Description

This is a recommendation to short Equity Office Properties at a price of $54.85/share and earn a return of about 1.7% over the next few weeks, as Blackstone’s all cash offer for EOP at $54/share is accepted and closed as soon as Feb 8th.

The key to why I think the deal will go through is based on the following facts from EOP’s most recent proxy statement:

-There is a 500 mil, or $1.25/share break-up fee payable to Blackstone if EOP sells to some one else, meaning that for any deal to be better, a buyer must value EOP at the least above $55.25/share.

-Blackstone’s offer is 100% cash, with financing commitment already in place.  A shareholder vote is scheduled to take place and pass on Feb. 5, for closing on Feb 8th.

-The Vornando-lead competing bid is $52/share, comprised of 60% VNO shares and 40% cash.  Their financing is subject to inspection of EOP’s books.

-The EOP board has set a deadline of January 31 (tomorrow) for any other offers.  As of the market open, no competing offer has been submitted by the Vornando group.

-The EOP board favored the original $48.50/share bid over the Vornando $52/share offer, even before Blackstone raised the bid to $54/share cash.  The concerns sited by EOP board included lack of financing commitments and with a large portion of the deal VNO stock, uncertainty with respect to how Vornando shares will trade post merger, as there is no collar on the Vornado offer.

A write up on shorting EOP would not be complete unless I explained why others can’t pay more.  At $55.25/share (the bid a buyer must beat), EOP is being priced at approximately $38 billion.  Based on management’s own guidance for 2007 NOI this is only a 5.2% nominal cap rate.

Now why can’t it go lower you ask?  Firstly, it’s a diversified national office portfolio, and there not many buyers who can swallow it whole.  Secondly, the portfolio valued at 5.2% nominal cap is already near impossible to finance with PE style 70% debt/capital.  Why?

Nominal cap-rates are calculated by taking EBITDA and dividing it by EV.  One can not ignore the fact that there is a REAL amount of maintenance cap-x associated with owning commercial real estate.  In EOP’s case, a conservative estimate is at least 15% of NOI (80 bps of EV).  Thus, the economic cap-rate (fcff yield) is about 4.4%.  

Now with the eco-cap at 4.4% and BAA2 bond yields at about 6.4%, there is a NEGATIVE 200 bps spread to the cost of debt.  Thus, a deal financed 70% debt/cap has an economic (FCFF- Maint Cap-X) interest coverage ratio of 1.02x, and an ’07 EBITDA coverage of 1.15x.  Who can pay more?  Blackstone ‘wins.’  $54 is a knock out bid.

Catalyst

No counter-offer submitted by tomorrow.
Deal closing on Feb 8th or shortly thereafter for $54/share cash as planned.