In a bid to strengthen assets, increase market muscle and secure its position as the No. 1 real estate investment trust in the country for the foreseeable future, Equity Office Properties Trust will merge with the West Coast's largest REIT, Menlo Park, Calif.-based Spieker Properties Inc.

As a result of the Feb. 23 announcement, the Chicago-based powerhouse opened a yawning gap between it and the second largest office REIT, Boston Properties Inc., which owns 37.6 million sq. ft. of office, industrial and hotel properties. Once the merger is complete, Equity Office will own 124 million sq. ft. of office space nationwide, including the 25 million sq. ft. gained through the purchase of Spieker.

The unexpected news of the merger left many industry observers in a state of near shock, a condition that quickly corrected itself as everyone scrambled to explain the whys and wherefores of the deal. In the flurry of speculation, analysts and observers generally gave high marks, with some caveats, to the union of the fifth largest REIT, as measured by equity market capitalization by the National Association of Real Estate Investment Trusts, and No. 1 Equity Office.

By the numbers

The stock-and-cash transaction, valued at about $7.2 billion, comes with $2.1 billion in debt, $431 million in preferred stock, $905 million in cash, $180 million in transaction costs and $3.6 billion in equity. David Shulman, head REIT analyst at Lehman Brothers in New York, characterized the merger as a fair deal. “The Spieker assets were bought at a good price, but not a bargain like the Cornerstone takeover,” he said, referring to last June's $4.6 billion deal between Equity Office and Cornerstone Properties.

With its latest acquisition, Equity Office will now realize huge, across-the-board economies from Spieker's Washington and Oregon markets, where Spieker owns almost 5 million sq. ft. of office and 5.68 million sq. ft. of industrial properties, and from California's nearly 30 million sq. ft. of existing or planned properties.

“Forty percent of its operating income will come from the three Pacific Coast states,” Shulman added.

That such a high percentage of income would come from what is generally perceived as a weakening market had others shaking their heads. Their view was that Spieker came “cheap” because of waning momentum on the West Coast, where for the past two years now-failed and failing Internet-related start-ups had driven the market to previously unheard of highs.

Moody's Investors Service pointed to California's slowing rent growth and rising vacancy levels, which if continued, “could result in lower than expected earnings performance.” Others, perhaps not wanting to question Equity Office Chairman Sam Zell's investment acumen, saw the merger as an indication that he viewed stalled rent growth and rising vacancies as temporary conditions.

Still, when compared with the nation as a whole, the continued strong job growth in the Western states enhances operating fundamentals. Zell said he remains confident that the West Coast markets and their educated workforce will remain strong centers for technology-related businesses. He defended the deal, stating that market forces, including the potential for possible decreases in rent, had been taken into consideration in underwriting the transaction.

Describing the merger as a good fit, Salomon Smith Barney analyst Gary Boston noted that Equity was “already on the ground” in Spieker's markets. The combined entity will provide a diverse, national portfolio with plenty of built-in growth, said Boston, who added that he's not worried about a weakening West Coast market. “The deal will increase Equity Office's presence in some of the best markets in the country.”

There is no doubt that the merger will bring the smaller markets into the national spotlight, but Equity Office will benefit too — from increased clout in Seattle, Portland, Ore., Sacramento, Calif., and the San Francisco Bay and Los Angeles areas. The merger will put Equity Office — which owns such trophy properties as New York's Worldwide Plaza, Boston's Rowe Wharf, Chicago's Civic Opera Building, Atlanta's Central Park, San Francisco's One Maritime Plaza and Los Angeles' SunAmerica Center — at the top of the Seattle, San Francisco and Silicon Valley markets. Additionally, Equity Office will now become the second largest landlord in the Los Angeles market in terms of total square feet owned, behind Los Angeles-based Arden Realty Inc.

The acquisition is consistent with the strategy Equity Office has articulated since it went public four years ago. With a market cap of $20 billion, soon to be $28 billion, the REIT looks to build critical mass in high-job-growth office markets that have barriers to development. Zell said these fundamentals are “the hallmark of Spieker's portfolio.”

