The New World Of Real Estate

Its titans are quickly turning a private industry public as they amass vast empires

It almost seems as if much of the $3 trillion in commercial real estate in the U.S. is up for grabs. On Sept. 9, Starwood Lodging Trust, which owns more than 100 hotels, won the battle for Westin Hotels & Resorts with a bid of $1.6 billion in cash, securities, and debt, creating a hotel empire with more than $4 billion in annual revenue. A few days earlier, Equity Residential Properties Trust, the country's largest apartment owner, snapped up Evans Withycombe Residential Inc. for $1.1 billion in securities and debt. And Simon DeBartolo Group Inc., the nation's largest regional mall operator, has placed a $1 billion bid on the table to acquire Retail Property Trust, which owns a choice portfolio of malls.

To some--including badly burned investors--the buoyant activity appears reminiscent of the painful commercial real estate debacles of the mid-1970s and early 1990s. As those episodes demonstrate, commercial real estate is prey to boom and bust cycles, largely due to long-term construction commitments. Overbuilding, overleveraging, and overreaching have regularly produced waves of bankruptcies and billions in losses.

A MAMMOTH WAVE. But if an audacious new breed of real estate tycoons has its way, this time it will be different. 0ver the past few years, the world of commercial real estate has dramatically transformed itself in a way that could temper those cycles. The reason: what Sam Zell, the biggest owner of office buildings, apartments, and manufactured housing in the country, calls "a massive revolution in how the real estate industry is viewed, financed, and valued, and in its long-term role in the U.S. economy." That revolution will not abolish real estate cycles. But Zell and other real estate experts argue that it will lead to more stability. That should mean a healthier industry more hospitable to investors.

By far the most crucial changes in the business involve the financing and management of real estate. Until the early 1990s, most real estate was owned by private, family-owned companies that relied entirely on borrowed money and generated returns by flipping properties. The 1990s bust, though, caused private financing to evaporate. The mortgage-backed security market emerged to provide debt financing. And as industrial corporations had done decades earlier, real estate firms started tapping the public market, via initial public offerings, for equity capital.

The vehicle was the real estate investment trust, or REIT, which was created by Congress in 1960 but that had never attracted much interest. Now REITs are proliferating rapidly. "We are watching what could be the biggest asset class in the country--bigger than the Treasury or bond market--begin to go public," says Andrew Davis, manager of the top-performing Davis Real Estate Fund. "Ultimately, REITs are the way real estate should be owned."

REITs are companies that own, manage, and develop pools of properties, from apartments and office buildings to self-storage facilities and now, even prisons. In exchange for following rigid guidelines, such as paying out at least 95% of taxable income in dividends and earning that income primarily from leasing buildings, REITs are exempt from corporate taxation.

Now, a mammoth consolidation wave is creating dozens of huge, far-flung REITs with billions of dollars in portfolios that stretch from coast to coast. The market capitalization of the REIT industry has soared from $8 billion in 1990 to $120 billion today. The total capital of REITs and the handful of real estate operating companies that exist is $200 billion. The commercial mortgage-backed securities market has grown to $144 billion. In the ways that they function, these new mega-REITs are light-years away from the old family-owned empires. REIT execs argue that their companies should weather industry cycles much more handily than the old firms. They offer these advantages:

-- permanent public financing;

-- modest leverage, with debt levels of roughly 30% of equity, vs. the 70% or higher levels prevailing in the 1980s;

-- large, diversified portfolios and economies of scale;

-- active management, vs. the passive approach of

the old REITs, and professional, corporate-style management;

-- accountability to shareholders, including abundant disclosure of information;

-- one of the highest percentages of management ownership of any industry in the U.S.

Richard E. Rainwater, who took Crescent Real Estate Equities public in 1994, a company now worth $3.2 billion, sums it up: "Often, private ownership led to improper financing, managing, and evaluation of real estate. The public market keeps those kinds of mistakes from being made."

Yet other real estate executives willingly concede that, despite the new REITs' virtues, mistakes certainly will be made. Bernard Winograd, chief executive of Prudential Real Estate Investors and former chief financial officer of Taubman Centers Inc., a REIT, says professional management will inject some discipline in an industry notorious for its freewheeling ways. But he adds that "the public markets are just as capable of overshooting the mark as the private markets are." Barry S. Sternlicht, head of Phoenix-based Starwood Lodging Trust, a large REIT, cautions that today's prices are getting steep. "It will be fascinating to see who gets caught with the empty chairs," he says.

