Sector Analysis

Martin Cicco: To begin, it is worth noting that this panel represents the heads of organizations that control more than $100 billion worth of real estate assets. Let’s start with a quick overview of the property markets. Are the real estate markets stabilizing, getting better or worse? Terry, how’s the apartment business?

Terry Considine: The apartment business has been quite soft for the last couple of years, partly because of job losses and partly as a result of interest rate-induced supply.

Martin Cicco

Cicco: Sam?

Samuel Zell: I agree with Terry. I think it continues to be a relatively weak market. The biggest factor has been that in previous periods of weakness there has been a cessation of new construction. This time around construction has continued, thereby postponing the recovery. As a result, the apartment industry has been affected by a confidence gap, but I think it is diminishing as the activity level quiets down.

Cicco: David, it’s been a great run for the consumer. How’s the retail business?

David Simon: Retail has been solid and steady. Comparable NOI (net operating income) growth has been 3 percent to 4 percent. Demand for space is still going strong. We’re fortunate to have under-market value leases for our company so we can continue to grow our NOI, and we don’t see that changing. Retail always has its ebbs and flows, particular retailers come and they go, but quality real estate can continue to grow its EBITDA.

Cicco: You’re up, Steve. The consumer keeps going; do you still like the retail business?

Steven Roth: Retail is acting better than expected. The interesting thing about retail is that it is less of a commodity than other kinds of real estate. An office building here, next door, across the street, are almost the same, but great retail properties in unique locations are sustainable, extraordinary investments. I’ll add that great office properties in unique locations are also sustainable, extraordinary investments.

Cicco: Ed, is the office business better than six months ago?

Edward Linde: I don’t think there’s been any measurable change. Wishful thinking would have me say that things look better, but, frankly, until we see real economic recovery and job growth, we’re not going to see much of a change. There’s no pressure on corporate America to expand into more space and until they feel that pressure, there won’t be much change.

Roth: I would add to what Ed just said. Vornado’s office buildings are located in New York City and Washington, D.C. We’re able to hold occupancies in these markets, but pricing is suspect. The tenants think it’s a tenant’s market and, by and large, it is. We also, as David said, have below-market rents and are therefore able to hold our income stream. We’re not able to get the rents that we could have gotten two or three years ago, but we can hold occupancies and asset values continue to go up pretty dramatically, actually.

Cicco: Sam?

Zell: All I can say is that we have rented approximately 12 million square feet since December 1, 2002. We have record levels of activity. We don’t like the price, but what we’re seeing is a renewed level of interest.

We are being—and I’m using the word carefully—attacked on “blend-and-extend” deals, i.e., tenants who have leases expiring in 2007 and 2008 are coming to us and saying, “Rates are at record lows, why don’t we write a new deal and we’ll give you five more years of term.” That level of activity suggests that the decision makers, who, for almost a year, operated like they were deer caught in headlights, are starting to anticipate and recognize that there is a tomorrow. And all of sudden they are saying, “wait a minute, rates are low, landlords are suffering, this is the time to get even.” And they’re trying. But just the fact that they’re trying is an awesomely positive event compared to the last couple of years.

Everybody forgets that this recession and this weakness in the office market began in the West and only about a year ago came to the East. It is very easy to sit in New York City and pretend that what’s happening here is just a minor example of what’s happening everywhere else in the country. New York has felt this last. We’re starting to see positive absorption on the West Coast that we haven’t seen in more than 24 months.

Cicco: Tom, you’re based halfway between the coasts. You feel any better in the Midwest?

Thomas Hefner: It’s always better in the Midwest. Occupancies are moving up; net rents are still working toward the bottom. Activity has perked up. I happen to think corporate America has used this period of time to rethink their business models and how they want to run their businesses. And I think clarity will begin to appear, and is beginning to appear.

Our experience with tenants is that they have two philosophies on lease terms right now. Either they want to remain short-term because they’re still figuring it out, or they want to try to lock in long-term and there’s not much in between.

Economic Outlook and Interest Rates

Cicco: Are we going flat line or are we in the midst of recovery?

Simon: What we really need to see to feel better is some job growth. If the service industry is moving to India and other places, and manufacturing is less and less important in the U.S., where’s the job growth going to come from? Ultimately this affects all of us here; office, apartments and also retail in the sense that our consumer—the U.S. consumer—will spend the money as long as they feel comfortable that they have a paycheck coming in.

