Silicon Valley Bet Looking Dubious

In February 2001, 11 months after the Nasdaq composite index peaked, Sam Zell made a $7.2-billion bet on the future of Silicon Valley.

Zell, 62, who calls himself “the Grave Dancer,” announced that he was buying Spieker Properties Inc., a Menlo Park, Calif.-based real estate company with half of its 28.3 million square feet of office space and 10.1 million square feet of industrial space in Northern California, where many of the technology companies with shares traded on the Nasdaq Stock Market are situated.

So far, Zell’s bet has been a loser. Nasdaq continued to plummet, shaving an additional 51% off its value by October 2002, and Silicon Valley rents sank to an average of $25 a square foot in the first quarter of 2004 from $55 in the fourth quarter of 2000, according to Boston-based Torto Wheaton Research.

More important, Zell’s Silicon Valley venture has clouded the long-term vision he has pitched to investors. Spieker was the third multibillion-dollar acquisition in five years by Zell’s Equity Office Properties Trust, a company that buys and manages office buildings.

The purchases, for stock and cash, were part of Zell’s plan to build a real estate investment trust that would be national in scope. Zell said the large size would let the REIT hire top managers and save money on everything including carpeting and financing. Those cost savings are only beginning to materialize.

Zell, who is chairman of three Chicago-based REITs, says his bet will still pay off because Silicon Valley remains the headquarters of U.S. innovation and will eventually rebound.

“As ill-timed as the Spieker transaction might appear, I don’t think you necessarily get to pick the time that you get to dominate the intellectual capital of the United States,” Zell says in his Chicago headquarters, an Art Deco office building that formerly housed the now-defunct Chicago Daily News.

Meanwhile, the pain continues. Office occupancy in Equity Office-owned buildings fell to 86.3% at the end of June from 94.6% at the end of 2000.

Last year, the average gross rental rate for expiring leases was $28.77 a square foot, and the average for new tenants or renewals was $24.91 -- a 13.4% decline.

That so-called rolldown in rents will continue at 10% this year and 15% in 2005, says David Fick, a REIT analyst at Legg Mason Wood Walker Inc., a Baltimore-based securities firm.

Equity Office Chief Executive Richard Kincaid says he doesn’t rule out cutting the $2 a share the company pays in dividends each year. One of the attractions of REITs is that, by law, the trusts must pay 90% of their taxable income to shareholders, excluding capital gains, as cash dividends.

Last year, Equity Office’s operating cash flow wasn’t enough to cover the dividend. The company has sold a net $1.73 billion worth of properties since 2001, which allowed it to maintain the payout. David Loeb, a REIT analyst at Friedman, Billings, Ramsey Group Inc., an Arlington, Va.-based investment bank, says Equity Office will fall short by about $225 million both this year and in 2005.

In July, Moody’s Investors Service downgraded the long- term debt rating of EOP Operating, the partnership through which Equity Office holds its properties, to Baa2 -- two levels above junk -- from Baa1, citing the eroding performance and the dividend coverage shortfall.

Zell says time will prove him right. “Part of being who I am is following my own convictions as to what the right directions are,” he says. “Maybe we’re in the third or fourth inning.” The outcome of the game won’t be decided until later innings, probably not before 2007 or 2008, he says.