Getting caught in fierce down cycles has always been an occupational hazard in commercial real estate. After a flourishing start in the 1960s, the REIT industry fell into a black hole in the mid-1970s, largely because of high interest rates, excess leveraging, and lax business practices. REIT assets slumped from $20 billion in 1974 to only $7 billion in 1979. In the 1980s, a new breed of healthier REITs emerged, but were largely overlooked: Loans for up to 100% of development costs flowed freely from banks and savings and loans. What equity capital was needed came from foreign investors and private limited partnerships that benefited from tax incentives. And when another even larger black hole opened in the 1990s, largely as a result of the thrift fiasco, financing from traditional sources dried up completely and prices plunged.

INCREDIBLE BARGAINS. That was the catalyst that revolutionized the industry's financing. Seeing an opportunity, real estate financiers paired with Wall Street firms to form "vulture funds" that bought up distressed properties. Led by Goldman, Sachs & Co., they picked up bargains at what now seem incredibly low prices. For his efforts, Zell, partnering with Merrill Lynch & Co., earned the moniker "the grave dancer."

Crushed by debt, cash-strapped developers had no choice but to turn to the public equity market. In late 1991, Merrill Lynch launched a new era for REITs by raising $130 million in an initial public offering for mall developer Kimco Realty Corp.--the first integrated operating company to come public as a REIT. Soon after, Taubman Centers pioneered a new twist on the REIT format called an "umbrella partnership," or UPREIT, which let entrepreneurs exchange buildings for stakes in a parent company that was then sold to the public. That opened the floodgates, allowing private developers to obtain liquidity without having to pay capital-gains taxes. By 1993, REIT offerings hit a record high, with 50 REITs going public, raising a total of $9.3 billion. Also stepping into the capital vacuum were innovators such as Nomura Securities Co.'s Ethan Penner, who almost single-handedly jump-started the commercial mortgage-backed securities market.

By 1995, the REIT industry had come into its own. "Even after 1993 and 1994, it was still unclear whether this would have permanence," says Richard B. Saltzman, a managing director of Merrill Lynch's Investment Banking Group. But by 1996, he says, the markets achieved a near-irreversible critical mass.

Even with their rapid growth REITs are just a sliver of the $3 trillion commercial real estate market. But as public REITs grow in size and expand the scope of their business, they are having a ripple effect on the entire industry. To survive, many private firms, as well as smaller REITs, are choosing to partner with their public brethren. Some of the action is fueled by a generational shift, as 70- and 80-year-old entrepreneurs look for a way to make their estates more liquid.

In order to attract institutional investors, REITs are in a race to get bigger faster. Institutional investors are starting to forsake direct investment in real estate to focus on buying--and swapping properties into--REITs. On Aug. 18, for example, a Dutch pension fund swapped $1 billion worth of U.S. office buildings for $508 million in cash and $547 million in the stock of office REIT Cornerstone Properties. In 1990, about 90% of REIT shares were owned by retail investors. Now, well over half of outstanding REIT shares are owned by institutions.

The real estate players that have survived are those with the ability and foresight to adapt quickly to changes in the industry. The most visionary of them are Sam Zell and William Sanders. The two are far apart in temperament. Zell is a colorful, outspoken, often abrasive man who enjoys riding his motorcycle with a group of business executives called "Zell's Angels." Sanders, who is described as private, professorial, and gentlemanly, albeit given to occasional temper tantrums, is a workaholic--he even uses a Dictaphone to capture his thoughts while driving down his miles-long driveway on his vast ranch in Santa Fe, N.M.

The evolution of Zell's real estate business shows the industry's dramatic transformation. Back in the early to mid-'70s, Zell foresaw the first big property crash and rushed to pick up distressed properties. In the late 1980s, anticipating more problems, he prepared to launch vulture funds to pick up distressed properties. His first such venture was with Merrill Lynch in 1988. His purchases proved too aggressive, and the liquidity crisis of the early 1990s started squeezing him. Zell was saved by the public markets and the forbearance of some lenders, which allowed him to deleverage while he continued to buy. Now, Zell heads three REITs: Manufactured Home Communities, with $594 million in market cap; Equity Residential Properties Trust, with $3.7 billion; and Equity Office Properties Trust, with $4.6 billion.