To the extent that lay-offs and lack of job growth opportunities exist, I would expect some pull back in terms of their consumption habits. But I don’t see job growth yet; maybe it’s around the corner but I’m not enough of an expert to predict that.

Zell: In almost every previous recession, you first see growth and in the first six months to nine months of growth, you also continue to see job losses. And I think that where we are today is very similar to those previous periods where the country has started to grow but we’re still dropping jobs. I think that a turnaround is in the offing and I personally think that interest rates are going up, inflation is going to be a problem, and all this fairy tale thinking that’s been going on about deflation and 2 percent interest rates for the rest of your life, I don’t believe it and I’m fixing all my loans.

Considine: Marty, I’d agree with Sam with one qualification. I think inflation, instead of being a problem, is going to be a relief, and that it’s going to benefit holders of hard assets. I think you can see the enormous appreciation of the euro in the last 12 or 15 months as an indicator of inflation. My expectation is that job growth will follow at the end of this year. The timing is hard to call, but all the indicators are that this enormous fiscal and monetary stimulus will result in increased activity and increased inflation.

Cicco: You’re fixing the interest rates.

Considine: Not yet, but we’re watching it.

Cicco: Tom?

Hefner: I think emotionally it feels like we’re treading water but I think intellectually, we’ve probably begun a recovery. In three months, we’ll probably believe we’ve started a recovery.

And we don’t ever wait on interest rates. If you want to bet against the market, do opposite of what we do. But at these rates, we’ll take them all day and we won’t wait. We’ll take some interim dilution because I tend to agree with Sam that the world isn’t going to be a low interest rate environment for very long.

Cicco: Ed?

Linde: I agree with most of what has been said. If you’d asked me this question 30 days ago, I probably would have been more pessimistic. I don’t think it’s going to manifest itself in the real estate business for a bit because, as Sam just said, job growth doesn’t happen until the recovery starts to really progress.

I think the fact that we are now seeing—and I take with a great big grain of salt what the economists say—some return in business investment and low inventory levels that are now going to start to be rebuilt and things of that nature. I think that gives us grounds for optimism. I do think that interest rates will probably stay low for some period of time—maybe longer than some economists predict. Although I don’t have a great fear about deflation, I just think interest rates are going to be kept low. That’s because I think there’s going to be a real effort not to cut off whatever recovery starts too soon, and I think there is as much politics as economics in that.

As far as fixing rates, over the last six months we [Boston Properties] have done more than $1 billion of bonds. Obviously, we did the first one too soon, but the last one was at 5 percent, and I’m happy to take those rates all day long.

Cicco: How far out?

Linde: Ten and 12-year maturities.

Cicco: My resident Ph.D., you haven’t said anything.

Steven Roth: Clearly there is a recovery beginning; there’s no question about that. The real issue is how vigorous the recovery will be and that’s very difficult to predict. The best thing we have going for us is that it is the policy of the government of the United States to support economic ebullience. And they’re doing it in spades, and they will do whatever it takes, including lowering interest rates again and again if that’s what it takes.

With respect to interest rates, I’ve heard all of you geniuses, but every time you’ve locked in fixed rates in the last six months, or year ago, or three years ago, or five years ago, you were beyond wrong. So I think you have to be fairly respectful of trying to guess the bottom. The fact of the matter is that since 1981 and Federal Reserve Chairman Paul Volker, the United States has been in an unbelievable bull market for interest rates. I do not yet see anything that suggests that that bull market is over, that the bell is ringing.

Now, I grant you that interest rates are lower than they have been, but they’re zigging down; when the knife is falling, it’s very hard to catch that knife. If you bet wrong on interest rates, fix your balance sheet and lock in rates, but rents keep going down, you are dead. So you have to be very careful.

The way we look at it, the largest single variable cost we have is the cost of money. So if there’s a guy who owns a million foot building and he’s got locked-in 7 percent rates, and I can build a new building next door and borrow the money at 4.3 percent, I’m going to hurt him.

I spend more time on rates now than almost anything else and I’ve come to the conclusion that I can’t be quite as dogmatic as Sam. We at Vornado have an incremental approach to rates. Empirically, we’ve observed that if you had floating rates over the last 10 or 15 years versus fixed, you would have been right in all but three or four months of the last 15 years.

One last comment: it seems to me that the globalization of the world is something that has been coincident with the decline of inflation and the decline of interest rates over the last decade or two. And globalization is not being turned back.

Cicco: Well done. David?

Simon: Well, I was going to ask Steve, why don’t you do more floating rate debt with your worldly view?

