Sam Zell, the master real estate investor, has built a fortune on the cycles that shape his industry. These days, he believes the current turmoil in financial markets is more an emotional reaction to yet another period of excess rather than a true credit collapse.

In a wide-ranging lecture at Wharton moderated by real estate professor Peter Linneman, the Chicago-based investor said markets currently are spooked by problems with U.S. subprime lending. However, they still have capital to deploy, unlike during other real estate busts when financing could not be arranged at any price.

“We’re not really in a quote ‘credit crunch.’ I think what we are in is a ‘confidence crunch,'” said Zell, funder of the Samuel Zell and Robert Lurie Real Estate Center at Wharton. “I would argue the excess liquidity that existed eight weeks ago still exists today. It has a different risk premium on it, but the actual amount of liquidity has not changed.”

Zell said the slump should come as no surprise: “Over the last three years people were flippant. They bought anything they wanted and were proud that they didn’t do due diligence. I think they have all been chagrined and are scared out of their minds.”

‘The Godfather Offer’

According to Zell, private equity firms awash with capital were able to benefit from “preposterous” leverage and offer premium prices to publicly held real estate firms. Zell said he considered a deal like that a “Godfather offer” because no publicly held company could responsibly refuse. Indeed, in February, Zell sold his flagship business, Equity Office Products (EOP), and its portfolio of 540 prime office buildings to the Blackstone Group for $39 billion. At the time, it was the largest private equity deal ever completed. Zell predicted that markets will soon stabilize, although they will become more risk averse and less leveraged than in recent years. “Today, you would never be able to replicate the Blackstone deal.”

Following the sale of EOP, Zell turned his attention to another transaction. He has become a major investor in the Tribune Company, which publishes the Chicago Tribune and Los Angeles Times and owns other media properties. The company is going private: The shareholders recently approved adoption of an ESOP (employee stock ownership plan). When the transaction closes, the ESOP will own 100% of the company. Zell will own a warrant to purchase 40% of the company that he can exercise at a future date over the next 10 years. The ESOP will remain the majority owner of the company. The Tribune transaction is under regulatory review and is expected to close by the end of the year.

Zell did not discuss that deal directly but pointed to his reputation as a contrarian investor. He recalled the first time he saw the market turn. In the early 1970s, the real estate industry was infused with optimism and expanding rapidly. Zell did not see how there would be enough demand to fill the real estate space under development. So he stopped doing new deals and structured a company to focus on distressed real estate. “Everybody else said, ‘Sam, you don’t understand.’ I have heard that my entire career. Even when I buy newspapers in 2007, everybody says, ‘If you didn’t understand before, now you really don’t understand.'”

Zell is chairman of Equity Group Investments, a mix of private holdings and public companies, including Equity Residential, a leading apartment owner; Equity LifeStyle Properties, which owns 300 vacation and manufactured housing communities; and Capital Trust, a commercial real estate finance company. He told the Wharton audience that he has never recovered from his first course in economics when he learned about supply and demand. “I would tell you whatever business I’ve been in — real estate, barges, rail cars — it’s all about supply and demand.”

While still an undergraduate and later a law student at the University of Michigan in the mid-1960s, Zell began to buy properties in Ann Arbor. Later, he partnered with his fraternity brother, Robert Lurie, and together they built a real estate empire before Lurie died of cancer in 1990 at age 48.

Following a market crash in 1973, Zell spent the next three years acquiring $3 billion in real estate assets, much of it for $1 down. He built the portfolio by going to lenders and offering to take future operating losses off their hands in return for equity. Zell was able to carry the properties long enough for them to return to — and exceed –prior valuations. “As it turns out, we made a fortune,” he said. In the 1980s, the real estate industry was again marked by aggressive lending that sparked a development boom. “The idea was build it and somebody will buy it, and that somebody was the Japanese,” Zell recalled.

Edifice Complex

When Linneman asked Zell why he had never become a developer, the bearded, gravelly-voiced mogul replied that development is too risky for his taste. “In that business, it helps to have an edifice complex,” said Zell. “At least half of your rate of return comes from the psychological benefit you get from seeing the building go up. I never suffered from that particular affliction.”

Again concerned that the market could not sustain the prices that investors were paying, Zell and Lurie spent much of the 1980s diversifying their holdings into other businesses. Their strategy would be the same as it had been in real estate — to look for opportunities in places where others were ignoring the rules of supply and demand. “We thought if we are good real estate guys, then we are good businessmen,” Zell said.

While real estate professionals have excellent transactional skills, he added, they often lack the foresight to plot strategy. “When it comes to delegating the negotiation of a transaction, I would always pick a real estate guy over a corporate guy,” said Zell. On the other hand, real estate people lack the ability to “look around the corner. To them, the tree is always growing to the sky. Therefore, we have enormous and very volatile cycles that continue to this day.”

At the beginning of the 1990s most of the nation’s commercial real estate was concentrated in the hands of about 50 or 60 large private investors. Again, the cycle turned and those companies were caught in a severe credit squeeze marked by massive foreclosures and the nation’s savings and loan debacle. The way out, Zell explained, was to tap the public markets through what previously had been a little-known financing vehicle, the Real Estate Investment Trust (REIT). REITs continued to be the driving force in commercial real estate until the past year or so when private equity acquisitions, such as his own Blackstone transaction, put many holdings back into private hands, according to Zell.

He described his strategy during the three-week bidding war for EOP that broke out between Blackstone and Vornado Realty Trust, the nation’s second-largest REIT, which had offered a combination of cash and stock for Zell’s company. The key to the deal was structuring a $720 million break-up fee, Zell said, adding that the stock deal would have taken months to close and, in hindsight, might have run into serious problems following the market jitters that developed in August.

Accelerated Housing Demand

Today, Linneman noted, Zell’s holdings are split between real estate and other businesses. An example is Anixter International, which dominates the market for Ethernet cables. When it comes to real estate, Zell said he is focusing on development in emerging markets through a company called Equity Group International.

In 1999, Zell decided the REIT concept that had worked so well in the United States could be replicated in other parts of the world. He now controls major homebuilders in Mexico and Brazil and is also branching out into India, China and Egypt. He said the Guadalajara office of the Mexican company, Homex, is open 24 hours a day, seven days a week, to meet the needs of Mexican homebuyers. “The beauty of all these places is there is unlimited demand,” said Zell. “If you go back to Econ 101, these countries have huge backlogs of housing demand. The population is increasing and housing has not.”

Zell acknowledged he does not always get it right. He told the story of how he acquired the Carter Hawley Hale stores in California in 1992. His firm did an analysis and determined that the 79-store chain would be worth at least 80% of the purchase price if it had to be sold in a fire sale. Soon after, Zell was faced with a sharp recession and a major earthquake in Southern California. In 1995, he decided to bail out and sell the chain to its competitor, Federated Department Stores. The price? Even though he lost money on the deal, Zell finds comfort that his firm calculated the downside correctly. Federated paid 80% of what Zell did. “The investment was a failure, but the process was a success. We identified the risk we were prepared to take and we took it.”

Linneman noted that Zell is known by the nickname “the grave dancer.” According to Zell, the term grew out of the headline of an article he wrote describing his strategy of profiting off distressed real estate following the inevitable bubbles of investment enthusiasm. Zell said the article shows how “I was dancing on the skeletons of other people’s mistakes.”

Zell, however, also pointed out that the last sentence of the article reads: “He who dances closest to the graves, always has to be careful he doesn’t fall in.”