By Christopher M. Wright

Name: Richard B. Saltzman Title: President of Colony Capital, LLC and member of Kimco Realty Corporation's board of directors Age: 47 Experience: Saltzman joined Colony from Merrill Lynch where he most recently served as managing director and vice chairman of investment banking. He joined Merrill Lynch in 1982 and has been in real estate investment banking for 24 years. Among other honors, Saltzman received the REIT Industry Achievement Award from NAREIT in 1999 and was named Real Estate Investment Banker of the Year several times by Commercial Property News.

Real Estate Portfolio recently asked Richard B. Saltzman, industry leader and former NAREIT board member, to share his thoughts on the capital markets and the real estate industry as a whole. Saltzman, president of Colony Capital, LLC and former managing director and vice chairman of Merrill Lynch's investment banking division, is often credited with introducing the modern REIT to Wall Street among many other accomplishments.

Portfolio: You were instrumental in the first modern-REIT initial public offering (IPO), the creation of the taxable REIT subsidiary concept and the formation of one of the first real estate opportunity funds. Has the REIT industry fulfilled your expectations?

Saltzman: Although still in grade school when the first REIT-enabling legislation was passed in the 1960s, I am proud of being around to help recapitalize the real estate industry when it was experiencing a depression in the early 1990s. Overbuilding and economic recession had led to a shutdown in conventional capital markets and REITs were a way for companies to recapitalize their balance sheets. Fortunately, there was liquidity in the securities market at the time.

The REIT legislation had been amended in 1986 allowing REITs to become vertically integrated. For the first time, REITs could become self-managed, behaving and performing as proactive operating companies. Previously, REITs by definition had to be passive like mutual funds.

Growth in the REIT industry since has not been linear. REITs go up, they correct, then they go up again. But in general, the growth has been steeply, positively sloped and it is remarkable how well companies and investors have done. I look at the overall picture and I see a great result.

Portfolio: What do you predict for the REIT industry in the future?

Saltzman: I hate to make these macro general statements. ...

Portfolio: Go ahead.

REITs go up, they correct, then they go up again. But in general, the growth has been steeply, positively sloped and it is remarkable how well companies and investors have done. I look at the overall picture and I see a great result.

Saltzman: What has emerged, at least in the U.S., is the effectiveness of REITs in representing what I would call "core conventional real estate investing strategies." If you want diversified portfolios and excellent managers, and you like your investments made in a modestly leveraged way, as many investors do, you have all that in REITs. So REITs will continue to be an important and viable part of the real estate capital markets.

Portfolio: How did the concept of taxable REIT subsidiaries come about in 1999?

Saltzman: The tax code changes in 1986 permitting REITs to be operating companies only went part of the way. Taxable subsidiaries were the next logical evolutionary step to give REITs more flexibility. The rules were preventing REITs from becoming fully integrated operating companies and from doing the best job for shareholders. With taxable subsidiaries, REITs can now pursue the best strategies for shareholders and not be outside the boundaries of REIT compliance requirements.

Portfolio: Have taxable REIT subsidiaries lived up to their billing?

Saltzman: I think expectations were quite modest at the time. People were willing to consider taxable subsidiaries on an incremental basis and some companies did not need them at all. Taxable subsidiaries do add value and let REITs compete on a level playing field in the marketplace. They allow REITs to develop and trade real estate more actively without significant limitations. I view that as a positive because nothing in investment theory suggests that assets should be held forever. Taxable subsidiaries also allow REITs to offer adjunct services to tenants. The subsidiaries pay tax but REITs are no longer at a competitive disadvantage.

Portfolio: Have you been surprised at the areas in which taxable REIT subsidiaries have been formed? Telecom, for example, is pretty far removed from a REIT's core competency.

Saltzman: I haven't really been surprised. As for telecom, the Internet was front-and-center in the late 1990s and it was natural for REITs to explore and offer these kinds of services. It's not something I anticipated, but it certainly was appropriate for REITs to investigate the merit of these strategies. It's worked in some cases and not in others, but that's just normal trial and error in a capitalist economy.

Portfolio: How did real estate opportunity funds get started? Some say it was in the early 1990s when lots of distressed properties were on the market.

Saltzman: I had the privilege of playing a meaningful role in establishing one of the first opportunity funds, the Zell/Merrill Lynch series of funds, beginning in 1988. So actually the idea predates the early '90s. Subsequently, there was a proliferation of funds looking to take advantage of distress sales by the Resolution Trust Corporation (RTC) and others, many of them involuntary owners such as banks, who were looking for liquidity.

Portfolio: As I understand it, the idea of an opportunity fund is to make a 20 percent return investing in distressed properties. How do you get an above average return in a flat economy?

Taxable subsidiaries do add value and let REITs compete on a level playing field in the marketplace.

Saltzman: No doubt, it's harder today than 10 years ago. The opportunities are clearly much more micro than macro, particularly in the United States. In fact, there is a debate in the academic and investment communities about what the appropriate benchmark is for opportunity funds. With 10-year treasuries at 4 percent and low inflation, maybe 20 percent is too high.

In Europe and Asia, however, it has been easier to produce these levels of return. For example, distressed portfolios have been sold by government agencies and banks in Taiwan, South Korea and Japan and there is substantial corporate and government restructuring taking place in Europe. The opportunity recently has been deeper and more macro in these locales.

Portfolio: Some say Japan is a dam waiting to break and lots of distressed properties will come on the market when it happens.

Saltzman: Observers have been saying that for 10 years but it's less than clear. Certainly, we've already seen some sales, but while there's lots of inventory, it's not clear how much will come on the market in the next year or two. Unlike the U.S. in the early 1990s, the Japanese government has been willing to move only very slowly in the hope that things get better.

On the other hand, the market opportunity may be cycling back to the U.S. With an improving economy and higher interest rates, we may see pockets of distress here in the next 12 to 24 months, but not nearly of the same magnitude as in the early '90s.

Portfolio: Haven't real estate prices already been bid up in the U.S. because too much capital is sloshing around?

Saltzman: Investing is about relative value. There have been capital inflows to real estate because it has offered better returns than fixed income or stocks in recent years. No doubt real estate is getting bid up as part of that equation. Will real estate continue to be perceived as a good value or has it reached equilibrium? It's certainly possible that investor perceptions of relative value will shift once again.

Portfolio: Do public markets and private real estate investing play different roles?

Saltzman: Yes, and as the market continues to evolve, I think these differences will actually become even more apparent. My prediction is that private markets and public markets will coexist side-by-side and both will grow. The primary province of the public markets is what I would describe as conventional "plain vanilla" investing strategies.

Public markets tend to be less receptive to new ideas and venture capital-type investments that are typically perceived as riskier. Private markets, on the other hand, are the alter ego. It's the place for higher risk strategies, niche investing and new ideas. Real estate is not terribly different from other industries in that regard—the larger, more established companies are in the public market and the private market is where you find more venture capital, speculative investments, and experimentation, as a general rule.

The seeds for this evolution in our industry were planted in the late 1980s and early 1990s with the creation of both opportunity funds and the modern REIT. It continues to evolve and play out to this day with very positive benefits for investors and the real estate capital markets.