Buying Archstone Inc. (ASN:US) will give Equity Residential and AvalonBay Communities Inc. (AVB:US) apartments in U.S. markets where development is difficult and rents are rising even as growth of the multifamily market slows nationally.
Sam Zell’s Equity Residential, the largest publicly traded U.S. apartment landlord, will acquire about 60 percent of Archstone, and AvalonBay, the second-biggest, will get the rest, the companies said yesterday. The purchase from Lehman Brothers Holdings Inc., valued at $6.5 billion in cash and stock, will increase the size of Equity Residential’s portfolio by 20 percent and AvalonBay’s by 37 percent.
The acquisition will help the landlords grow quickly in coastal cities where expansion is hard because of the scarcity and high cost of land, said Craig Leupold, president of Green Street Advisors Inc., a Newport Beach, California-based research firm. Those areas are likely to hold up better than the U.S. overall, with its slowing growth in rents and occupancies.
The markets “have traditionally been more highly sought after because they tend to have higher barriers to entry and have enjoyed better demand, translating into better-than-average rent growth,” said Leupold, who has buy ratings on Equity Residential (EQR:US) and AvalonBay. “Also, the cost of homeownership is much higher in those markets, so the propensity to rent is higher.”
Equity Residential’s properties will be located mostly in Washington, D.C.; San Francisco; Southern California; and New York, while AvalonBay’s will be chiefly in the mid-Atlantic region and Southern California, the real estate investment trusts said in separate statements. The transaction will give Chicago-based Equity Residential 78 properties with 23,110 apartments, while Arlington, Virginia-based AvalonBay will receive 66 complexes with 22,222 units, putting it ahead of Camden Property Trust and Apartment Investment & Management Co., according to data compiled by Bloomberg.
Equity Residential climbed 1.5 percent to $55.25 at the close of New York trading, while AvalonBay rose 2.6 percent to $132.35. While investors will benefit from the deal because Lehman scrapped an Archstone initial public offering as part of the plan, there may be “near-term pain” for shareholders because the companies are issuing stock that may dilute value, Rod Petrik, an analyst with Stifel Nicolaus & Co. in Baltimore, said in a note to clients today.
“The equity raised for this deal will pale in comparison to the potential of the $6.5 billion Lehman equity overhang, had the IPO moved forward,” Petrik wrote.
Multifamily REITs have fallen this year as the rental market slows. While U.S. apartment rents are projected to rise through 2017, the rate of annual growth peaked in the second quarter of 2011 at 5.1 percent, Axiometrics Inc. said in September. Rents are on pace to gain about 4 percent nationally this year, according to the Dallas-based research firm.
A Bloomberg gauge of 16 apartment REITs fell 1.2 percent in 2012 through yesterday. A decline for the year would be the first since the financial crisis in 2008, according to data compiled by Bloomberg. Including reinvested dividends, the gauge has returned 1.3 percent this year, trailing a 14 percent gain for a broader index of 126 publicly traded REITs, the data show.
Investor interest in apartments is waning, in part because record-low mortgage rates are turning some potential renters into homebuyers. The National Association of Home Builders/Wells Fargo index of builder confidence increased to 46 this month, the highest level since May 2006, from 41 in October, figures from the Washington-based group showed on Nov. 19.
With the purchase of Archstone, AvalonBay and Equity Residential are focusing on expanding in markets where they expect apartment demand to stay relatively strong.
“It has been our strategy to more deeply penetrate our high-barrier-to-entry core coastal markets,” AvalonBay Chief Executive Officer Timothy J. Naughton said yesterday on a conference call about the deal. The Southern California properties are “particularly attractive not only over the longer term but also over the next several years.”
Equity Residential has been “working hard to reduce the capital commitment in lower-barrier, lower-cost housing markets, and redeploy this capital into more urban, high-barrier markets along the coasts,” CEO David Neithercut said on the call. “The Archstone portfolio contains the kind of high-quality properties in these core markets that we’ve been adding to our own on a one-off basis over the last 10 years.”
The company said it will fund the acquisition in part through the sale of as much as $4 billion in properties. Equity Residential will sell “a large portion of our remaining assets” in Phoenix; Atlanta; Orlando and Jacksonville, Florida; and California’s Inland Empire, Neithercut said. Its purchase includes four projects with 1,225 units that are under construction and 15 parcels of land.
The combined purchase price includes $2.69 billion in cash and Equity Residential and AvalonBay shares valued at $3.8 billion as of the market’s close on Nov. 23. The buyers will assume about $9.5 billion of debt and $330 million of preferred equity. Of the debt to be assumed, about $8.6 billion is held by Fannie Mae and Freddie Mac.
“By bringing in AvalonBay as a partner, EQR was able to share the risk and finance the deal more easily than working alone,” Alexander Goldfarb, an analyst with Sandler O’Neill & Partners LP in New York, said in an interview. He has a buy rating on Equity Residential and a hold on AvalonBay. “It’s a unique opportunity,” he said.
Equity Residential said that it will pay its portion of the transaction with about $2.02 billion in cash and 34.5 million shares issued to Lehman. It will assume $5.5 billion of debt, and obtained a commitment for a $2.5 billion bridge loan from Morgan Stanley Senior Funding Inc.
Equity Residential expects the transaction to lower its 2013 normalized funds from operations (EQR:US) by as much as 4 cents a share, chiefly because of the planned property sales, it said in its statement. FFO is a measure of cash flow used by real estate investors.
The company intends to sell between $3 billion and $4 billion of assets, with $1 billion expected to close before the Archstone deal, $650 million under contract or intended to be, and the rest over the course of 2013. It will sell 19 million shares to help fund the acquisition.
“If capital market conditions erode, EQR could see increased dilution from the transaction,” Jeffrey Donnelly, an analyst at Wells Fargo Securities LLC, wrote in a note today.
AvalonBay’s portion of the transaction includes $669 million in cash, about 14.9 million shares issued to Lehman and the assumption of $3.9 billion of debt. Goldman Sachs Lending Partners LLC agreed to provide a $2.2 billion bridge loan should “additional lender consents not be received,” AvalonBay said. The company also is selling 14.5 million shares to the public.
AvalonBay said it expects to increase its first-quarter dividend (AVB:US) by 8 percent to 12 percent, in part because of the acquisition.
Equity Residential and AvalonBay have 120 days to complete the transaction, which isn’t subject to shareholder approval and doesn’t have any financing contingencies. The purchase is scheduled for completion in the first quarter of 2013. Should the buyers fail to “perform their obligations” under the transaction agreements, they will be required to pay damages to Lehman of as much as $800 million, AvalonBay said.
After the deal is finished, Lehman will be the single biggest investor in both Equity Residential, with a 9.8 percent stake, and AvalonBay, with 13.2 percent.
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