Last week’s announcement by Chicago-based Equity Residential (EQR) that it entered into an agreement to spend $1.325 billion in cash for a 26.5 percent ownership interest in Denver-based Archstone, which owns 48,922 units and has 1,332 units under construction, took some people by surprise.

Everyone expected Equity to be in on the Archstone deal. The twist was the decision to buy only half of the 53 percent owned by Bank of America and Barclays Bank, instead of the whole package. Lehman Brothers, the owner of the remaining 47 percent of Archstone, has the right of first offer (ROFO) on that 26.5 percent and up to 60 days to match. But after that, Equity is free to bid on the other 26.5 percent. Lehman retains the right of first offer on that as well.

The Wall Street Journal reported that Sam Zell, Equity's chairman, could outbid Lehman by buying Archstone in chunks. Andrew J. McCulloch, an analyst for Newport Beach, Calif.-based Green Street Advisors says Equity may have a better chance of securing some portion of Archstone by bidding on only 26 percent, as opposed to bidding on all 53 percent of Bank of America and Barclays' share. 

"It's creative how Equity structured the bid,” he says. “By Equity having an option to buy the second piece, Lehman and a potential partner don't know what they will have to bid to take down that second piece should they exercise their ROFO on the first. That's by design by Equity."

The Whole Enchilada
While the bid was for a little more than a quarter of the company, make no mistake that Equity wants the entire portfolio. "They want the whole thing," McCulloch says. "Their goal is to get a seat at the table and get that seat at a reasonable price. Once they get their foot in the door, they may be able to expedite the issue, but they are willing to wait it out."

Still, Lehman doesn’t want to lose management control of the company, which would happen with Equity in the picture. Analysts believe Lehman and Archstone’s CEO Scot Sellers are courting possible buyers so that he can keep Archstone’s management team intact. In fact, a recent Bloomberg article said Lehman is trying to raise about $2.6 billion to take full control of Archstone. “We believe Sellers wants to preserve the Archstone management team and platform and thus would likely prefer capital sources that would allow him to achieve that end,” according to a report from New York-based Sandler O’Neill + Partners.

Analysts mention Blackstone and Brookfield Asset Management, two known bidders for Archstone, as possible suitors, but Sandler O’Neill + Partners wonders if Brookfield may not be as appealing. “While Brookfield could also look like a white knight, we believe a review of the management turnover at General Growth Properties following the involvement of Brookfield would give Sellers pause about partnering with [them],” the report said.

As investors speculate on who could be Archstone’s white knight, Lehman is fighting back. Earlier this week, it filed a report with the SEC challenging the validity of Equity's offer. Lehman contends that there are better ways for maximizing Archstone’s value than the Equity sale, and that it wasn’t provided with information shared between Bank of America and Barclays Bank, according to Bloomberg.

With this as the background, Green Street wrote that the Equity bid could essentially be an "opening salvo" in the bidding process for Archstone, which could last into mid-2012. "We are likely months away from knowing how this will all play out," McCulloch says.

In an interview with Reuters, Equity CEO David Neithercut acknowledged that it could take years for everything to settle down. "The Lehman estate is in a liquidation process," Neithercut told the news organization. "So ultimately something must happen with their interest in Archstone. We're obviously willing to (wait) because we made the offer... now whether that's 12 months, 24 months, 36 months, I don't know."

Paying for Archstone
Equity's bid places a 5.4 percent nominal cap rate on the 2012 NOI and puts the entire enterprise valued at about $16 billion. Given current market values, Green Street estimates that Equity's bid represents a 3 percent to 5 percent discount to unlevered asset value (and potentially more if Archstone has a low economic interest in some of its more recent purchases in low-barrier markets). It says that discount is due to the existence of above-market-rate debt and the risk of assuming a non controlling limited partner stake.

Sandler O’Neill + Partners projects a 50 to 75 basis point cap rate discount. “We think Equity, if ultimately successful, would be buying one of the highest-quality apartment portfolios at a 10 percent to 15 percent discount from fair value before Equity generates upside from operational and financial synergies,” said Sandler O’Neill + Partners in a research note. “Further, Equity's access to capital and fortress-like balance sheet would allow Equity to recapitalize [i.e. refinance and delever].” Green Street says Equity plans to fund the deal with a $1 billion bridge facility provided by Morgan Stanley, line proceeds, cash proceeds, and funds from dispositions. That would increase the company's leverage by 600 to 800 basis points, but still keep leverage under 50 percent. The small stake it's pursuing would not require it to bring on an equity partner and provides it with veto power over financing and external growth decisions. The firm expects an eventual equity offering by Equity if it wins the bid.