Puget Sound Business Journal (Seattle) - by Jeanne Lang Jones Staff Writer
Friday, February 1, 2008
Photo: Dan Schlatter
The rising value of Seattle’s Columbia Center, right, was a “tipping point” in the events leading up to a nationwide sale of more than 500 properties.
Seattle's 76-story Columbia Center played a key but little-known part in sparking one of the largest buyouts in U.S. history.
The $39 billion acquisition of Equity Office Properties Trust by the New York private equity firm Blackstone Group drew worldwide attention last year, but only a tiny coterie of insiders know of the deal's Seattle origins.
Washington's tallest skyscraper not only helped ignite interest in selling off Equity Office Properties' national office portfolio, but EOP's rich trove of properties in the economically vibrant Puget Sound area kept the massive deal afloat at moments when it threatened to sink.
Ultimately, EOP's Seattle-area holdings tipped the balance toward Blackstone through a dramatic round of rapid-fire dealmaking that enabled Blackstone to emerge as the winning bidder.
Also little known is the role played by a seasoned broker who had learned his trade in Seattle. Not many will admit to taking a haircut on a deal, but broker Roy March now chuckles about trimming his long hair during the champagne celebration of the deal's completion.
The EOP-Blackstone deal will shape the Puget Sound area office market for years to come, adding further upward pressure on rents. Office tenants now face new landlords more willing than EOP to spend money on renovations, but less willing to take lower rents in order to keep their buildings full.
Within months of the buyout, some local properties changed hands four times. The new landlords' confidence in the local market has been justified, with rents rising more than 20 percent.
The sale of Chicago-based EOP's national portfolio first took root in the spring of 2005, when executives at the real estate banking firm Eastdil Secured LLC began sizing up EOP as a potential seller, said March, Eastdil's CEO. A wholly owned subsidiary of Wells Fargo, the New York firm provides financing and brokerage services.
EOP, the publicly traded real estate investment trust founded by cigar-smoking Chicago office mogul Sam Zell, was trading some 25 percent below the intrinsic value of its sprawling national portfolio. Zell's bet that EOP's huge footprint would cut overhead and lure bigger tenants wasn't paying off as planned. Cash flow couldn't cover the annual shareholders' dividends, forcing the company to sell assets.
Eastdil executives also believed EOP was undervalued but, even at bargain prices -- $28.78 a share at its lowest that year -- there were few investors that could afford to purchase its massive, 524-building portfolio. However, there was one likely candidate that Eastdil had recently represented in a series of significant office sales: CalPERS, the nation's largest pension fund, representing more than 1.5 million California public employees and some $250 billion in assets.
Eastdil broached the subject with the head of the pension fund's real estate investments, who expressed interest, March said. At the same time, Eastdil undertook an evaluation of EOP holdings across the country.
EOP's buildings in Seattle and the Eastside accounted for just under 9 percent of the REIT's holdings. The firm had little trouble valuing EOP's Puget Sound area portfolio. Both March and Eastdil Managing Director Jeff Weber had worked in Seattle early in their careers.
EOP was intrigued by the idea of selling itself to CalPERS, "but the question was whether or not it could be pulled off," March said. "(EOP's) impression of a big public pension fund was that it would be slow moving and not very creative."
Eastdil had "detailed conversations" with CalPERS that spring, but the talks sputtered after CalPERS' real estate head left the fund. Still, Eastdil continued to pursue potential partners -- including Blackstone -- able to help CalPERS purchase the portfolio. But the parties could not agree on the assets' value or whether the portfolio should be divided. By the summer of 2006, the potential deal had gone dormant.
Then EOP hired Eastdil to sell its 1.2 million-square-foot Watergate Office Towers in Emeryville, Calif., while the New York state Common Retirement Fund, EOP's minority partner in Seattle's 1.5 million-square-foot Columbia Center, hired Eastdil to sell its stake in that building.
Eastdil was startled to find that the worth of both properties had grown substantially. Between the spring and fall of 2006, the value of Seattle's tallest building had risen 20 percent.
EOP, which had been weighing whether it should put its stake in Columbia Center on the block, too, sensed opportunity, and decided instead to buy out its partner.
The ball had been set in motion. Said March, "Columbia Center was a tipping point because of its size."
Meanwhile, Eastdil had just helped Boston-based Beacon Capital Partners sell assets on the East and West coasts. Those sales, March said, "gave us further confidence in the value we were seeing in Columbia Center."
That confidence was further buoyed by the strongly oversubscribed initial public offering of Santa Monica, Calif.-based real estate investment trust Douglas Emmett.
