Questioning Blackstone's big deal

NEW YORK (Fortune) -- The biggest mergers and acquisitions have a way of going sour: think Time Warner (Charts) and AOL, Boston Scientific (Charts) and Guidant, KKR and RJR. Earlier this month, when Blackstone won the distinction of the largest ever private-equity buyout with its $39.2 billion buyout of Equity Office Partners (EOP), it looked like the powerhouse firm might be tempting a similar fate.

The difficulty is inherent in the real estate business. EOP's enormous complex of office space includes about 540 properties totaling more than 130 million square feet, much of which legendary vulture investor Sam Zell amassed during the 1990s. During that time, property owners struggled with lower valuations. When they couldn't keep up with their loans, Zell bought on the cheap and earned the nickname "the grave dancer."

Blackstone's record-setting real estate buyout has it flipping properties quickly.

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Now he's cashed out, and Blackstone's formidable investment makes sense only if the market keeps rising. Soaring rents and land values have been driving U.S. real estate investment trust (REIT) prices higher, but real estate research firm Green Street Advisors says the phenomenon will last only in certain regions. "The expectation of higher rents is the only way to justify the EOP deal," says Cedrik Lachance, a Green Street analyst, adding that it could be difficult to generate a high rate of return on the purchase. Green Street, which does not buy or sell REIT stocks, has followed the Blackstone buyout closely, to gauge its effects on the overall real estate market.

Blackstone's real estate whiz kid, 37-year-old Jonathan Gray, paid a premium to beat out rival Vornado (Charts) and take EOP private. He and his team raised the bidding twice, going up more than 14%, from $48.50 to $55.50. "In the near term there's no doubt that rents are rising, but it's going to be very market specific. You have markets such as San Francisco, west L.A., and New York City where expectations of growth are legitimate, but in markets like Dallas and Philadelphia growth will be inflation level at best," says Lachance.

Blackstone declined to comment on the EOP deal, but it has been selling off properties at lightning speed in the nation's most attractive markets. California's Irvine Co. is the latest buyer, picking up 17-buildings in San Diego County for an undisclosed amount of money. Macklowe bought eight Manhattan buildings for $7 billion the day the EOP deal closed; Beacon Capital Partners bought properties in Washington and Seattle for $6.35 billion. Bloomberg reports that San Francisco-based Shorenstein bought buildings in Portland, Oregon for $1.2 billion, and rumors abound in the Sacramento market that Shorenstein will buy EOP holdings there as well.

The rapid-fire deals suggest that Blackstone does not want to get stuck paying to improve properties for which it has already paid a hefty price. "Historically, private equity firms held companies for longer periods of time and substantially improved them," says Josh Lerner, a Harvard Business School professor who researches venture capital and private equity activity. "But these companies are being graded on [internal rate of return]. In this case, holding on may not be in [Blackstone's] best interest."

The question of whether Blackstone paid too much is exacerbated by the fact that REIT yields are dipping. Generally speaking, U.S. REIT yields are at about 3.8%, says the National Association of REITs, their lowest yield relative to Treasuries since 1985. Reports place EOP's capitalization rate at between 4% and 5%, which Green Street says is a record low for a REIT purchase; it's about what an investor could get with a 10-year Treasury note, which yields around 4.8% and is considered a safe-haven investment to the world.

Institutional investors have also been net sellers of REITs since November, says a research note from State Street, the first time in two years that this financial services firm has not been a buyer. Not surprisingly, then, Wall Street seemed to signal that EOP was not worth the high price paid. Vornado, whose bid had been slightly higher than Blackstone's, saw its stock pop 7% after the company pulled out of the bidding. A Wachovia (Charts) research note said "Vornado's $3 billion-plus of marginal investment capacity will generate higher [returns on assets] than the $20 billion-plus of EOP-allocated capital, and possibly sooner."

All of which adds up to a lot of pressure on Gray. He has been described as the smartest real estate man working today, and he's selling off major pieces of the EOP pie as quickly as he put together the winning bid. An economic speed bump in the form of higher borrowing costs could make this expensive buyout a loser if the firm is still holding too much property. Higher interest rates would slow economic growth and business expansion, dampening the rental market.

The ripple effect could extend to the banks that lined up to give Blackstone money for the EOP buyout, including Bank of America (Charts), Bear Stearns (Charts), Goldman Sachs (Charts), Morgan Stanley (Charts), Citigroup (Charts) and Wachovia Corp. And that doesn't even include the many limited partners - which are typically pension funds and other institutional investors - that gave money to Blackstone. As the rest of the firm partied at Schwarzman's lavish 60th birthday gala, Gray's gift to the boss was to find buyers, lest the EOP deal end up as private equity's biggest mishap to date.