Right after Thanksgiving, two of the nation’s largest REITs seized the chance to swallow more than a hundred of the most desirable apartment properties in the country. What could possibly go wrong?

But credit agencies including Moody’s Investors Service and Fitch Ratings immediately pronounced the deal a “credit negative,” even though the two companies have a credible plan to finance the acquisition and integrate the properties into their portfolios.

In the deal announced Nov. 26, Equity Residential and AvalonBay Communities Inc. entered into an agreement with Lehman Brothers Holdings Inc. to acquire the assets and liabilities of Archstone Enterprise L.P. for approximately $16 billion. That includes more than 40,000 apartments located in the most prized real estate markets in the country. For the most part, the properties fit smoothly into the business plan and long term strategy of both companies. The properties are even managed using similar software platforms, which will help the buyers integrate the properties.

“In the long term we agree with the notion that this is a good deal,” says Chris Wimmer, vice president and senior analyst for Moody’s Investors Service.

However, in the short term, both Equity and AvalonBay have taken on a mountain of debt just as some economists worry about another potential round of panic and instability on Wall Street. Congress has begun to argue seriously about the national budget and Europe is only now beginning to mend its tattered banking system.

“These are the types of events that could disrupt the capital plan that would bring their credit profile back in line,” says Wimmer. Remember, the only reason that the Archstone portfolio is for sale is because of a massive deal to take the Archstone REIT private soured in the financial collapse, when short-term capital became almost non-existent. Because it overextended itself, in this deal and many others, Lehman Bros. declared bankruptcy in 2008.

Equity has been attempting to buy the Archstone portfolio from Lehman and its partners for more than a year. AvalonBay has also been involved, though their part in the transaction was only announced this month. “Last January we reached out to one, and only one, firm: AvalonBay,” says David Neithercut, president and CEO of Equity. “From the very beginning of our pursuit of this opportunity with more than 40,000 apartment units worth more than $16 billion, we knew that we would need a partner.”

Splitting up the portfolio

It must have been difficult to decide which properties would go to Equity and which to AvalonBay, since they both wanted similar things. AvalonBay wanted “to more deeply penetrate our high-barrier-to-entry core coastal markets,” says Tim Naughton, president and CEO of AvalonBay. For its part, Equity wanted to “own an irreplaceable portfolio of high-quality assets in the nation’s high-barrier coastal markets,” says Neithercut.

The two companies solved the problem by each taking some properties in each of Archstone’s major markets, but weighting the balance to fit their strategic goals.

Equity took 78 of the operating Archstone properties, plus land and projects under development—including 14 in San Francisco and eight in Boston. “These have been extremely challenging markets in which to increase our exposure,” says Neithercut. The deals grows Equity’s portfolio in Boston by 41 percent and in San Francisco by 48 percent. AvalonBay also took two properties in New England and nine properties in Northern California.

More than a third of the 66 apartment communities bought by AvalonBay are located in Southern California. Those 23 apartment communities, totaling 8,507 units, are a triumph for AvalonBay, which has been working to increase its portfolio in Southern California for several years. “Southern California’s supply constraints and development dynamics have challenged our ability to grow within the region,” says Naughton. Now is a good time to buy. “We believe the Southern California is early in the expansion part of its cycle,” he says. Equity also bought 12 Southern California properties in the deal, totaling 3,374 apartments.

Both REITs took on properties in the Washington, D.C., metro area, even though they expect high competition from new apartment construction in the area over the next several years. Equity bought 24 properties in the area, while AvalonBay bought 18. These properties are concentrated in Northwest Washington, D.C., and the Rossyln-Ballston corridor in Arlington, Va. These submarkets are more able to absorb new supply or more protected.

The 1031 exchange

Equity is already working to pay for the massive transaction by selling properties. “For nearly 10 years, Equity Residential has been working hard to reduce our capital commitment in lower barrier, lower cost housing markets,” says Neithercut.

Thanks to the Archstone deal, Equity can now sell many of these properties in tax-advantaged, 1031 exchange deals. That includes a large portion of Equity’s remaining assets in Phoenix, Atlanta, Orlando, Fla., Jacksonville, Fla., and the Inland Empire of California. Equity plans to raise more than $1 billion before closing.

Though the buyers expect strong returns on their investments over time, in the short term Equity admits to paying more for the properties that it is buying, on an income basis, than it is receiving for the properties that it is selling. This activity will dilute normalized funds from operation going forward. “We will clearly be selling assets in our exit markets at yields or cap rates in excess of that at which we will be acquiring our Archstone assets,” says Neithercut.

Equity paid a high $367,003 per stabilized apartment unit for the portfolio, or a low capitalization rate is approximately 5.0 percent. When adjusted for transaction costs and the debt mark-to-market, the cap rate would be approximately 4.7 percent. AvalonBay puts its cap rate for the deal in the “high 4 percent range.” Cap rates describe the net operating income from a property as a percentage of the sale price.

But given the prime locations of these properties, even those low, low cap rates sound like a relative bargain to some analysts. “They got a bit of a discount,” says Wimmer.