In April 2003 billionaire investor Samuel Zell turned over the CEO reins of Equity Office Properties Trust, the biggest U.S. real estate investment trust, to Richard Kincaid. Then 41, Kincaid had led a restructuring of the Chicago-based REIT begun in the wake of the September 11 terrorist attacks, and Zell needed him to navigate the still-rocky economic waters.
Kincaid quickly began to shift EOP, which owned more than 125 million square feet of office space, out of overdeveloped and underperforming markets. He consolidated the company’s 169 offices — the result of three major acquisitions between 1997 and 2001 — into 48 regional offices and service centers, as part of a new operating model that emphasized occupancy and retention rates rather than rent revenue.
By the end of October 2006, EOP was trading at $42.50, up 64 percent during Kincaid’s tenure as CEO. Nonetheless, its longer-term performance dramatically lagged behind that of its office REIT peers. So when New York–based private equity firm Blackstone Group made an unsolicited $48.50 a share offer in mid-November for EOP, Kincaid, with the blessing of the REIT’s board, decided that taking the company private was the best option.
“It was one of the most difficult decisions I ever had to make as an executive,” says Kincaid, who is unlikely to have a job with EOP after Blackstone completes the acquisition. “But we had a fiduciary responsibility to our shareholders.”
At $35.5 billion, including the assumption of more than $16 billion in debt, Blackstone’s purchase of EOP is the largest leveraged buyout in history. REITs are being gobbled up at a rapid clip, predominantly by private equity firms. During the first 11 months of 2006, there were 13 mergers or buyouts of publicly held REITS, representing more than $76 billion, including debt. In March, Blackstone paid $5.6 billion to acquire CarrAmerica Realty Corp., a Washington-based company that owns 26 million square feet of office space.
Matthew Lustig, a managing director who oversees North American real estate activities at Lazard Frères & Co. in New York, says that private equity shops have a big advantage over publicly traded REITs. They can obtain leverage in excess of 50 to 60 percent and trade in and out of properties quickly to generate a profit. Office properties are easier to flip than shopping malls or apartment buildings, and Lustig expects several properties from Blackstone’s EOP purchase to be sold before the buyout closes, which analysts expect to happen in the first quarter of 2007.
Many investors implicitly agree with the logic of deals like these. “The market is dictating that it’s more profitable to own commercial properties privately today,” says Stuart Shiff, CEO of San Francisco–based DivcoWest, a real estate investment and management firm. That makes it tougher for REIT investors: When their shares are bought out, they must reallocate into other REITs, driving up valuations.
Publicly traded REITs face inherent growth challenges. To avoid paying corporate taxes, they must pass on at least 90 percent of their income to shareholders. As a result, REITs cannot build up cash hoards and are restricted from taking on heavy debt loads. Generating consistent long-term performance for shareholders is therefore tricky.
“Initially, we thought we could run a truly national company, but in many markets we owned assets with no barriers to entry,” says Zell, who in 1976 founded the real estate management company that would become EOP. “And having no barriers to entry made for [rent] fluctuations. It’s hard to explain that to shareholders.”
The challenges with running a publicly traded REIT can be traced back to 1960, when president Dwight Eisenhower signed a cigar excise tax bill that contained a provision establishing real estate investment trusts. Although that provision would evolve over the next three decades, the basic concept has not changed: REITs — which as property owners have to pay real estate taxes — can avoid being doubly taxed as long as they pass the bulk of the income from their properties to investors.
The first REIT to go public was Kimco Realty Corp. The New Hyde Park, New York–based company was founded by Milton Cooper and Martin Kimmel in 1960. Kimco specializes in the development and management of shopping centers and made its initial public offering in 1991. “At the time we went public, real estate was a dirty word,” says Cooper, Kimco’s chairman and CEO.
Since then some 200 REITs have gone public, according to the Washington-based National Association of Real Estate Investment Trusts. “By and large, REITs have performed very well, and there’s tremendous demand to own real estate now,” Cooper says.