Roth: Because you can’t stand the gamble. By the way, there’s no such thing as long-term money in our market. If you have five-year money and you roll over five-year money, you still have a 70-year building. If you have rolling five-year money, that’s almost floating rate in a way.

But the other thing to think about is that the balance sheet of every one of our companies is way over market rates. If we could refinance our debt at anywhere near today’s rates, we would increase our income stream $150 million a year.

Zell: Funny nobody ever mentions that, they only mention that the rents roll down.

Roth: That’s the point. One of the reasons that you have to be very careful with fixed rates is that rents can roll down even more. Rates are now benign, and I want to see the color of the tenant’s eyes and know the rents are going back up before I get really aggressive on fixing rates. That’s where I am.

Zell: I think we need to add one more thought to this discussion: I challenge all of you to look at the headlines from late 1992 and early 1993, a period very similar to where we are right now. And those headlines were: jobless recovery, double dip recession, and potential deflationary impact. Same headlines in 1992 and 1993 as you’re reading today.

I took Economics 101 and here’s what Econ 101 taught me: I have a government that had a $150 billion annual surplus that is now running $300 billion or $400 billion negative for as far as the eye can see. You know, Greenspan can keep rates way down, which is what he’s doing right now. I think that’s phenomenally inflationary. In other words, if you artificially keep rates down, how is that any different than price controls that inevitably lead to an enormous bounce on the other side.

Everybody talks about this housing bubble; I think the American public is smarter than the guys on Wall Street. I think the American public said, “if I’m getting 1.5 percent on my savings account and inflation is 2.5 percent, I ought to take the money out of the bank and buy more brick and mortar. And that’s what they did. And everybody refuses to attribute that to the possibility that the American public could be smart. But, in fact, they understand inflation because they’re out there buying stuff everyday. All you people who are talking about deflation everyday, are you noticing that every month you have more money left over because your operating costs are cheaper? Tell me what’s cheaper out there. Where is all the deflation?

David, what’s happening on the retail side? Are the prices in the stores going down?

Simon: They are in certain apparel categories, yes.

Cicco: Terry, deflation? Inflation?

Considine: I think Steve’s right. If we’d known 20 years ago what we know now, we would have all gone short and floated down.

Zell: No, we would have bought Microsoft.

Considine: We’ve had a 20-year decline in interest rates, which is stunning, but the question we face today is one of straight-line extrapolation. And at some point, lines turn which, for example, is why we're not worried about the Dow at 36,000.

I think Sam’s more right looking around the corner. I think that in a democracy, the temptation to solve political pain by printing money is enormous. You have a president who has done a great job in a lot of areas and who has seen what happened to his father. He is not going to go into the next election without doing everything he can to prime the pump. The result of that is going to be increased economic activity. I think it’s going to work, but the dollar will continue to devalue. You’re looking at inflation—anything that you buy that’s produced in Europe has just gotten 30 percent or 40 percent more expensive in a 12 or 15 month time frame. That’s an amazing change.

Roth: There’s no doubt there is a recovery going on, right? The question is, what’s the duration of it, what’s the size of it, how vigorous will it be? That’s the issue. It will have to be proven that the recovery will be significantly vigorous in some measurable time frame—three years, two years–to drive interest rates significantly higher. I don’t believe it.

Considine: But do you believe that we are close to the end of it?

Roth: Well, there’s more up than down, of course. What we’re doing is what I think all of you are doing. We incrementally buy a little money at this price, see it drop, buy a little more at that price, marvel at it, say it’s amazing, see it drop, buy a little more.

Linde: And then you’ll follow it up.

Roth: Yes, sure. We’re always chasing it.

Linde: Fact of the matter is your revenues don’t change.

Roth: Well, the revenue will change based on these conditions. All I’m saying is that you have to average down; you can’t make the big bet.

Considine: That change in revenue is inflation to your tenant.

Roth: Absolutely.

Simon: Let me ask you this question, if you had 40 percent to 50 percent floating rate debt today, what would you be doing?

Roth: What would I be doing? I would be sleepless.

Simon: Would you be fixing your rate?

Roth: You can’t live with 40. First of all, the market won’t let you, and the second thing is that it is too aggressive.

Considine: But any one who was in the business in the 1970s is going to be cautious about owning long-term assets with short-term floating rates.

