Real-Estate Firm Mines
Vast Untapped Capital

How much money was WorldCom Inc. leaving on the table?

That was the question Hilco Real Estate LLC needed to answer last September, when WorldCom -- now called MCI -- hired it a few months after the telecommunications company filed for Chapter 11 bankruptcy-court protection. MCI gave Hilco a mission: Squeeze as much money as possible out of the 25 or so properties MCI identified as surplus real estate. Raw land in Schaumberg, Ill., an airplane hangar in Jackson, Miss., and a data center in Atlanta are among the properties the company was looking to sell.

It all added up to potentially a lot of money. An MCI spokeswoman declined to say how much of the company's real-estate portfolio is being sold. But outsiders note that while corporate revenues and stock prices have declined dramatically in the past few years, real-estate values have increased.

The most "untapped" source of capital for companies in financial straits is their real-estate holdings, says Mark Smith, managing partner of Ernst & Young LLP's real-estate advisory practice. Still, he warns, if a firm "has a valuable piece of real estate in a highly desirable location or useful purpose to others, the company can see potentially millions of dollars left on the table if they jump in when they're in a troubled situation."

Worth More Than That

That was certainly true when Hilco, based in Northbrook, Ill., was hired by MCI last fall. Item No. 1 on Hilco's agenda: Put the kibosh on MCI's agreement to sell its vacant two-building office complex in Arlington, Va., to Tishman Speyer Properties for $101.4 million. "Even as an empty building, we believed there was at least $10 million more" MCI could get for the asset, says Hilco Chief Executive Mitchell Kahn.

How Hilco managed to do so and to raise the value of the property by at least $60 million more offers a guidepost for other distressed companies looking to sell real estate to ease some of their financial troubles. The property, called Pentagon City, is headed for the auction block next Wednesday.

Mr. Kahn and his colleagues spent two weeks canvassing the Washington-area market, making phone calls and meeting with more than a dozen real-estate brokerage firms and landlords, and reviewing recent property transactions in the area. That gumshoe effort convinced Mr. Kahn not only that Pentagon City was worth more than $101 million as an empty building, but also that his firm had a good shot at finding tenants to lease the entire 540,000-square-foot property. "We found out there were a number of government contracts of a large nature coming down the pike," he says.

But persuading MCI to kill the deal was "a difficult sell," says Mr. Kahn. "Having a debtor in bankruptcy staring at a number like [$101 million] and convince [it] not to take that money is a challenge. But we had become more and more confident that this was the right thing to do."

After several unsuccessful pleas to get MCI to end the Tishman deal, Mr. Kahn says, he sat down with senior executives from MCI and its turnaround consultant and made a unique offer: He would guarantee the sale of the property. Hilco was slated to earn a base fee and a percentage of the proceeds above $100 million. (For most of the properties Hilco sells for MCI, it gets a percentage -- 3% or lower -- of what the assets sell for.)

"I told them I'm willing to throw away our fee structure and provide a guarantee that the property would sell for at least $101 million," says Mr. Kahn, "and we would split the upside above that."

MCI didn't take Mr. Kahn up on his offer on the fee structure, but the proposal itself convinced MCI that he had few doubts. A few days later, at MCI's request, the bankruptcy court ended the agreement to sell Pentagon City to Tishman, which was not compensated for the deal termination. Tishman declined to comment.

Two-Pronged Approach

Now that Hilco had convinced MCI that it could get more money, the real-estate firm had to make sure it happened. Hilco thought the best way to proceed with disposing of the asset would be to simultaneously seek a tenant for the property while soliciting bids on the vacant property from prospective buyers. The two-pronged effort allowed Hilco to both move quickly to sell the property in the event that a tenant was not found, as well as establish pricing for renting out the property.

Operating in bankruptcy proceedings, however, created a special problem in securing a tenant, who might be concerned about delays in getting any lease approved by the court. That was the worry of the Transportation Security Administration -- a unit of the U.S. Department of Homeland Security created in 2001 to protect the nation's transportation systems -- which needed to move quickly with any prospective landlord.

So Mr. Kahn asked the bankruptcy court to give MCI the authority to consummate a lease deal with the agency if the property was selected by the agency. That move was "highly unusual," says Mr. Kahn, because "you rarely go to court to get approval for something that you may or may not later chose to do."

That was an "excellent" strategy to quell the agency's concerns, says Henry Chapman, a broker at real-estate services firm Trammell Crow Co., which was hired by the Transportation Security Administration to find it a home. In fact, very soon after the court authorization on Dec. 10, the agency signed a lease at Pentagon City and started moving in before year end. The lease, which real-estate services firm Spaulding & Slye Colliers in Washington helped Hilco secure, is valued at about $183 million over the life of the 10½-year contract.

Stalking Horse Contract

With that lease deal, Hilco began soliciting another round of bids to sell Pentagon City at auction with the aim of selecting a so-called stalking-horse contract. Under this approach, each interested bidder submits a bid. Hilco determined the highest bid, factoring in which bidder would most likely have the capacity and financial wherewithal to close a deal. Hilco then negotiated a purchase contract with that winning bidder. The offering price within that contract -- the stalking-horse contract -- plus a breakup and other fees is used as the minimum bid at the auction. If the stalking-horse bidder doesn't end up buying the property, MCI must pay a breakup fee.

Next week's auction will be open only to those bidders from which Hilco receives a qualified contract agreement. That process reduces the number of people "who show up that aren't serious in participating in the auction," says Mr. Kahn.

With bankruptcy-court approval, Hilco selected Jamestown TSA L.P., an entity set up by Jamestown, a real-estate investment firm, as the stalking-horse bidder. One of the most active buyers of U.S. trophy office buildings in recent years using German investment funds, Jamestown offered to pay $162.3 million for the Pentagon City complex, which includes nearly $29 million to cover construction costs that MCI put up to improve the property for the Transportation Security Administration and closing costs. If the property ultimately sells to a party other than Jamestown, MCI will pay Jamestown $2.6 million. The minimum bid at the auction is $165.1 million.

Hilco used the same general strategy to sell another MCI asset, a data center in Somerset, N.J., which is slated to be auctioned off Wednesday. Like Pentagon City, Hilco secured a tenant, Bank of New York Co., for the vacant property before selecting a stalking-horse bid. Without the tenant, the property would be worth about $20 million. Last week, Hilco prequalified 21 bidders for that auction. Bidding will start at $3.6 million, slightly above the stalking-horse contract bid of $31 million from Argent Ventures LLC, a New York real-estate investment firm.

As for Pentagon City, some real-estate brokers say the property could fetch as much as $175 million. Mr. Kahn and his colleagues have had "internal debates" on how high the bidding for each property might go. "There may be a lunch or two wagered" on the ultimate sale price for the assets, he says, but it's "nothing we would publicly talk about."

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