STREET APPROVAL. Zell is an ardent believer in gaining economies of scale through consolidation. Since its IPO in 1993, Equity Residential has dropped its general and administrative costs to less than 2% and has seen per-unit property-management costs drop as well. For a glimpse of how Zell benefits from economies of scale, take a look at his 14,000 apartments in Seattle. He used to spend $150 per unit for an apartment-listing service; now, his own listing service has cut the cost in half. As for insurance costs, negotiated on a national basis, he figures they will drop 25% in the wake of a newly acquired portfolio of apartments.

The stock market approves of Zell's strategy. The one-year return of Equity Residential, Zell's flagship REIT, is 50%. Zell has been on a roll in 1997. In just his apartment REIT alone, he has bought units worth almost $2 billion so far this year, and he has another $1 billion deal pending. By comparison, his apartment acquisitions in 1996 totaled $754 million. "Within the bounds of discipline, he wants to be as aggressive as possible," says institutional REIT analyst Mike Kirby of Green Street Advisors Inc., based in Newport Beach, Calif. "Zell's view is that you can hardly make a mistake by being aggressive--unless you are stupid."

Operating from his headquarters off of Santa Fe's main historic square, William Sanders is perhaps the most powerful landlord in the country. He presides over an incredibly complex ring of REITs with a combined market cap of $8.6 billion, and he has stakes worth about $2 billion in scores of other REITs. In a business dominated by unabashed self-promoters, Sanders is an oddity. His name doesn't even hang on his small office building. There is not a single color photo of him available. He is said to make anyone who works with him--inside the company or out--sign confidentiality agreements. "We don't want anyone to make off with our ideas. I am shocked at what my competitors say publicly," he says in a polite phone conversation to explain why he won't be interviewed.

There is nothing hidden about Sanders' goal: to drive the securitization of real estate around the world by creating dominant public companies in several focused property classes. Sanders' ascent has much to do with timing. In 1988, he sold his stake in the company he had previously founded and run, Chicago's LaSalle Realty. Two years later when the market--and LaSalle's reputation--fell apart, Sanders had already started over in Santa Fe. But rather than merely snap up distressed properties, he decided to first set up a research and development arm to map strategy and act as a merchant bank to startups that he would then bring public.

The first investment was Security Capital Pacific Trust, a tiny, shaky El Paso REIT that Sanders remade into the dominant owner of apartments in the Southwest. Security Capital Atlantic plays the same role in the Southeast. Denver-based Security Capital Industrial is the national leader in warehouse and distribution space. Homestead Village, a spin-out from Security Pacific and Security Atlantic, is a big extended-stay hotel operator in the Southwest. Separately, Security Capital us Realty has made lucrative strategic investments in existing public or private REITs such as CarrAmerica Realty Corp. and Storage USA. Sanders' funding and research has turned both of these companies into powerhouses. To raise funds for a half-dozen new launches, including a luxury-hotel company and a European real estate investment unit, Sanders is bringing the center of his operations, Security Capital, public as a regular corporation, not a REIT.

GRANDER AMBITIONS. While Sanders takes the cake for complexity, perhaps the most aggressive acquisitor at the moment is Vornado Realty Trust, based in Saddle Brook, N.J. Vornado is headed by the shrewd 55-year-old Steven Roth. It has racked up a total return of 74.2% over the past year and is up 32% so far this year. Roth, who likes keeping a very low profile, wouldn't speak for attribution.

Since Roth began operating Vornado in 1980, the company's focus has been on shopping malls in the Northeast. But the support of rapidly growing capital markets is enabling Roth to have much grander ambitions. His REIT is selling for an 80% premium to the value of its underlying assets--the highest premium in the industry. In order to keep generating stellar returns, Vornado is refusing to limit itself to a certain product type or geography. Roth has a good incentive to boost the stock price: He and a few other executives own about 50% of the company.

Late last year, Roth shocked the industry by hiring former Goldman Sachs partner and real estate investment banker Michael D. Fascitelli, one of the most prominent dealmakers in the business, for a compensation package heavy in stock options and estimated to be worth as much as $50 million. Fascitelli was brought on to make the most of Vornado's balance sheet by putting more of the company's capital to work in an entrepreneurial way by investing across sectors and regions.

