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MODERN
SARDINEMANAGEMENT
Mr.
A
had
a
can
of
sardines.
He
sold
them
to
Mr.Bfor
$
7.
Mr.BsoldthemtoMr.
C
for
$2.
Mr.
C
sold
themtoMr.0for$3.Mr.0
opened
them
and
found
theywererotten.
He
complained
toMr.
C
thathewantedhis
money
back.Mr.
C
said
"No,
you
don't
understand.Thereareeatingsardines
and
tradingsardines.Thoseweretradingsardines."
by
SamuelZell
P
remise:Thecurrentoversupply
of
realestate
is
dif-
ferentfrompast
cyclical
excesses.Thepresentsitua
tion
is
aresult
of
commoditization
of
realestate.Realestateinvestmentratherthanbeingtheresult
of
in-depthunderstanding
of
thedynamics
of
theindustry,hasbe
come
thein-depthfocusonthenumbers.Thisnumericalorientation
has
replaced
discipline
andunderstanding.Theresults
of
thismisdirection
will
be
one
of
thebiggestlosses
of
capitalinthe
country's
history.
Real
estaterepresentsa
unique
investmentinanon
fungible
asset.The
unique
characteristicsare
induplic-
able.
Modern
valuation
techniques
applicable
to
industrialanalysisarebeingappliedto
brick
andmortar.Focusedanalyticalapproachemphasizesbroadnumericalassumptionsthatpresumerealestate
to
beanation
al
market.
Samuel
Zell
is
founder,
principaland
chairman
Df
theboardDfEquityFinancialandManagementCompany,
a
Chicago-based
nationwide
realestateDrganization
which
owns
and
Dperates
a
nationalportfDlio
of
residential
andcommercial
properties.
He
also
is
chairman,
presidentand
chief
executiveDfficf'r
of
Creat
Amf'rican
ManagementandInvestment,Ine.andchairman
of
thebDard
Df
FirstCapitalFinan
cial
CDrpDratiDn,
a
whDlly-owned
subsidiar!-,
Df
Great
American.Mr.
lell
is
a
frequentcDntributDr
to
various
real
estatepublications
as
well
asa
speakerandpanelist.He
is
a
graduateDftheUniversity
of
Michi
gan
and
theUniversity
of
MichiganLawSchool.
Realestateinvestmentdecisions
do
notlendthemselvesto
macroeconomic
issues.
Real
estateisalocalmarket,
by
definition.
It
is
not
possible
to
focusonnationaltrends;onemustfocus
on
localissuesandcharacteristics.Internalrates
of
returnandothermathematicalformulasforrealestateprojectionsattemptto
legitimize
thepresumption
of
predictableresults.
Twenty
yearsagotherealestateinvestorwastaughtthatthethreemost
important
lessons
of
realestatewere
"location,
location,location".
Todaythis
axiom
is
re-
placed
by
internalrates
of
return,
price
per
unitor
square
foot
andprojections
of
futureinflationrates.Althoughthese
new
factorsarerelevant,theyalsoindicate
we
havelostsight
of
thebasiccharacteristicsthat
drive
anddeterminethevalue
of
realestate.Thecurrentloveaffair
with
projectionshassubstituted
modern
analyticaltechniquesforthebasicunderstanding
of
thebusiness.
Real
estate,
as
an
investmentvehicle,
historically
has
been
driven
by
cash
flow.
Itsrole
in
an
investmentport
folio
wasstability,
low
risk,taxbenefitsandinflationprotection.Thehighinflationaryperiod
from
1977to1981distortedthisperception.Theproliferation
of
realestatesyndicators,
REITS,
pensionfundsandfinancialinstitutions,
viewing
realestate
as
growth
stock,
un-
realisticallyraisedperformanceexpectations.
Without
FAST
EDDIEHAD
A
CAN
Of
ABDULLAH
SOLD
THEM
TO
PREPPIE
SOLD
THEM
TO
SARDINES,
WHICH
HESOLDPETER
PREPPIE
FOR
$2.
MARVINMULLET
fOR
$3
.•.
TOABEL
ABDUllAH
FOR
$1.