Cicco: But that’s the disconnect between the public and private market. Your balance sheets have all stayed about the same level; you’ve not played the floating rate game…

Roth: Maybe another way to look at this is debt duration. So if you have four or five year average debt duration, that’s a lot different than 13 or 15 year average debt duration. So we’re focusing on floating rate versus fixed rate. I think that is really how you should view the weighted average of your balance sheet and how you turn it over. So if you have four or five year average debt, if you are a real estate guy, that’s almost floating rate debt.

Think about it. You can get to those maturities pretty quickly and turn them over. So if you really want to make a bet, take your whole balance sheet and lock it out 17 years at 5 percent. Maybe that would turn out to be a great bet, but then you’re really betting the ranch.

Cicco: Let me move on to some general industry issues. With the Wall Street pull back, sell side research clearly is going to get shorter. Will it have much of an impact on the sector?

Roth: We love our analysts. We need our analysts. We need them to tell the story, we need them to get the facts out.

Hefner: Companies the size of those sitting up here are not going to be affected by much of it at all.

Zell: I think when it’s all said and done, we are going to be affected no more or no less than the rest of the Street. The rest of the Street is going to have to come up with another methodology for providing or creating research that they haven’t come up with to date. You can’t have research that basically is nothing more than a sales run for the investment banker. Yet, at the same time, you have to have a methodology for financially supporting research because all of us benefit from the fact that there is research out there.

I would suspect that over the next couple of years, it will get bounced around until we find some kind of a balance. In the mean time, I think we and everybody else will probably end up being under-covered for a while. I’m not sure that’s such a disaster.

Linde: I don’t even know what under-covered means because if you think about who holds our stock—and I know this is not universal—but there is a high proportion of institutional holders of REIT stocks. While I’m sure the analysts were of great value to them and continue to be of great value to them, they were using that raw data but doing their own analyses. So, I don’t think that it’s going to have the impact on the REIT industry that it might have on an industry that’s more widely held by individual stockholders.

Zell: Or on an industry that is more difficult to follow. We’re a relatively simple business compared to some of the really complicated ones.

Roth: The way I see it, the analysts’ work product is broken down into two functions: fact gathering and reporting, and opinion. Fact reporting and numerics are almost the same; it’s amazing. There also isn’t a lot of difference in the opinions. At least 95 percent of the analytical work is in the fact gathering; about 5 percent is in opinion.

Cicco: Do you think the new tax legislation will have an impact on the relative valuation of REITs? This may be tough to answer until we see what corporate America does with the dividend policy.

Simon: I sit on another public company’s board and they are an unbelievable cash cow. They still think they can reinvest for the benefit of their shareholders. The tax law change has had no impact on their thought process with respect to dividend payments: period, end of story. That’s one case out of thousands, but I don’t see corporate America changing their attitude toward dividend payments due to the tax changes.

Linde: I agree.

Zell: I also share that opinion. It just doesn’t make sense that because dividends are going to be treated differently it is going to have some impact on REITs. Anybody here who thinks General Electric will rearrange its balance sheet so that it can pay a big dividend is kidding himself. And I think that is true of most companies, with the exception of some companies that have historically been cash cows that have not paid out, who will now pay out.

Simon: And their stock will probably go down because it will signal to the market where the reinvestment opportunities are.

Roth: At the margin, pricing is affected by the pre-tax investor. A large percentage of REIT stocks are owned by non-tax paying entities. The fact of the matter is that REIT dividends are significantly higher than the S&P 500 average (6.8 percent compared to 1.7 percent). Those investors at the margin will pay much more for the REIT stock’s income stream.

With respect to corporate America starting to pay dividends because they’re influenced by the tax law, I think a counterbalancing issue is the 15 percent capital gains tax. A company that is too cash heavy, and therefore doesn’t have sufficient high-return, internal opportunities, is probably going to downsize by figuring out a way to pay out a one-time large capital gain distribution. I think their shareholders would rather have that than a trickle of dividends.

Considine: I offer a slightly different point of view: corporate America has retained too much earnings over time and invested it badly. On the margin, we’re moving toward eliminating the corporate income tax. The REIT vehicle actually is quite a good direction to go, in my opinion, because it makes re-investment subject to marketplace disciplines. So, the bigger outcome of all of this is that businesses will be more efficient and that will benefit REITs more than some narrow comparison of the taxability of our dividends.

Cicco: In your view, what are the biggest challenges to the REIT industry?

Simon: I don’t think there are any huge challenges out there. By and large, the industry has done a terrific job. The returns on a one, three, five and 10-year basis have been spectacular. The companies are terrifically capitalized for the most part. We had a lot of companies go public; very few, if any, blew up, compared to the dotcom or the technology world. We’ve had no material bankruptcies; we’ve had no meaningful defaults on debt, etc.