Since Fascitelli signed on in December, 1996, Vornado has been aggressively expanding into a hot sector: office properties. The company has also been buying up holdings of some of the best-known private real estate operators. On Apr. 15, Vornado became the first REIT to storm New York City when it closed on its purchase of 4 million square feet of space in seven midtown Manhattan office buildings owned by New York real estate magnate Bernard Mendik, one of the city's biggest private property owners. Roth had called on Mendik after learning that he planned to take his New York City office company public as a REIT. As Roth recounts in a letter to shareholders, Mendik, a former client of Fascitelli at Goldman, was cordial, but he never called back. Then, "the day after it was announced that Mike was joining us, Bernie called Mike. Our deal was announced on Mar. 12."

Soon after the Mendik deal, Vornado outbid a number of REITs and opportunity funds, including Starwood Capital and Leon Black's Apollo Group, for the mortgage on the 41-story, 875,000-square-foot office building at 90 Park Avenue in New York. Vornado, which had been outbid in two previous deals, paid $185 million, $20 million more for the property than the seller had expected. At the moment, Vornado is said to be competing with premier mall REIT Simon DeBartolo Group to purchase the mall portfolio of the O'Connor and Jacob groups. If successful, Vornado would grab the portfolio before it goes public, as planned, with partners in a new megamall REIT IPO.

Green Street's Kirby says he isn't worried about players of Roth's caliber getting too aggressive. He notes that in the past Roth, "has only pulled the trigger twice" and that each time Roth took such aggressive action, it proved right on the mark.

The first time Roth made a big move was in purchasing the Two Guys department-store chain for its real estate in 1980, when the retailer went bankrupt. Roth then went on to outmaneuver none other than Donald Trump to buy bankrupt retailer Alexander's Inc. "Here is a guy who has exercised enormous discipline, saying, `Now is the time I need to get aggressive,"' says Kirby. "Investors are willing to go along for the ride."

If prices get too high, Vornado has development and redevelopment opportunities. Not only does it own the prime Alexander's site in New York City but Vornado has bought up much of the property around the busy Madison Square Garden area, including the office building atop Pennsylvania Station. The company envisions an entertainment and restaurant complex at the site.

BREAKING THE "SHACKLES." Rainwater is a dealmaker of a different sort. He has some 30%, or $425 million, of his $1.5 billion in net worth tied up in Crescent Real Estate Equities, which, next to Vornado, trades at the industry's highest premium to underlying value. Rainwater believes that 10 years from now, the value of REITs will top $500 billion and that in 15 years, it will hit $1 trillion. "There's still a tremendous amount of real estate in private hands that will eventually come into the public market," he says.

Rainwater created a record this past April by easily raising $533 million in a secondary equity offering. He has used those funds to gobble up high-quality office properties in the Southwest. Rainwater argues that energy prices are getting ready to take off and that the Texas economy, and Houston in particular, will be one of the main beneficiaries.

Crescent "acquires markets, not buildings," declares Crescent ceo Gerald W. Haddock. The REIT owns 50% of all Class A office space in Houston, 30% in Denver, 35% in Austin's central business district, and 12% of such high-quality office space in Dallas. Crescent's dominance in Houston has allowed it to raise rents at Houston's Greenway Plaza by 15% to 20%, as well as in some Dallas suburbs, where it has increased rental rates 25% to 30%.

Crescent operates somewhat like Rainwater's personal venture-capital fund. Its assets include resorts, retail, residential, and health-care-related properties. "We refuse to be categorized by a single, isolated sector," says Haddock. "We are a growth company because we have broken the shackles of the traditionally passive REIT."

In June, Crescent spun out a new operating entity as a regular corporation, not a REIT, to handle some of the operations that the REIT, by law, cannot. Crescent Operating Inc., which some analysts are dubbing "baby Crescent," includes a 50% interest in Charter Behavioral Health Systems Inc., the nation's largest behavioral health-care provider, and 100% of the lessee's interest in Crescent Real Estate Equities' seven hotel/resort properties.