 
giving
upthestabilitycharacteristicsdiscussedabove,the"numberscrunchers"haveelevatedrealestatebe
yond
realisticexpectation.Thiselevationprocesshasbeenachieved
by
superimposingnumericalassumptionsandattemptingtomakerealestate
conformto
expectationsapplicabletootherbusinesses.Atypicalrealestateanalysistodayassumesstablegrowth
with
yearlyincreasesinrevenuesgeneratedbyinflation.Futurerevisionsandalterationsin
demand
or
competition
are
not
incorporated
or
anticipated.
If
ananalystmadethesameassumptions
of
General
Motorsor
othercyclicalcompanies,theprice
of
theearningsratios
would
double.
Suchananalysis
would
receivevery
littlecredibility
fromthestreet,
but
is
acceptedinrealestate
as
amatter
of
course.Usingnumericalanalysisonrealestateandconversion
of
theinvestmentvehicle
to
aperformancevehicle,refleetsanaivetethat
only
canleadtodisaster.Theproliferation
of
non-realestate
thinking
individualsinthebusinesshascreatedperformanceindexesthatborderontheludicrous.Theideathatalocalizedmarketparticipant,namelyrealestate,canberealisticallyvaluedandincorporatedintoameaningful
nationwide
measuringsystemdoesnotmakesense.The
concept
of
quartertoquartervaluation
of
brick
andmortargeneratesnumbers
only
relevant
toinstitutional
investors
'who
demandtables
comparableto
those
used
in
stockmarket
investment.
How
meaningfularethesenumbers?Arecomparablesreallyatruemeasure
of
value?Doesthesale
of
theBank
of
AmericaTowerin
San
Franciscoreflectthemarket,or
is
ita
unique
property
sale?
Becauserealestate
is
asingularand
nonfungible
asset,itspricestructuremirrorsnot
only
its
income,
but
alsothebuyer'sperception
of
itsfuture
competitive
roleinaspecific
community.
Thebiggestlossesinthepasthighinflationaryperiod
will
be
recognized
on
acquisitionswhosepricejustification
will
be
comparablesales.Thismisconceptionfurtherdistortsevaluationwheninvestors
use
salesandperformanceinothercities
as
part
of
purchasejustification.
Historically,
the
premier
purchase
of
realestateoccurredbyopportunisticpurchasing.Conventionalwis
dom
madethe
acquisition
of
theUrisproperties
byOlympia
&
Yorkin1976thesinglebestacquisition
of
thelastdecade.
Would
theindexes
of
realestatevaluationin1976suggestthiswastheappropriate
time
to
commit
funds
to
New
Yorkofficespace?
Would
an
as-
sessment
of
comparables
in
New
Yorkhavesupportedthepurchase?Clearlynone
of
thesetests
would
haveendorsedthismove.Yettheresults
of
thatacquisitionhavebeenspectacular.
RealEstatePerformance
Real
estateperformance
is
areflection
of
pastandnotaprecursor
of
futurelevels
of
activity.Themostsignificantfactor
influencing
realestate'sfuturevalue
is
competi-
tion.
Onecould
arguethatthehigherthe
occupancy
andtherates,themore
likely
thislevel
of
performance
will
notcontinue.
Real
estateperformance
is
what
encour
ages
new
development.
When
evaluatingamarket,the
2
truetest
of
itsstrengthandtheI
ikelihoodof
futureperformance
is
therelationshipbetweentheeconomics
of
developmentandmarketperformance.Forexample,
if
officerentsinagivenmarketarestrongat$20netasquarefoot,andcost
of
construction
is
$150asquarefoot,thendevelopmentand
newcompetitionfollows.
Thus,a
new
developmentthatearnsa13.33%yieldencourages
new
buildings.Constructioncontinues
until
theyieldfactordeclines
to
discourage
new
market
addi-
tions.The
yield
factordeclines
as
aresult
of
both
in-
creasingvacancyfactorsandreduction
in
ratesor
con-
cessions.Tryingtoequaterealestateeconomics
with
corporatestrategiesindicatesthegreatestweakness
in
analyticalcomparison.Forexample,aconsumer
prod-uctcompany
developsa
new
product.Assuming
it
is
successful,the
company
is
abletomateriallyimproveits
profitabilityby
increasingmarketshare.Marketshareexpansionleadstolarge
production
runs
whichlower
costandincreasemargins.
