand is still everything and where you can just excise information, understand information and execute accordingly, then what you’re really doing is what I call ‘logical things,’” Zell said.

An investment tax credit in 1979 fueled the country to build 120,000 rail cars in one year. From 1979 to 1985 only 20,000 rail cars were built in the whole country, Zell said, and at the same time, about 65 percent of cars were scrapped.

The country was growing, demand was increasing and supply was shrinking — making it obvious to Zell that he would have a great opportunity. He bought every used rail car and eventually ended up with just shy of 100,000.

“The logic behind it was really very simple. If they [aren’t] making more of it … and demand is constant, there’s a point at which those two cross and the owner gets extraordinarily rewarded,” Zell said.

When the country was flooded with excess office space in 1991 and vacancies were as high as they’ve ever been, Zell bought buildings at 40 cents on the dollar.

“I guess you would call it logic that said America is going to recover and those buildings are going to be full – and if I have the ability to manage them and the staying power, I have the ability to make a fortune. And I did,” Zell said.

There was $7 billion in the REIT industry when Zell became involved, and today the REIT industry is $700 billion. He said he’s optimistic about the industry and 10 years from now it could be double or triple that size.

It’s important to address liquidity when talking about the U.S. real estate market, Zell said.

“The level of liquidity within our society is at a level unmeasured by any historic standards. What that’s doing, among other things, is creating enormous demand for passive income. We will continue to see that happen over the next 10 years,” Zell said.

Commercial real estate construction from July 2007 to December 2013 experienced its slowest period that anyone can remember, Zell said. When thinking about the next 10 years, Zell said it’s important to consider supply and demand, and how a five-year hiatus on development may affect pricing, availability and access to capital and real estate.

Interest rates are “extraordinarily low” by any standards, Zell said. The average cost of U.S. debt has been 5.6 percent and today it’s 1.8 percent. It’s “highly likely” that it will return to average in the future and those in real estate are “scared to death” of what will happen when a five- or 10-year loan comes due.

As a result, he’s been moving debt as far out as he can and will “happily” pay 50 basis points more for 20 years as opposed to 10, he said.

“I think that’s the single biggest challenge for the real estate industry going forward: How are we going to deal with an enormous change in the cost of capital,” Zell said.

From 1975 to 1978 Zell bought $3 billion worth of real estate and “made a fortune.” He created $3 billion worth of debt at roughly 5 percent when the inflation rate was 13 percent.

“It’s really hard not to make a fortune if that’s the set of circumstances,” Zell said. “In many cases, I believe that you will see premiums being paid for debt written today that will be not realistic five years from now. As far as I’m concerned, if I take out a $25 million loan at 4 percent today, that’s going to be an asset in the next five to seven years … because of the arbitrage that I think is going on.”

Zell has always been a fan of diversification because “our ability to control the world around us is relatively limited,” he said. Within real estate, he diversified his investments from apartments to shopping centers, office buildings and mobile-home parks. There were various times and periods where one outperformed the other and balanced his company.

“We can’t predict the future. We can only prepare ourselves for the future,” Zell said.

His “canvas” is the world, and while he is active in the U.S. real estate market, he’s also building and creating real estate platforms in emerging markets.

The Fukushima disaster in Japan was “probably one of the best things to happen to Mexico,” he said, because it impaired the supply chains, causing companies to be nervous about their dependence on Asia. Based on that, he’s investing in manufacturing facilities in Mexico and “so far, so good.”

“We’re constantly looking at which is the better alternative, where do we invest,” Zell said.

He was very active in the creation of the modern REIT era and felt the benefits were so significant that they could be replicated around the world, which led him to build real estate platforms outside the United States.

Part of the decision-making process is defining the downside and evaluating how much risk the business is taking on.

“If we know that going in, we feel very protected and we feel we have enormous advantage,” Zell said.

He gave the example of a chain of department stores that he acquired out of bankruptcy. He sent out a real estate team to liquidate the 79 stores and tell him what the company would get — and they came back three weeks later with a number $50 million less than he was paying.

“From my perspective, that identified the scale and scope of the risk,” Zell said.

After three years, he sold the company for exactly $50 million less than he paid, and he said it was a successful transaction.

“We didn’t make any money. We lost money, but we scaled and understood, addressed what the issue was, what the risk was – turned out we were right. And if we’re right on the risk, then we’re able to execute accordingly and that’s the way we look at everything,” Zell said.

At 72 years old, Zell is the first one in his office at 6:30 a.m. and the last to leave at 7 p.m.

“The truth of the matter is I have always done really well because I love what I do, because I love a challenge and the idea of getting up every day and taking on a new set of challenges — nothing can make me happier, nothing could give me more fulfillment,” Zell said.

He’s always known that he was different — he recognized that he was driven and motivated by things that other people didn’t respond to. By the time Zell graduated from law school, he was managing about 3,000 apartments in three cities.

“No one told me I couldn’t do that when I was in school — so I did,” Zell said.

When he found out that the building a friend was living in was going to be torn down and replaced with a 15-unit apartment building, he told the company he wanted to manage it. As a student, he knew what the target demographic wanted. The company went for the idea.

Zell worked at a law firm after graduating from law school, drafted a contract and it came back covered in red ink. At 24 years old, he went to see the senior partner and told him that he didn’t think drafting contracts was a good use of his time, so he went back to doing deals.

“That was the only job I’ve ever had in my life — and the only boss I ever had,” Zell said.

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