Zell took EOP public in July 1997. At the time, his company had about 30 million square feet of properties. He quickly quadrupled his holdings through three of the biggest mergers in REIT history, buying Beacon Properties Corp. for $4.4 billion in 1997, Cornerstone Properties for $4.7 billion in 2000 and Spieker Properties for $7.3 billion in 2001. Kincaid, who joined EOP in 1995 and became chief financial officer two years later, led the financial and integration strategies. In July 2001, as COO, he oversaw the first global bond offering ever for a REIT. But as EOP acquired more properties, its office occupancy rate, which had peaked in 1998 at 95 percent, was falling.
Then came the September 11 terrorist attacks. Despite Kincaid’s restructuring effort, occupancy dropped to 86.6 percent by the end of 2003. EOP was hit hard by weakness in West Coast property markets following the bursting of the dot-com bubble. Most of the buildings it had acquired from Spieker were in San Francisco and San Jose.
“We made a series of early acquisitions and gave up some early performance to take on properties we thought were critical to our makeup at the time,” Zell says.
The company’s funds from operations were also falling. FFO — or, net income adjusted for depreciation, amortization and gains or losses on real estate sales — is a key metric used by analysts and investors to gauge REIT performance. At EOP, FFO peaked at $3.18 a share in 2002. Last year it was $1.35, as the company took losses on the sales of several properties it had acquired during its earlier buying spree. EOP has been a big seller in Atlanta, New Orleans and Columbus, Ohio, and has exited the Cleveland, Dallas, Houston, Indianapolis, Philadelphia and Phoenix markets entirely.
Zell and Kincaid used the money from those sales to add properties in growing markets like Portland, Oregon, and San Diego, as well as to buy back shares. This year the changes in EOP’s portfolio started to have a positive impact on the company’s occupancy rate. By the end of the third quarter, it had improved to 91.1 percent, up from 90.4 percent at year-end 2005.
Nonetheless, the stock remained listless. At $30.33 a share at the start of 2006, EOP was trading within 25 cents of its price on the day Kincaid became CEO, nearly three years before. This spring EOP shares finally started to rise, reflecting an improvement in the overall office market as well as a small increase in the company’s occupancy rates. Most of the move was fueled by the takeover speculation that has engulfed the entire REIT market since Blackstone announced that it was buying CarrAmerica Realty.
Though EOP was trading at $42.50 by October’s end, the company’s total return, including dividends, was 81.31 percent for the three years ended October 31. The Bloomberg index of 20 leading office REITs — which includes Vornado Realty Trust, Boston Properties and SL Green Realty Corp., as well as EOP — had a total return of 112.03 percent for the same period.
That made EOP an attractive target for Blackstone, which this year raised a private equity fund that closed at $15.6 billion (but is raising new money), along with a $5.25 billion real estate fund, according to Blackstone spokesman John Ford. (He declined to comment on the pending EOP buyout.) In addition to its acquisition of CarrAmerica, Blackstone used that war chest to buy Chicago-based Trizec Properties for $8.8 billion (including the assumption of $4.1 billion in debt). The Trizec deal closed in October, a month before Blackstone announced its purchase of EOP.
Blackstone plans to use $3.2 billion in equity for its buyout of EOP and will tap the mortgage-backed-securities market for $29.6 billion of bonds from arrangers Bank of America Corp., Bear Stearns Cos. and Goldman Sachs Group, according to a Securities and Exchange Commission filing. Those firms are also providing $3.5 billion in equity bridge financing.
Investment bankers, analysts and REIT company managements all agree that the buyout wave isn’t finished. “As long as the private companies see value that the public markets do not, privatizations will continue,” says Kimco’s Cooper. “It’s a matter of doability. With the world drowning in liquidity, what once was impossible is now doable.”
Cooper says that Kimco is very happy being a public entity. Of course, EOP’s Kincaid had been saying the same thing before Blackstone came calling.