Real
estateworksinreverse.Whereasaconsumer
product
has
an
almost
unlimited
audience
for
expansion,themarketforrealestate
is
con-
fined
to
thesize
of
thebUilding.Themoresuccessfulthedeveloperatrentinghis
building
andincreasingrates,the
more
likely
to
attract
competition.
Thereforetheeconomies
of
scale
which
increasemarginsandprofit
ability
inconsumerproductsarenot
available
to
realestatebecause
of
its
finite
size.
Dar
To
Access
Ratherthanfocusonnumericalindexesininvestmentdecisions,theinvestorshouldfocuson
unique
characteristicsthatprotecttheinvestmentfromcompetition.Thusbartoaccess
is
a
critical
element
in
theevaluation.Aregionalshoppingcenterillustratesthisprinciple.Acenter
is
anchored
bymajor
departmentstores
which
representthemagnetsthatattractshopperstothemall.
Whenthedeveloper
negotiateshislease
with
major
tenants,
an
integral
portion
consists
of
operatingagreementsandradiusclauses.Operatingagreementsrequiretheretailer
to
operatethestore
at
thatlocationunderitsname
for
periods
as
long
as
30years.Radiusclausesprovidetheretailer
will
notoperateanotherstore
within
adefinedsurroundinggeographicalarea.These
two
factorsenablethistype
of
investment
to
be
more
secureand
with
agreaterpromise
of
successbecausethe
likelihood
of
competition
isless
probable.
The
recent
legislation
in
San
Francisco
limiting
theheightanddensity
of
the
downtown
area
is
anotherex
ample
of
abar
to
access.Thislegislationprecludesthe
ability
of
competitors
to
enterthemarket.Italsochangestheeconomics
of
developmentsince
limiting
theheightreducestheeconomies
of
scalethereforerequiringmorelandpersquarefoot
of
building.
Thesefactors,combined
with
the
limited
geography
of
the
city,
makethisaprotectedhighcost(totheuser)market.Houston,
with
no
zoning,
presentsthereversecase.The
boomin
energywastheenginethatencouragedthemassiveoversupplyin
every
form
of
realestate.Butthisoversupplywasfurtherexacerbatedbythelack
of
REAL
ESTATE
ISSUES,
SPRING/SUMMER1986
 
impediments
to
expansion.Thus,residentialproperties
of
recentvintagewererazedfor
new
officespace.Everypiece
of
landrepresentedanother
opportunity
with
unfortunatelypredictableresults.The
ease
withwhich
sup
ply
wasincreasedreflectsamarket
with
nobarstoaccess.Demographics
is
anotherstatisticalbenchmarkcurrently
influencing
real
estate
investments.
Although
demographicsprovidea
window
inageographicalareatofutureexpectations,they
donot
provideleading
in-
dicators
for
thepotentialsuccess
of
agiveninvestment.
In
many
instances,justthereverseoccurs.Investorsoftenhavehad
difficulty
distinguishingbetweenwhatportends
well
forthoseintherealestateactivitybusi
ness
versusthose
in
theinvestmentrealestatebusiness.Therefore,
growth
statistics
may
be
verybullishfor
builders,architectsandconstructionlenders,butthis
activity
only
attractscompetition.Themostintelligentinvestmentmayperform
poorly
if
it
is
surrounded
by
toomuchsupply.
Quality,
as
abar
to
access,
only
works
if
the
quantity
element
of
theequation
is
undercontrol.The
ultimate
bar
to
access
is
replacementcost.
If
intheabove-mentionedexample,therentswere$12netand
new
constructionwasstill$150afoot,there
would
benoincentive
forcompetitionuntil
ratesrose
to
alevelthat
allowed
forprofitabledevelopment.
ReplacementCost
Replacementcost
is
a
component
which
requirescarefulanalysis.It
is
notlimited
to
cost
of
construction,anditrequiresanunderstanding
of
allthedevelopmentelements.
During
constructionlandcostandinterestaremajorelementssubjectto
wide
swings.Thelandpricesandconstructionloancostsfluctuate
widely
dependingonlocalconditions.Inboomperiods,landvalueshave
doubled
andtripledinresponsetoadevelopmentfren
zy.
Cost
of
fundsalso
has
wide
fluctuations.These
two
factorsmateriallyinfluence
an
investor'sperception
of
his
vulnerability
to
newcompetition
andthecomforthecan
draw
fromthecost
of
acquisition.
