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A leaner and meaner Equity Office Properties begins to emerge

The largest office landlord in the country, Equity Office Properties Trust, has long subscribed to the theory that “bigger is better.” But the Chicago-based REIT (NYSE: EOP), which is chaired by billionaire financier Sam Zell, is aggressively pruning its portfolio while simultaneously making strategic acquisitions. Specifically, Equity Office has engaged in a massive disposition campaign with asset sales totaling $433.9 million during the first half of 2006 alone.

Thanks to a slew of second-quarter acquisitions — notably the $525.1 million purchase of Manhattan’s 1540 Broadway — Equity Office does remain a net buyer so far this year. But the company is once again in the disposition mode. The behemoth REIT recently announced that it’s exploring the sale of as much as $2.5 billion in assets over the next 12 months.

This large disposition campaign, plus the run-up in EOP share prices in recent weeks, has fed rumors that REIT investors are gobbling up shares in advance of Equity Office being sold.

“The stock has performed well because investors realize that the value is there,” says Jeff Johnson, chief investment officer at Equity Office, who oversees acquisitions, dispositions, joint ventures, and other investment activities. “Those who buy our stock for that [takeout] reason are not being wise investors.”

Even so, Johnson acknowledges that Equity Office is constantly evaluating ways to enhance shareholder value. Exiting several laggard office markets over the past 18 months has been one solution. Earlier this month, Equity Office sold a 1.2 million sq. ft. office tower at 191 Peachtree St. in Atlanta for $153 million to Cousins Properties. The building was 80% vacant. An oversupplied office market was one reason behind the sale. The city’s office vacancy rate registered 20% at mid-year, well above the national average of 14%.

“We are looking into supply-constrained markets where we can take a value- investing approach. We’re also looking for markets that have a well-educated and well-paid workforce,” Johnson says, emphasizing that Atlanta does exhibit the latter two qualities.

One market that Equity Office has targeted in recent years is Austin, Texas. As part of the mega deal, Cousins Properties also agreed to sell Austin office gem Frost Bank Tower for $188 million to Equity Office. The fully occupied, 525,000 sq. ft. office building sold for roughly $354 per sq. ft., a record price for Austin.

“Our investment strategy for a long time has been to buy the best office buildings in each market,” says Johnson. “That strategy hasn’t shifted much, if you look at our track record.”

Equity Office now owns 3 million sq. ft. of office space in Austin, making the REIT the city’s largest office landlord. Not only are the barriers to development significant in and around Austin, but the city also boasts a strong economic core of government and high-tech jobs — and more are on the way. Samsung Electronics agreed to build a massive semiconductor plant in the Austin area. According to the Greater Austin Chamber of Commerce, the plant is expected to create nearly 1,000 new jobs that pay an average anuual salary of $60,000.

Analysts expect Equity Office to lighten its load in Chicago, Denver and Northern California over the next few months. Add to that list any markets that subsequently get labeled “non-core” by Equity Office. Occupancy rates in the REIT’s Chicago and northern California portfolios registered below 90% at mid-year [see chart, below]. The Chicago portfolio also suffered a 0.4% occupancy decline during the second quarter.

Shifting Portfolio Occupancy For EOP

EOP 2Q 06
EOP 2Q 06
EOP 1Q 06
Boston 13.9% 93.1% 90.2% 2.9%
San Francisco 11.1% 89% 88.9% 0.1%
*New York 9.9% 97.6% 96.5% 1.1%
Los Angeles 9.2% 93.2% 93.3% -0.1%
San Jose 8.5% 88.4% 86.2% 2.2%
Seattle 8.1% 93.9% 93.2% 0.7%
Washington DC 7.4% 94.9% 95.7% -0.8%
Chicago 6.9% 89.9% 90.2% -0.4%
Orange County 4.5% 92.3% 94.0% -1.7%
**Atlanta 3.2% 78.6% 83.0% -4.4%
All Others 17.3% 89.8% 89.6% 0.1%
Total: 100% 90.6% 90.6% 0.0%
*strongest portfolio segment occupancy
**weakest portfolio segment occupancy

Source: EOP

What bodes well for Equity Office, not to mention most office REITs, is a broad-based market recovery. Grubb & Ellis reports that the national office vacancy registered 14% at mid-year, down from 14.3% the prior quarter and down from 15.6% at the end of the first quarter of 2005. Not all markets improved, however. Atlanta posted a 2% decline in Class-A rental rates during the quarter, and the volume of sublease space on the market increased sharply.

Conditions may worsen before they get better in the Atlanta office market, too. Grubb & Ellis reports that 3.8 million sq. ft. of new office space is slated to hit the market over the next 6 to 12 months. Only the Washington, D.C./Virginia/Maryland suburbs and Phoenix currently have bigger supply pipelines at 14.5 million sq. ft. and 4.1 million sq. ft., respectively.

Parke M. Chapman is senior editor of National Real Estate Investor

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