Risks and rewards

Spieker chairman Warren “Ned” Spieker said that his company agreed to the merger to “reduce risks” for its shareholders but that the decision wasn't motivated by weakening markets. Analysts have surmised that one of those risks is the amount of development Spieker has in its pipeline.

Traditionally, Equity Office has developed properties through joint ventures while Spieker — originally the Northern California/Pacific Northwest division of Dallas-based Trammell Crow Co. — has run the activity in-house. Some analysts, like Salomon's Boston, see the pipeline as an opportunity for additional growth, while others, like Standard & Poor's (S&P), perceive it as a potential risk if demand continues to weaken in markets where development is planned. But even in weakening markets, the growth of the combined portfolio can be expected to increase. Banc of America Securities analyst Lee Schalop said the spread between in-place rents and market rents for Equity Office's properties will increase by 50 cents, to $9.50 per sq. ft., in the combined portfolio.

This, he added, represents about $1.2 billion in growth in the West Coast markets. “Shareholders are picking up a tremendous portfolio with in-place rents that are significantly below market,” Schalop added. “The impact on the value of the portfolio from these below-market rents is a lot higher than the $2.50 a share discussed by Spieker management.” Rents on the Spieker portfolio will roll over in the near term, while Equity's will come up for renewal in the mid- to long term. Together, said Schalop, the additional income represents about $1.2 billion in earnings growth in the West Coast markets.

Speculation on shareholder reaction also was mixed. “We think it's a good deal for Spieker shareholders, but we think it's a great deal for Equity Office shareholders,” said Schalop. “We have been a big supporter of Spieker's stock based on its exposure to the supply-constrained markets of the West Coast.” Salomon's Boston also saw the merger as a plus for Spieker shareholders who will keep a big chunk of what they own on the West Coast and add properties in strong East Coast and Midwest markets like Boston, Washington, D.C., and Chicago.

Some were less enthusiastic, expressing concern that Spieker's shareholders, already anxious over slipping stock prices due to the West Coast's sagging economy, will be disgruntled by the small premium they will receive.

Under terms of the deal, which shareholders must approve, Equity Office is paying $13.50 in cash and 1.49586 shares of EOP for every Spieker share for a total value of $57.52, about a 10% premium to Spieker's market close immediately after the merger announcement. The combination of cash and stock equates to a total price per share of $58.50 to Spieker shareholders.

Cultural challenges

The integration of two or more companies has always presented problems of corporate culture clashes, unforeseen expenses, prolonged integration and high turnover. S&P, which rated Equity Office as stable and Spieker as positive on news of the merger, noted in a release that the combination of Equity Office's regional operating infrastructure and management's experience in integrating large portfolios would support the success of the merger, but it also cautioned the size of the deal would present challenges.

According to the rating service, “The acquisition is by far the largest to be undertaken by Equity Office, but the company's pre-merger size should provide a solid operating platform to help smooth the process.”

With more than 600 employees at Spieker's properties in all of its core markets, people issues are a “big deal” in the agreement, according to Lehman's Shulman. “I never underrate this,” he said. But with Equity Office's track record for successfully integrating Cornerstone, and in an earlier merger, Beacon Properties, most analysts expect few, if any problems. “They have a couple of big mergers under their belt and a team that seems to have worked out the kinks in the process,” echoed Boston.

The merger, expected to close in June, will put 616 office buildings under the Equity Office umbrella. It intends to sell Spieker's 13.5 million sq. ft. of industrial properties. On completion of the merger, Ned Spieker and executive officers Craig Vought and John Foster will join the Equity Office Board of Trustees.

Equity Office may already be the dominant force in the REIT world, but according to Schalop there is even more opportunity. “Despite its growth and size, Equity Office will own only roughly 4% of the 3.1 billion sq. ft. of total U.S. office space,” Schalop said. “Significant consolidation opportunities remain.”

Jane Bowar Zastrow is a San Francisco-based writer.