The Human Barometer

By Janet Morrissey

Maybe it's time to bury the label that has always attached to the Chicago investor Sam Zell. He has been called the "grave dancer" because of his appetite for distressed or mismanaged assets, from real estate to railcars. Yet Zell manages to find an awful lot of life in dead assets--his net worth is estimated at $6 billion.

Sometimes Zell, 66, shares his views with friends through an annual New Year's e-mail, in which he changes the lyrics of a song to reflect his thoughts. In January 2006, he opined on the private-equity boom through a remake of Raindrops Keep Fallin' on My Head--changed to "Capital keeps rainin' on my head/ So much is out there that the world is out of whack/ When will we see balance back?" The ending: "We need to be prepared for slim annuities."

This year Zell orchestrated the largest leveraged buyout ever when he sold his Equity Office Properties (EOP) Trust to Blackstone Group for $39 billion in a hotly contested bidding war. He also led the winning $8.2 billion bid to acquire the Tribune Co.--a deal that is yet to close. Zell won't comment on Tribune, but during a recent trip to New York City, he did sit down with TIME's Janet Morrissey to talk about the economy, the debt markets, housing and where he sees the greatest opportunities today.

Did your sale of Equity Office Properties Trust mark the top of the real estate market and the peak of the private-equity boom?

I didn't think about it as a market-topping scenario, but I would say to you that it's unlikely that a deal of that size is going to get done again.

We continuously and consistently told everybody that we--by virtue of going public and taking the public's money--had a responsibility both fiduciary and otherwise to protect them and recognize value. In the case of EOP, somebody made us an offer that was higher than our own internal assessment of the value, and under that set of circumstances, I had an absolute obligation to respond, which I did. And what made EOP so unique is that it had such an extraordinary collection of what people refer to as trophy assets, and that drove the whole process.

Will private equity still chase after public real estate companies and real estate investment trusts (REITs)? Is there still an attractive spread between where the public markets value real estate and where the private market does? Or has the turbulence ended this?

Well, clearly today the private-equity access to unlimited debt with very little covenant protection has certainly changed. And that certainly would make taking companies from the public to the private much more difficult. It started because the private guy could finance at a much higher rate than the public guy could, and therefore the assets moved from public to private. Guess what happens when the private guy can't finance at that rate? The assets are going to go from private to public, just as they did in the '90s.

Do you see the debt markets getting worse before they get better?

We have slowly started to recover. And liquidity is slowly returning to the debt market. However, I can't see a return to the levels of debt that were made available before or the covenant-light scenarios. So the pendulum has swung back to a more conventional debt market. We're actually having to put up equity and have covenants you have to look to.

You own a residential REIT--Equity Residential--and thus have an interest in how housing plays out. We're already starting to see investors renting instead of selling homes they bought, because they can't unload them. And a glut of new rental housing could impact rents in buildings like yours. Where is housing headed?

The key to housing is the employment rate. As long as the employment stays basically full--say, under 5.5%--I see no major crisis in the housing market. Yes, we have a subprime issue. Yes, we have a lot of investors who got hung out, but I don't see the crisis the way the media portray it. And consequently, as long as employment stays strong, I don't see any issue as far as rental housing is concerned. Our apartment company continues to rent at 95%. We continue to see same-store-sales increases from one year to the next. I don't think that the unsold inventory of houses will have any dramatic effect on the apartment-rental business. The cost of owning is helping the rental-housing business today, and it will continue to do so. I don't expect any significant competition from unsold houses.

You say you don't see a crisis. Yet we're hearing about a growing number of defaults, and credit has become tighter even for conventional mortgages--not just subprime ones.

But we're also building a lot less houses now. For many years, we averaged about 1.6 million houses a year. And then in the last four years, we went to 2.1 million. We're regressing to the mean. So there will be a period of indigestion but no crisis. No meltdown in the housing market. That's ridiculous.

What about all the individual investors who jumped into the housing boom to flip homes and were left with hundreds of homes to sell when the music stopped?

All of those people were all about greed. And where is it written that thou art entitled to flip a profit? Not anywhere I know of. So I'm not very sympathetic. And the fact that all of these investors allowed their greed to overcome their fear--that's the way the world works.

Where do you see the economy going? Are we heading for a significant slowdown or recession in 2008, as some economists have predicted?

Not 2008. If you had to pick the next cycle change, logic would say it would be sometime in 2009 because of a new presidency and because of the various factors in the market. And that's a probability. But I don't see it as 1990 or 1974 or any of those periods where we had a real serious downturn.

You don't see similarities between those periods--which also faced high leverage and turmoil in the debt markets--and now?Of course there are similarities. But in those other scenarios, all of those things happened at the same time as a recession happened. It accelerated the negative. The fact that we've had a financial crisis at the same time as the country is in a growing phase will mute the impact overall. So we'll have a relatively minor correction, but more than likely a correction.

Why do you think a new presidency could hurt the economy?

Well, I think a new President comes in and wants to fix the problems--whatever the problems are. And if you look back at the first year of most Presidents, they take steps and operate under the thesis that maybe I've got to inflict a little pain, but I'll do it in the first year so that by the fourth year they won't remember. That's been the story of politics in this country for a long time.

You have a long and successful track record for picking up distressed assets, turning them around and pocketing big returns. Do you anticipate a glut of distressed assets out there in the near future, given the problems in the credit and debt markets?

I don't think there's going to be any massive amount of distressed assets. I believe that at the moment the most interesting opportunities in real estate are outside the U.S., where the level of growth is significant--a multiple of maybe two or three times the growth rate in the U.S. And so we've been looking at and investing in various countries around the world--particularly the emerging markets.

Which countries?

Mexico, Brazil, India and China, to start. Our focus so far has been primarily in the low-cost-housing area, where we're actually building houses. But we're involved in the shopping-center business and the office-park business as well.

You said you see two to three times the growth in these countries. Are you referring to demand? Rents? Rental growth?

I'm talking about the growth of the economy. In other words, China is growing at double-digit--we're growing at 2%. Last time I checked that compiles to 5 to 1. India is growing at 8% or 9%. Mexico is growing at 6%, Brazil is growing at 8%. So all of those places are growing much more rapidly than we are. And that creates demand and therefore creates opportunity. In many of those countries, they have a very, very limited real estate supply because of the historical unavailability of capital.

Do you see M&A activity slowing down?

We will continue to see mergers and acquisitions. Now, to a large extent, they've been derailed by virtue of the fact that you've had such an active public-to-private market--and I've just said that I think the public-to-private market is going to take a hiatus. But that will lead to more M&A transactions among public companies going forward.

I know that you send out a New Year's e-mail message to friends each year giving your thoughts and predictions on the market. Care to share this year's theme?

All I can tell you is this year's going to be real neat.

Can I get on your mailing list?

Absolutely not. [This article contains charts. Please see hardcopy of magazine.]