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Billionaire Zell: Commercial real estate demise ‘greatly exaggerated’

Real estate mogul Sam Zell dismissed worries that commercial real estate problems would force the economy and financial sector into another crisis.

“A lot of savants have come public and stated that commercial real estate is the next shoe to drop and that banks are going to suffer again,” said Zell, who spoke before almost 700 people in San Diego last week as part of the Burnham-Moores Center for Real Estate’s 14th annual Real Estate Conference.

“I would suggest to you that the likelihood of that happening in any degree even remotely close to what happened in the single-family market is very unlikely.”

The commercial real estate industry will avoid mirroring residential real estate’s losses because the fraud in the loan paperwork and underwriting is far less prevalent, the chair of Chicago private investment firm Equity Group Investments said.

Furthermore, lenders would much rather extend terms on loans and wait for better times -- commonly referred to now as “pretend and extend” -- instead of foreclosing, taking a loss and getting stuck with an asset. Owners who can afford to, will hunker down and carry on.

“I believe it was Confucius who said that 'a rolling loan carries no loss,'" Zell quipped.

This won’t result in the multitude of distressed opportunities some fear or seek.

“There ain’t no grave-dancing opportunities because nobody’s got the equity that you can grave dance on,” Zell said, making a reference to his nickname of Grave Dancer, acquired from his history of buying “dead” assets. “If there are opportunities in distressed real estate, it’s not in the buying of real estate, it’s in buying the debt.”

He said it would be more likely that owners whose properties are worth less than their mortgages, or are “underwater,” will sacrifice substantial equity to investors and institutions willing to relieve their debt burdens. There is plenty of capital in the market ready to snap up high-quality assets, Zell added.

Mark Riedy, the executive director of the Burnham-Moores Center, agreed.

“The game right now is buying debt because then you can foreclose on a property,” he said after Zell’s remarks. “You buy a debt at a cheaper price, (and) you don’t have to worry about what the value of the property is.”

Zell described the reports of commercial real estate’s reported demise as “greatly exaggerated” but acknowledged the sector has its share of problems to work through: Valuations and rents remain low, while vacancy rates and capitalization rates are high.

For retail and industrial properties, only the fittest will survive, said Zell, who is particularly pessimistic about so-called lifestyle centers, or mixed-use commercial developments aimed at a more upscale market.

Apartments, buoyed by available debt from mortgage giants Fannie Mae and Freddie Mac, remain the healthiest of the asset classes, he said.

Owners of property sold between 2000 and 2007, overleveraged and hurt by what Zell called the “total re-pricing of the asset base,” have little to no equity and thus no incentive to sell.

“We’re talking about 'clearing of a market' but you can’t clear a market until there’s motivation to sell,” Zell said.

Zell described the commercial real estate downturn as a “very concerted period of pause” and a “demand recession,” evidenced by the lack of new commercial real estate construction since July 2007. He expects little to no development for the next five years and joked with an audience member that contractors should consider going to medical school in the meantime.

Zell’s words on the issue of supply and demand in the real estate market are critical, Riedy said.

“He brought everything back to that fundamental concept,” Riedy said. “We got far, far away from that. We quit looking at what supply is and what effective demand is and who the people are who have the demand. And because money was so plentiful, we got away from the basic equation, and when you do that, eventually it becomes unsustainable and collapses.”

This year will see some improvement, however, Zell said. Demand will return slowly, absorbing some of the supply. Capitalization rates, which move inversely to values, will come down slightly.

He added that occupancy rates will rise, albeit at lower rates than at the peak, and predicted that by mid- to late 2011, vacancy scenarios would become more traditional and would be a less critical part of real estate analysis.

Zell also offered some thoughts on the residential real estate market during the question-and-answer portion that followed. He believes the single-family market is “at equilibrium” but thinks that more affected markets like San Diego will recover more slowly.

Zell added that the homeownership rate needs to come back down to 62 percent -- the U.S. Census Bureau reported it was at 67.6 percent in the third quarter -- before he would consider the market sustainable.

The Daily Transcript’s Kevin Sue contributed to this report.


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