Securitization
Securitization
is
anothermagic
word
that
has
beenaddedtorealestatelexicon.Itrepresentsthe
pooling
of
realestatemortgagesinto
commercially
tradeableinstruments.
Justas
thecurrentmassiveoversupply
of
realestate
is
afunction
of
buyerratherthanuserdemand,
so
too
is
securitizationgrowththeresult
of
demandbytrad
ers
andinstitutions,notfromashortage
of
funds.Consequentlyscandalscontinue
to
surface
as,
lendersfindtheirsecuritypoolsimpaired,anddefaultratesareabovehistoricallevels.Whenanunderwriter
is
processingaloanhe
knows
will
sellimmediately,hiscareandconcern
is
directly
relatedtothelength
of
timeheownstheloan.Thisphenomenon
is
strikinglysimilar
to
thedevel
oper
who
buildsaprojectforsaleratherthanadevelopmentheanticipates
owning
l o n g ~ t e r m .
Thecurrentattempttodevelopsecuritizedcommercialmortgages
only
extendstheseparation
of
theinvestorZELL:
MODERN
SARDINE
MANAGEMENT
fromtheriskhe
is
taking.Securitizationconvertsmortgages
into
a
commodity
thatblurstherisktotheinvestor.Whereas
government
bondsandgovernmentagencybondstradeatariskdifferential,therisk
is
clearlydeliniatedan
an
efficient
marketfollows.Inrealestatemortgages,the
amount
and
qualityof
informationeitherprecludesinvestigation
or
requireseffortthat
is
unlikely
tobeundertaken.Theproliferation
of
securitizedtransactionsrepresentafurther
move
towardthereplacement
of
realestateexpertise
with
the
common
denominator,aMasters
of
BusinessAdministration(M.B.A.).
Segmentation
Segmentationandmarket
timing
are
new
additions
to
therealestatevocabulary.Segmentationrepresents
an
attempt
to
subdividethedemandside
of
theequation
so
as
to
justifycreation
of
a
new
product.Thecurrent
boom
intheconstruction
of
new
lodgingfacilities
is
aclearexample.Ahotel
is
ahotelunlessit'sabudgetfacility,a
highway
facility,a
convention
facility,asuitefacility,a
luxury
facilityorasuper
luxury
faciIity.Themostrecentphenomenon
is
thesuitehotel.
Many
marketsinthecountryhavenosuitefacilities
or
veryfew,andthus
we
areseeingthembeingconstructedinarapidproliferation.
When
an
investor
is
consideringthistype
of
investment,
what
is
therelevantmarketanalysis?Thedeveloperpresentsthecasethattheall-suitehotel
is
notimpacted
by
other
similar
facilities.Reality
says
thatalllodging,inanygivenmarket,competes
with
oneanother.Although
its
naturemaydiffer,there
is
almostalwaysaprice
point
that
will
changebehavior.Certainly
airline
deregulation
has
proventhatprice
is
averystrongfactorinbehavior
modification.
Thecreation
of
Jawprices
has
dramaticallyincreasedthe
number
of
seatsavailable,therebyaffectingthefullpricecarriers.
[s
thelodgingindustryanydifferent?Can
we
justifytheproliferation
of
new
segmentedfacilitiesbased
on
demandforlodging,ordoesitreflect
application
of
unusedincreasedcapacity?Doesthehotelchain
with
adevelopmentdepartmentmakefutureinvestmentdecisionsbecause
of
needinthemarketplace,
or
needinthedepartment?
Once
againwe
see
arecurringthemeinlodgingthat
has
beenperceivedinallrealestate,separation
of
riskfromresponsibility.Historically,hotelchains
or
franchiseoperationsownedthefacilitiesthey
built.
Thus
overbuilding
haddirectandoftentimescatastrophic
impact
ontheowner.Themarketbecamethe
ultimate
disciplinarian.Todaythehotelchainsoperateonmanagementfeesthatputtheentireresponsibility
for
financialfailureontheinvestor.A
new
hotelthatdoes
poorly
createsmassivelossesforthe
owner
anda
diminutionof
income
forthemanager.Thus
when
afeasibilitystudyona
new
facility
is
undertaken,theinvestor,notmanager,facestheresponsibilityfora
poor
decision.
MarketTiming
Market
timing
is
anotherconceptborrowedfromthemanagerial
world
andincorporatedintorealestate.The
3
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