One of the youngest titans to emerge is the supremely confident 36-year-old Barry Sternlicht, head of Phoenix-based Starwood Lodging Trust and Starwood Capital, based in Greenwich, Conn. As a 28-year-old partner at Chicago's JMB, the real estate advisory firm, Sternlicht was involved in one of the firm's biggest disasters ever--its purchase of Randsworth Trust, a $425 million wipeout. As jmb's deal flow crashed, Sternlicht grew restless. After seeing one of the first Resolution Trust Corp. auctions, he knew it was time to go. "A band would play every time they auctioned something off. It was priceless--like they were selling cows. I thought: `There has got to be value in those small packages."'

THE VULTURE'S NEW ROLE. Luckily, Sternlicht had a friend who let him test his hunch. With the help of Dan Stern, who was managing the fortune of the Burden family, Sternlicht raised an initial $60 million. With that, he started buying apartments in the West and prudently swapped them 18 months later for a stake in Zell's apartment REIT before it went public, locking in an immediate 200% paper gain. Sternlicht went on to focus on hotels. His smartest move was buying Hotel Properties Trust in 1995, a nearly bankrupt hotel company with a novel, rare, grandfathered tax structure called "paired shares," which allowed it to both own and manage hotels. Other hotel REITs have to contract hotel management to a third party, since the income stream from room-service operations and restaurants doesn't fit the guidelines of where a REIT's income can come from. In the past 2 1/2 years, as Sternlicht has bought more than 100 full-service hotels, the market cap of Starwood has grown from $8 million to $3 billion, rewarding shareholders with returns in excess of 75% a year.

Hotels are merely Sternlicht's public business. Privately, out of Greenwich, he runs Starwood Capital, an opportunity fund that has raised $2.5 billion and returned more than 50% per year to investors since 1991. Sternlicht recently concluded an awkward phase of his career, having to stay out of Starwood Lodging Trust's negotiations for the Westin chain, since Sternlicht's opportunity fund co-owned the property with Goldman Sachs. Having won Westin, Sternlicht now has a worldwide brand he can use to unite his portfolio. He may also spin out an office REIT from Starwood Capital, and is concentrating his new opportunity investments in the riskiest property category: raw land acquisition and development, including the conversion of military bases.

One of the most radical redefinitions under way is the role of the vulture. These players must move in bigger and bigger concentric circles to find 20%-plus returns. More than $10 billion in vulture-fund money awaits investment. Instead of picking off RTC properties, they are investing abroad and in real estate-intensive operating companies. Thomas Barrack, the head of opportunity fund Colony Capital in Los Angeles, defines his universe of real estate-rich options as ranging from timber to casinos. He has taken a majority stake in a British cinema company and owns one of the largest Duty Free shopping networks, as well as the posh Aman resorts in Southeast Asia. While finding new high-yielding investments may be tougher, selling existing holdings is a cinch. Acquisition-hungry REITs are paying higher and higher prices. "I love it," says Barrack. "We find niches of illiquidity, clean it up, and bring it in a wheelbarrow to Wall Street."

Of course, some private titans will always remain. Empires such as those of Chicago's Pritzkers and California's Shorensteins have enough heft to stay private and independent. Pressure from public markets to keep buying more properties is one reason why some private empires hesitate to take the route of the REIT. "The market is demanding growth," says Douglas W. Shorenstein, chief executive officer of Shorenstein Co., which controls much of the office space in the San Francisco market, including a quarter of the city's financial district, with such trophy properties as the Bank of America Tower. "If you become a REIT, you have to be an active buyer. And you have to ask the question: Is it the right time to be out there voraciously buying? We would have to be convinced that the public markets would allow us to wait to the down cycle to buy before we became a REIT."

Yet public markets also put some checks on the tendencies toward excess. That's because they react much more rapidly than do private markets. In the 1980s, capital continued to flood into the market even though the fundamentals had turned south. Today, however, if REIT cash flow starts to drop, REITs will quickly find it extremely difficult to raise capital for acquisition or development. Another important check: REITs will go into any coming bear market with far less leverage than in the last cycle. A downturn would likely mean a serious correction in stock prices, but not wholesale asset write-downs.

While the new generation of moguls is undoubtedly changing the way real estate is viewed as an investment, not even the force of Sam Zell's personality can abolish the real estate cycle. But if these new managers are able to operate their massive holdings with the right mixture of entrepreneurial zeal and professional governance, real estate could become a far more attractive asset to a far wider range of investors.

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