'We're going to do this'
The day of the Douglas Emmett offering, March met with Blackstone Group Senior Managing Director Jon Gray. During their conversation, Gray allowed that, should his firm consider buying EOP, he might pay a 4 percent cap rate for the properties, indicating his willingness to pay a relatively high price and accept a low initial annual rate of return on the holdings in order to secure them for anticipated future gains in value.
As the two men walked to the elevator, Gray peppered March with questions about the values of specific buildings.
"He looked at me and said, 'We are going to do this,'" March recalled. "I thought he meant in the sense of someone buying the Southern California assets, someone buying New York -- but he had decided the only way to do it so it would not break down, was to control the deal."
The week before Thanksgiving 2006, Blackstone and EOP announced a tentative acquisition agreement priced at $48.50 a share. Investors began calling Blackstone, inquiring about buying portions of the portfolio. A confidentiality agreement, however, tied Blackstone's hands.
Then, Vornado Realty Trust stepped into the ring to outbid Blackstone for EOP. Worried about losing the bidding war, Blackstone persuaded EOP that it was in EOP's best interest to let Blackstone negotiate with a short list of potential financial partners and/or buyers that potentially could take portions of the immense portfolio off its hands. On the list: Boston-based Beacon Capital Partners LLC, Shorenstein Properties LLC and the Irvine Co. from California and Morgan Stanley, Tishman Speyer Properties LP and SL Green Realty Corp. from New York.
Northwest on the block
March soon found himself acting as air traffic controller for a fast-moving series of deals being put together by Eastdil managing directors for properties around the country.
By March's account, when Beacon CEO Alan Leventhal asked what he could do to help, Gray responded, "Tell us what you are willing to pay for the markets that matter most to you -- Seattle, Portland and D.C."
Leventhal promised to get back to Gray the following week.
What Beacon liked about the Puget Sound area market was its strong job growth in knowledge-based businesses such as software that were less likely to lose ground to companies in emerging markets. The firm felt the rents in place in some of EOP's Seattle-area holdings were 20 percent to 30 percent below the going market rate.
With nearly half the leases set to roll within the next five years, those rents could quickly be brought up to the fast-rising market rate.
"We felt we could buy the assets at easily a 20 percent discount to their replacement costs," Leventhal said, "and we felt rents could easily grow 25 to 30 percent over the next few years."
Additionally, by participating in a flip, Beacon could do the deal with less debt than if it had to compete in the open market against firms willing to take on more debt to obtain the assets.
Meanwhile, Eastdil was busy juggling potential buyers for EOP properties in markets across the country.
"We had a multi-ring circus going on," March said. "We had San Francisco, we had New York, we had Stanford, we had Orange County and downtown LA in play."
Portland splits off
Beacon had agreed to buy all of EOP's Northwest properties to help make the transaction easier, but Eastdil asked Beacon to "unscramble the egg" so Shorenstein could buy the Portland properties. Leventhal readily agreed: "Portland obviously is a very good market, but we really target larger markets with more liquidity."
"When Blackstone came back to ask if we would mind eliminating Portland from our portfolio," Leventhal said, "we were pleased, because we never planned to hold it."
Beacon then asked Eastdil to help it sell any area buildings that didn't fit its investment objectives. The Archon Group in Irving, Texas, stepped up, agreeing to pay $1.2 billion for 15 of the 28 properties that Beacon was buying for $3.56 billion. Archon also agreed to conclude the transaction within 75 days, so it could be completed simultaneously with the larger transactions' February close. The agreement left Beacon with a net price of $2.37 billion for 13 properties, including the City Center Plaza building under construction in downtown Bellevue and the nearby 2.8-acre Griffin development site.
The remainder of EOP's holdings in the Puget Sound area were owned in a joint venture with an institutional investor and were not sold to Beacon.
With $700 million in equity backing the purchase of Beacon's 13 properties, Leventhal terms the deal "outstanding." Leventhal figures his firm's profit on the development sites and sales to Archon at approximately $200 million.
In the two weeks between Blackstone's final commitment to buy EOP and the sale's closing, March said, Eastdil had successfully arranged for the sale of $22 billion in assets.
By arranging to flip EOP properties to other buyers immediately upon acquiring the REIT, Blackstone substantially lowered its risk, allowing it to boost its bid another $3 billion. Blackstone beat Vornado's $41 billion cash-and-stock offer of $56 a share with a $39 billion all-cash deal at $55.50 a share.
To celebrate, Gray's wife brought a jumbo-sized Jeroboam of champagne to Blackstone's New York offices. Eastdil's March, who bears a passing resemblance to TV actor John Ritter in his "Three's Company" days, had been ribbed throughout the negotiations over his longish hair. He'd fended off earlier jibes, maintaining that, like Samson, he'd lose his strength if his locks were cut.