I think the industry had to prove it can run through a slow-down, and I think it has done so now. I’m not necessarily as bullish on the economy as the rest of these guys, but the industry has done a terrific job of being able to manage through whatever downturn there has been. So, I think there’s nothing keeping this business from moving forward in a positive fashion. People want to pick on the real estate guys, but I think we’ve done a very good job.

Linde: I agree completely with what David said. We’ve overcome what everybody thought was going to be the big challenge: that REITs aren’t going to make it when the economy turns down. I think we’ve demonstrated that is not an issue.

Another issue is that we are all likely victims of any one player’s mistakes, especially if it’s a public Enron-type mistake, or a mistake of not being able to live up to expectations that have been broadcast to the public with the implication that they are somehow guaranteed. What worries me is any one problem could tarnish all of us.

Hefner: I think the low percentage of public company representation in the real estate sector is a challenge. It’s a big world out there and we’re a very small piece of it. The truth is, the stage is set for an incredible run for real estate because now on everybody’s asset allocation model is a line called real estate and generally it’s got a 5 percent after it. And that’s huge for this industry, and we all now have a track record. I think the next 10 years is going to be a pretty incredible run for the holders of our stocks.

Cicco: Terry?

Considine: I think the biggest challenges are going to be operating businesses at the scale that these companies have achieved. However, the truth is that the scale today is small compared to the opportunity. This is an unconsolidated industry, and there’s a wealth of assets that could be owned productively by public companies. The acquisition of those assets and operation of them at a higher level than in the past is our biggest challenge and opportunity.

Zell: We need to get bigger as an industry, but with fewer companies. I think the fact that we have almost 200 REITs distracts from our message. The fact that there’s going to be less analytical coverage is part of the problem. I obviously agree with everybody’s concerns, particularly Ed Linde, in that that we’re all in this boat together and in order for our industry to succeed, we have to have an ethical standard. I think one of the great things about today’s world is that REITs have become the poster boys for good governance.

But I also think that this industry is still at a very embryonic stage. We really haven’t attacked the real question of return on equity. We cannot have an industry, long-term, that is predicated on continually raising more money from the stockholder base in order to buy assets to earn an investment return. We have to figure out ways to dramatically increase our return on tangible capital by thinking much more creatively. I think we have to be better and more intelligent and more strategic operators than we have been.

And lastly, I think there is a generational issue in our industry. It was roughly 10 years ago that the private real estate industry converted to the public markets. This took place over a relatively short period of time. Many of these companies are still run by their founders, one way or another. How our industry gets across that succession bridge is going to be a big issue and will help determine whether we create or lose value going forward.

Cicco: Mr. Chairman, the final word.

Roth: A couple of things I’d like to add. Only 10 percent to 15 percent of investment real estate assets are in the publicly traded format. That’s almost de minimus when you consider the size and pervasiveness of the real estate industry. Walk around every city, every town, and all you see is real estate.

This is a nascent industry with a couple of hundred companies. But, in the next 50 years, you can imagine the kind of scale that the consolidating publicly traded companies will have. There is no other industry today in America that I can think of that has such a vast proportion of private assets versus public assets.

One of the real issues in our industry is that nobody has been able to establish a brand in the real estate industry–although a couple of guys are trying. Nobody has been able to establish the kind of market dominance or price leadership that investors look for in leading companies in other industries in publicly traded commerce in America. So this is a very diffuse, unconsolidated industry. The opportunities for consolidation, growth and scale are monumental.

Also, for the last decade or so we have been running these companies in easy money times. Real estate is the most capital-intensive businesses that you can imagine. It’s not about real estate; it’s all about capital. It’s fairly easy to run these companies when interest rates are cheap and they’re getting cheaper every month. When capital gets scarce, and money is tight, that’s when the industry will be tested. We all will have to be up to that challenge and prepare for it. When money gets tight, it’s a whole different era. I have no idea when it’s coming, but certainly it will be coming.

Lastly, in addition to maintaining the charter provided to us by Washington, we will have succeeded as an industry when we attract non-dedicated REIT capital to regularly invest in our businesses. We have not succeeded in getting the broader institutional investors and mutual funds to treat REITs as part of their regular investment diet. We need to have that happen; we need to have that flow of capital going through our public securities.

Cicco: Ladies and gentlemen, that has been the view from the top. I thank you for your time.