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In order to safeguard its own interests in federal court, Equity Residential (EQR - Analyst Report), a multifamily real estate investment trust (REIT), recently filed a motion to "intervene as a party in interest” in the legal proceedings for acquiring a stake in rival company Archstone – one of the largest investors, developers and operators of apartment communities in the U.S.

Archstone is presently owned by a consortium of financial institutions that include Bank of America Corporation (BAC - Analyst Report), Barclays PLC (BCS - Analyst Report), and the bankruptcy estate of Lehman Brothers Holdings Inc. While the banks collectively hold a 53% stake in the company, Lehman holds the remaining 47%.

Despite continuous negotiations throughout the first half of the year, the owners failed to unanimously decide on how to unwind Archstone. This led the banks to put their ownership stake on the block in their concerted effort to raise cash and avoid a similar fate as that of Lehman.

Earlier, the industry was rife with speculation that Equity Residential would acquire the entire 53% of the banks’ share in Archstone for about $2.6 billion in cash and stock, creating one of the largest real estate transactions since the recession.

However, Equity Residential initially settled for a lower bid and decided to acquire about a 26.5% ownership stake (one half of the combined interests of the banks) in Archstone for $1.325 billion in cash, probably due to its complex ownership structure.

Insider sources had then revealed that the proposed buyout by Equity Residential valued Archstone at about $16 billion, including $11 billion in debt held primarily by government-sponsored mortgage companies like Fannie Mae and Freddie Mac. However, Archstone was originally valued at about $22 billion in 2007 when Lehman had first bought it.

The market value was partly eroded by asset sales worth approximately $2 billion, leaving it with about 77,000 apartments. The lower valuation was also due to the fact that the new owner would have a contentious partnership with every major decision requiring unanimous consent from all owners, which would likely dilute earnings.

The frenzy in owning apartment company Archstone became murkier with the ‘right to first offer’ by Lehman, under which the banks were obliged to present it with any offer they would like to accept and give the estate a chance to either match or beat it. Lehman had a brief period to respond and roughly about 50 days to put up the money.

As expected by insiders familiar with the situation and confirming the latest buzz in the industry, Lehman decided to forestall Equity Residential from owning Archstone and filed a legal suit against the banks for an alleged ‘breach of conduct’ amid claims that key information regarding the proposed deal were kept under wraps. Lehman further sought to have an injunction on the deal and decided to recover damages and legal fees from the banks.

The strategic decision to pre-empt the deal also stemmed from the inherent fears of Lehman about losing management control of Archstone should Equity Residential agree to buy it. Equity Residential already had a large management operation and Lehman feared that it might replace Archstone's management team and apartment management operation with that of its own.

The legal injunction by Lehman made matters more complex. In accordance with the initial agreement between the banks and Equity Residential, if Lehman agreed to buy the first half of the banks’ share, the second half on offer could be bought by the REIT for the same price or higher.

This in turn could make Archstone more expensive for Lehman should it aim to purchase the entire stake of the bank. On the other hand, if Lehman chooses not to acquire the second half of the banks’ share, it would saddle the company with an asset whose biggest rival had a considerable stake in it.

The present scenario, therefore, is a double-edged sword for Lehman, which was hoping to liquidate its biggest real estate asset for at least $6 billion in order to repay its creditors who collectively owe a staggering amount of $370 billion.

With creditors lining up for payment, a new investment is not what the company would have ideally liked. But the involvement of Equity Residential and the proposed deal has left Lehman with no other option other than vying for a part or the entire banks’ stake in Archstone.

In addition to Equity Residential, Archstone’s owners had also received competitive bids from other REITs like Avalonbay Communities Inc. (AVB - Analyst Report) – a private-equity firm; The Blackstone Group (BX - Analyst Report); and Canada-based investment firm Brookfield Asset Management Inc.

The renewed interest in owning one of the prized apartment companies in the U.S. is primarily due to the underlying fact that the multifamily sector has emerged as one of the best performing commercial real estate sectors in the recent quarters.

As ‘echo boomers’ (the children of the baby boomer generation) opt to move out on their own and more renters decide to part ways with family and roommates, the single-family homeownership rate across the U.S. has witnessed a continuous decline and demand for multifamily rental apartments has surged.

With new supply remaining muted until late 2013 or 2014, renting has emerged as the only viable option for customers who could not get mortgage loans or are unwilling to buy a house at present. Consequently, national apartment vacancy rates have dipped to 5.6% at the end of third quarter 2011 – the lowest since 2006.

Irrespective of the outcome of this ownership battle, the apartment sector as a whole is expected to benefit in the long run from market consolidation. In particular, Equity Residential is also expected to benefit from the acquisition of premium assets in some of the most desirable markets in the U.S.

By the end of the third quarter 2011, Archstone’s portfolio included 48,922 wholly owned and stabilized apartment units as well as 1,332 apartment units under construction, land sites for the potential development of 5,279 apartment units and 9,423 apartment units owned in unconsolidated joint ventures with third parties. The portfolio also included approximately 14,000 wholly owned or unconsolidated joint venture-owned apartment units in Germany.

The initial proposed purchase price of $1.325 billion for acquiring 26.5% of Archstone equates to a capitalization rate of 5.3% for the wholly owned and stabilized portfolio. Equity Residential expected to fund the acquisition through a combination of cash on hand, available borrowings under its $1.25 billion revolving credit facility, proceeds from non-core asset sale, bank term debt and secured and unsecured debt and equity offerings.

We maintain our ‘Neutral’ recommendation on Equity Residential, which currently has a Zacks #3 Rank that translates into a short-term ‘Hold’ rating.

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