Now, he good-humoredly agreed to let Blackstone's executives give him a trim.
One potato, two potato
Locally, some two dozen office buildings passed like hot potatoes from EOP to Blackstone to Beacon. Beacon then resold a portion of its holdings to Archon Group, which then sold one Seattle building to Tishman Speyer and another in Bellevue to a private investor.
"It was a very, very compressed negotiation and a very quick close," said Nancy Haag, director of acquisitions, operations and asset management for the West region for Archon Group, which is a wholly owned subsidiary of Goldman Sachs.
While Archon executives are watching what is happening with the national and regional economy, Haag said she is "very comfortable with what is happening in Seattle" since the sale.
"We like the diversification of the Seattle-area economy," Haag said, "and therefore, we were very interested in continuing to invest in real estate in the greater Seattle area."
Unlike EOP, which focused on keeping buildings full, both Beacon and Archon will concentrate on driving up rents and building values with an eye for later sales, local brokers said.
Their gamble seems to be paying off.
"Rents and values were moving in Seattle as fast as anywhere in the country," said Jeff Weber, a managing director at Eastdil. "While people were very bullish on the market going in, the actual performance of market rents has exceeded their expectations."
The empire assembled by the Puget Sound region's leading landlord, EOP, has been dismantled.
Several of Blackstone's buyers around the nation, however, are struggling with their financing in the wake of the current credit crunch. The New York Times recently reported that New York real estate mogul Henry Macklowe is pursuing financing in the face of a $6.4 billion debt payment due in February. The paper also reports that developer Robert F. Maguire III could be forced to sell Maguire Properties because the current debt markets have put so many of his tenants are in financial difficulty.
Meanwhile, even though the prices paid may have been high in relation to historic Seattle sales, everyone who purchased EOP properties locally will "be a winner" because of a shrinking supply of office space, rising rents and increased building values, said Bill Pollard, co-founder and principal in Bellevue-based Pacific Real Estate Partners. Pollard expects rents to continue rising this year on top of last year's already hefty gain.
"I think we have quite a bit more to go in Seattle," Pollard said, "as evidenced by continuing increases in rents we are seeing in San Francisco and Boston and other similar-sized gateway cities."
Construction costs are also rising, which will increase the rents that owners of newly delivered office buildings must charge.
Prior to the EOP portfolio sales, the Puget Sound area was the 15th-largest office market in the country but 24th in terms of rents, according to Don Fosseen, CB Richard Ellis senior vice president. But that is changing. In 2007, asking rents for premium Class A office space in downtown Seattle rose 20 percent to $36.78 a foot fully serviced, or including costs such as insurance, according to CB Richard Ellis.
Class A asking rents in Bellevue, meanwhile, rose even higher: 28 percent, to $37.50 a square foot fully serviced.
Meanwhile, new construction costs $450 to $500 a square foot, which means owners of new buildings will need to achieve rents in the $40-a-square-foot range fully serviced, Fosseen said. As a result, he anticipates double-digit rent increases again this year.
"Their timing couldn't have been better," OfficeSpace.com co-founder Kip Spencer said of Beacon and Archon's purchases.
In the months following the gigantic sale, Microsoft would sign a record-setting 1.3 million-square-foot leasing deal with Schnitzer West, which was followed by a series of other large tech company leases.
"(Institutional investors) were already very bullish on rents," Spencer said. "They essentially went in and looked at under-leveraged occupancy costs and adjusted the load factors and the parking rates. Then the market demand really helped validate their vision."
Parker Ferguson, co-founder of Seattle-based tenant representative Flinn Ferguson Corporate Real Estate, is less certain rents will continue their strong push upward.
"I think demand has cooled," Ferguson said.
He observes that the 700,000-square-foot City Center East office building now under construction in downtown Bellevue had not yet announced substantial pre-leasing as of press time. Additionally, Amazon.com will vacate a lot of space at its old headquarters on Seattle's Beacon Hill when its new South Lake Union campus is completed, starting in mid-2010.
Unlike New York City or San Francisco, the Puget Sound area still has a substantial number of sites that can be developed into additional office space to help keep rents in check, Ferguson said.
With hindsight, Blackstone's purchase of EOP occurred at a time of rare opportunity in the real estate market. Money was easy to borrow, and assets with a substantial potential upside could be bought relatively cheaply.
"You could borrow money at generationally low rates, at the same time you could grow your bottom line," March said. "We had a double whammy.
"It was," he said, "real estate nirvana."