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Redefining the market dynamics, leading multifamily real estate investment trusts (REITs) Equity Residential (EQR - Analyst Report) and Avalonbay Communities Inc. (AVB - Analyst Report) have recently entered into an agreement with Lehman Brothers Holdings Inc. to acquire the entire ownership stake of Archstone Enterprise LP – one of the largest investors, developers and operators of apartment communities in the U.S.

The deal valued at about $16 billion will envisage Equity Residential acquiring 60% of Archstone’s assets and liabilities, while the remainder will be acquired by Avalonbay. The transaction is expected to be completed by the first quarter of 2013.

The combined purchase price would include (i) $2.7 billion in cash, (ii) a pre-determined number of common shares of both Equity Residential and Avalonbay valued at $3.8 billion based on the closing price of November 23, 2012, and (iii) the assumption of approximately $9.5 billion of debt and $330 million of preferred equity. About $8.6 billion of the assumed debt is held by Fannie Mae and Freddie Mac.

Equity Residential’s Acquired Portfolio

Post-acquisition, Equity Residential would have 78 wholly-owned stabilized operating properties in its kitty, aggregating 23,110 apartment units with an average monthly rent of $2,492 per unit. The residential portion of the acquired portfolio is pegged at $367,003 per apartment unit. The properties are spread across diverse geographic locations, including Washington D.C., San Francisco, Southern California, New York, Boston, Seattle and South Florida.

In addition, the company is set to acquire four properties (one each in the Washington D.C. metro area, San Francisco, Phoenix, and South Florida) that are currently under development, and 15 land sites primarily in its core markets.  

Avalonbay’s Acquired Portfolio

Under the terms of the agreement mutually agreed by all the participating companies, Avalonbay would acquire 66 apartment communities totaling 22,222 apartment units, out of which six communities (1,666 apartment units) are under construction. Bulk of these properties are located in Southern California and the Mid-Atlantic region.

The company also purchased three land parcels, which are expected to contain a total of 968 apartment units. In addition, Avalonbay acquired ownership interests in joint venture entities that own 10 apartment communities totaling 2,040 apartment units, out of which one community (157 apartment units) is under construction.

Pre-Nuptial Joint Venture Agreements

Equity Residential and Avalonbay also entered in a joint venture agreement to co-own and co-manage Archstone assets that are placed in unconsolidated joint ventures that own apartment properties in various U.S. markets, and in a portfolio of apartment communities in Germany. Equity Residential would own a 60% stake in the joint venture entity, while Avalonbay would own the balance 40%.

Transaction Funding

Equity Residential is likely to fund the transaction through a combination of different payment options. These include issuance of approximately 34.5 million common shares to Lehman and payment of over $2 billion in cash.

The company has also assumed $5.5 billion consolidated and unconsolidated secured debt, including $5.1 billion of Fannie Mae and Freddie Mac secured debt. At the same time, the company has obtained a $2.5 billion bridge loan commitment from Morgan Stanley Senior Funding, Inc. Other possible sources of capital include available cash in hand, borrowing capacity under its $1.75 billion revolving credit facility, and debt financing.

A significant chunk of cash reserves is likely to be obtained from non-core asset sales and disposal of properties in exit markets such as Atlanta, Orlando, Phoenix, and Jacksonville. Equity Residential intends to raise proceeds of approximately $3 billion to $4 billion from asset sale transactions by the end of 2013. Currently, the company has approximately $400 million of assets under contract for sale, $250 million under letter of intent, and over $2.0 billion in various stages of marketing.

At the other end, Avalonbay would fund the transaction with (i) $669 million in cash, (ii) issuance of about 14.9 million shares, and (iii) assumption of $3.9 billion debt. The assumed debt includes $3.7 billion in principal amount for consolidated borrowings and $238 million for a proportionate share of debt related to unconsolidated joint ventures. Avalonbay also obtained a commitment from Goldman Sachs Lending Partners LLC to provide a $2.2 billion bridge loan facility.

Outlook Reiterated

Equity Residential reiterated its recurring FFO (funds from operations) guidance for 2012 in the range of $2.74 to $2.78 per share. However, the company expects its recurring FFO to dip by 4 cents per share in 2013 due to the planned asset sale transactions.

Mirroring it, Avalonbay also reaffirmed its FFO guidance for 2012 in the range of $5.45 to $5.50 per share and fourth quarter FFO in the range of $1.40 to $1.45.

The Fallout

The acquisition is likely to result in operational synergies for both Equity Residential and Avalonbay, improving the overall quality of the portfolio with assets in high-barrier, high-growth coastal markets. Furthermore, Equity Residential is also likely to benefit from the additional non-core asset sale required to fund the transaction, thereby accelerating its portfolio restructuring initiatives.

We maintain our long-term Neutral recommendation for both Equity Residential and Avalonbay, which currently have Zacks #3 Rank each that translate into a short-term Hold rating.

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