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September 2004. Security Analysis Equity Office Properties. James W. Sullivan Managing Director Senior Real Estate Analyst. Security Analysis. REIT METRICS. Funds Flow Operations (FFO) = net income plus real estate depreciation.

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Security analysis equity office properties

September 2004

Security Analysis

Equity Office Properties

James W. Sullivan

Managing Director

Senior Real Estate Analyst


Security Analysis

REIT METRICS

  • Funds Flow Operations (FFO) = net income plus real estate depreciation.

  • Funds Available For Distribution (FAD) = FFO less non-revenue generating capex.

  • Retained Free Cash Flow (FCF) = FAD less dividends on common and dilutive convertible preferred.

2


Security Analysis

  • The largest publicly held REIT

  • Owns 689 buildings with 124 mil. sq. ft. in 18 states and Washington, D.C., 27 MSAs, and 123 sub markets

  • Is primarily an acquirer (value added and otherwise) and selective developer

  • Has BBB+ credit rating and excellent access to capital

  • Since becoming a public company in 1997, the company has delivered CAGR as follows:

  • 19972005E

  • FFO per-share 4.8% $1.80 $2.61

  • Dividends 6.6% $1.20 $2.00

  • Annualized Total Return

  • * EOP: 9.8% vs. RMS: 10.7%

* EOP: July 11, 1997 IPO share price compared to August 31, 2004 share price plus aggregate dividend payments over period; RMS: July 1, 1997 value compared to August 31, 2004 value.

Equity Office Properties (EOP, $28.56, Underweight--as of August 31, 2004)

Source: Company data and Prudential Equity Group, LLC.

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Security Analysis

Equity Office Properties

Growth Model

  • Internal Growth

  • FCF

  • External growth

  • Ancillary and other income sources

  • Net Operating Margins

  • Financing activities

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Security Analysis

Equity Office Properties

  • Internal Growth

  • Occupancy rate and rental trend—weak job growth, negative pricing, mediocre operating skills

  • Poor market exposure

  • Margins—negative trends

  • Failed “other income” initiatives

  • Impact per-share FFO at 1.5x rate

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Security Analysis

Equity Office Properties

Unusually Weak Cyclical Trend

Source: Property & Portfolio Research (PPR) estimates.

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Security Analysis

Equity Office Properties

Cash Flow Stress

Source: Company reports, Prudential Equity Group, LLC estimates.

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Security Analysis

Equity Office Properties

Market Exposure

% of Property NOI

% of Office From Continuing

Top 5 MarketsPortfolio Sq. Ft. Operations

Boston 10.2%13.4%

San Francisco 8.9% 11.6%

San Jose 7.1% 10.3%

New York 4.1% 8.6%

Los Angeles 6.2% 7.0%

Note: Data is as of June 30, 2004 and includes consolidated and unconsolidated office properties.

Source: Company report.

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Security Analysis

Equity Office Properties

  • Secular Issues

  • Off-shoring

  • Labor force growth

    • Demographics

    • Female participation

Source: Company data and Prudential Equity Group, LLC.

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Security Analysis

Equity Office Properties

  • Free Cash Flow

  • 2004E: ($143.9 mils.)

  • 2005E: ($142.7 mils.)

  • Borrowed to pay dividend

  • Weaken credit ratios

  • Cut dividend or increase borrowing cost

Source: Company report and Prudential Equity Group, LLC estimates.

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Security Analysis

Equity Office Properties

  • External Growth

  • Excessive Liquidity

  • Unusually low cap rates

  • Limited value creation opportunity

  • Not a scale business

Source:Prudential Equity Group, LLC.

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Security Analysis

Equity Office Properties

Let’s Compare The Metrics

Peer REIT 10-Year

EOP Group Industry Average

Yield 7.2% 6.1% 5.2% 6.8%

Div/FFO 76.9% 72.9% 69.9% 74.8%

’04E/’05E Growth (3.5%) 0.5% 5.6% 6.6%

LTM Div Growth 0.0% 1.5% 2.7% 3.0%

P/FFO 2005E 10.7x 11.1x 12.7x 11.3x

Note: All calculations are as of August 25, 2004.

Source: Company data, First Call, and Prudential Equity Group, LLC.

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Security Analysis

Equity Office Properties

  • Our Conclusion—Multiple Should Compress

  • The REIT industry is overpriced.

  • EOP’s dividend should be cut 25%.

  • Resulting yield should be above industry average.

Source: Prudential Equity Group, LLC.

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Security Analysis

Equity Office Properties

Our Call

EOP Rel Industry

Current Multiple 10.7x 0.85 12.7x

2-Yr. Growth (3.5%) NA 5.6%

Yield 7.2% 1.40 5.2%

Div. Growth 0.0% 2.7%

Target Multiple 7.5x 10.3x

Yield at target 10.0% 6.4%

Div’d Return 7.2% 5.2%

Total Ret. Potential (21.0%) (14.0%)

Note: All calculations are as of August 25, 2004.

Source: Prudential Equity Group, LLC. estimates.

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Security Analysis

Equity Office Properties

  • Valuation:

  • The valuation method we use to determine our $20 price target is 7.5x our estimated 2005 FFO per-share of $2.61. The 7.5x

  • multiple represents a 5.0% discount to our warranted office sector average share price to FFO multiple of 8.0x. Over the last

  • five years, Equity Office’s shares have traded in a range from a 8.0% discount to the average sector multiple to a 20%

  • premium with an average 6.0% premium. We apply the 5.0% discount based on the portfolio’s overweight in the weakest

  • office markets in the country and the company’s lease expiration exposure to those markets. Furthermore, during the

  • downturn the company has reported, and provided guidance for, leasing costs higher than any of the Office REIT peers. This

  • combination should drive FAD payout ratios above peer averages and continue to pressure the dividend. Including the current

  • yield, our target price implies a total return potential of negative 18.4%.

  • Risks: Large vacancy rates at this point in the real estate cycle across most of the nation’s office markets provide tenants with

  • a multitude of office space options including both direct vacant space and space available for sublease. As a result, landlords

  • have little power to attract tenants other than through lowering rents or spending large amounts of capital to rebuild space.

  • Historically, office space demand growth has lagged office job growth by six to twelve months. Although recent job growth

  • statistics are encouraging, the level of demand necessary to raise rents and slow leasing costs to landlords may not arrive until

  • Although the recent office job growth statistics suggest occupancy growth toward the end of 2004 and in 2005, lower

  • rental rates on new leases and high leasing capital expenditures should continue to pressure office REIT results through 2005.

Source: Prudential Equity Group, LLC.

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Security Analysis

Equity Office Properties

Source: FactSet and Prudential Equity Group, LLC.

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