REIT's Uptick Despite
Performance Baffles Analysts

Of all the REIT stocks, Equity Office Properties Trust would seem to be the least appealing. Yet some investors are buying up shares in the Chicago-based company, buoying the stock.

In the past few weeks, trading has been active, and the stock price -- which fell 5% after the company cut its dividend last month -- has crept back up. A 5% drop and bounce-back is a significant change. So far, Wall Street analysts remain unimpressed.

In 4 p.m. composite trading yesterday on the New York Stock Exchange, Equity Office's shares were up 11 cents at $32.15, giving the company a market value of about $12 billion.

"I'm left scratching my head, thinking, 'Why would any investor want to buy a stock that is yielding less that the sector average, with lower-than-average growth prospects and not even covering its dividend in 2006?' " said David Harris, a senior real-estate investment-trust analyst with Lehman Brothers, who expects the stock to "underperform" the sector in the next year. (He doesn't own any shares, though Lehman Brothers seeks to do business with EOP.)

It is easy to understand why analysts aren't showing much love for EOP, the nation's largest publicly traded owner of office buildings by square footage. Compared with rivals, EOP has been a poor performer. EOP and Boston Properties Inc., another REIT, had their initial public offerings within a month of each other in 1997, both with shares priced in the $20s. Today, Boston Properties trades at $78 and has provided a total cumulative return of 131% in the past five years. Equity Office's total return during the past five years is 26%, the lowest of the 12 office REITs followed by Merrill Lynch.

To add insult to injury, EOP announced Dec. 14 that it would cut its annualized common-share dividend 34% to $1.32, effective for the first quarter of 2006. That is a loathsome move for REITs, which are public companies that acquire, manage and operate real estate and typically pay at least 90% of their taxable income as dividends. Some analysts saw it as particularly bad form for EOP, whose chairman, Chicago financier Sam Zell, had famously told them in 2002 that the $2 dividend was "inviolate."

But something had to give. The company hadn't covered its dividend, after capital expenditures, since the third quarter of 2003 and had to sell off assets. Even with the dividend cut, the company expects to have a shortfall of $50 million to $100 million in 2006. The projected dividend yield dropped to 4.1% from 6.2% because of the dividend cut and is now below the average REIT yield of 4.5%, according to Lehman Brothers.

At one time, Equity Office had aspirations of being a mega-REIT with a presence in the nation's most sizable markets. The portfolio grew from 32 million square feet of space at its IPO to 134 million. But analysts maintained EOP overpaid for some properties, particularly when it reached a deal to buy Spieker Properties Inc., a Silicon Valley REIT, in February 2001 just before the Bay Area market collapsed.

The bigger-is-better philosophy has been re-examined. Last year, the company sold off $2.7 billion of properties and exited from such moribund office markets as Dallas, Cleveland and Philadelphia.

Even at a slimmer 112 million square feet of space, EOP remains a large company. During a Dec. 14 call to analysts, company executives said the portfolio pruning was at an end, with Mr. Zell contending that EOP's current holdings are "keepers" in markets sporting job growth.

That argument didn't go over well with some analysts at a time when buildings are being bought at record prices.

"We just think there were some more assets that could have been sold over the next 12 months in what is, obviously, a strong seller's market," said Ross Nussbaum, a REIT analyst at Banc of America Securities Equity Research, who has a "neutral" rating on the stock. (He doesn't own any EOP shares; Banc of America Securities does have an investment-banking relationship with EOP.)

Furthermore, the company failed to articulate bold plans for long-term growth, analysts said. The company should have said, "Hey, we are downsizing the dividend to a sustainable level, and although it is not being covered in 2006 either, there is a new EOP emerging," Lehman's Mr. Harris said. "I think there was an opportunity missed."

Joseph Betlej, vice president and portfolio manager for Advantus Capital Management, said EOP's one redeeming value is that it has accumulated a tremendous portfolio of urban office buildings across the U.S. Advantus, a St. Paul, Minn., firm for institutional investors with $17 billion in assets, purchased about 220,000 shares of EOP across all its funds during the third quarter of 2005 but sold about 50,000 in the fourth. "Long term, we believe in the Equity Office story," Mr. Betlej said. "It's just that in the short term, we see better opportunities. Today, we only see EOP as a trading opportunity."

Yet someone besides the company is buying. It could be that investors believe that the worst is behind EOP.

After declining to make projections for several quarters, the company said in the Dec. 14 conference call that its earnings per share for 2006 would be in the range of 14 cents to 29 cents, and diluted funds from operations -- an industry benchmark that excludes gains or losses from property sales while adding back depreciation, among other adjustments -- would be $2.15 to $2.30 a share.

While those are unimpressive numbers, "they can now focus on running their company and not trying to find answers to analysts' questions," said Arthur Oduma, a senior stock analyst for Morningstar Inc., who rates the stock the equivalent of a "hold." (Morningstar doesn't do business with EOP.)

Anthony Paolone, an analyst with J.P. Morgan Chase & Co., who has a "neutral" rating on the stock, points out that the company trades at a discount to the value of its portfolio as well as at a lower funds-from-operation, or FFO, multiple relative to other office REITs. (J.P. Morgan Chase has an investment-banking relationship with EOP.)

Equity Office trades at 14.2 times its estimated FFO for 2006, while the office sector's weighted average FFO trading multiple is 15.1, according to Harris Nesbitt, the U.S. research and investment-banking subsidiary of Toronto-based BMO Financial Group.

Moreover, office fundamentals nationally are at their best since 2001. If that trend continues, it should put EOP in better stead. The company said it expects to have ended 2005 with an occupancy rate above 90%, and Richard Kincaid, the company's chief executive, predicted 95% occupancy within the next couple of years.

Thomson Financial shows that most stock analysts have a hold or "sell" recommendation on EOP. Jim Sullivan, a principal with Green Street Advisors, a Newport Beach, Calif., research firm, said a bullish buyer could think, "I'm getting a discounted price -- a discount to its office peers, a discount to what the real estate is worth. And that's a pretty good starting point for a company that, at the end of the day, owns a lot of really good assets."

That is certainly a view that EOP hopes will catch on. "What I think you'll find is that we have cleared away a lot of the uncertainties," Mr. Kincaid said. "The markets are improving and we are going to go on a pretty good run."

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