One Post Office Square is one of many high-profile office buildings currently in Equity Office Properties’ Boston portfolio.

Lehman Bros. is advising investors to sell Zell. Will that lead Zell to sell?

In downgrading Equity Office Properties from a “hold” to “sell” recommendation last week, Lehman analysts suggested that the real estate investment trust may increase its disposition strategy to ride out the economic downturn, a scenario that could potentially impact the local office market given Equity’s dominating presence in Massachusetts. Equity Chief Executive Officer Samuel Zell’s initial acquisition of Boston’s troubled 28 State St. in 1995 now extends to 55 buildings scattered throughout downtown Boston and Cambridge and into prime suburban communities such as Burlington, Waltham and Wellesley.

Equity officials insist any sales effort would be focused almost exclusively on smaller markets, with the Hub among 20 major regions to which the REIT remains committed long term. But some observers questioned whether Equity would be able to reap the returns necessary in fringe markets to make a substantial difference on its bottom line, whereas Boston remains among the hottest markets for investors.

“They could have great success” selling Hub holdings, said one Boston investment broker, although the source stressed there has been no indication from Equity that it is planning such a campaign. The broker noted that prime Boston buildings have attracted widespread interest in 2002, including the recent sales of 50 Milk St. and One Boston Place, as well as a pending deal by the New Boston Fund to acquire 116 Huntington Ave. in Boston’s Back Bay. Overseas investors have also remained active, and could be even busier in 2003, with a general interest towards the type of downtown properties Equity currently controls.

“I would not be surprised at all if Equity decided to rebalance its portfolio by selling [Boston] assets,” said the investment broker, adding, “There’s no better time than right now.”

Nonetheless, Equity Chief Investment Officer David Helfand told Banker & Tradesman last week that the Chicago-based REIT has no inclination to trade any of its Boston buildings. While acknowledging that commercial properties locally are selling at lofty prices, and acknowledging that its portfolio would likely draw considerable attention, Helfand said Equity’s faith in Boston rebounding has emboldened its willingness to stand pat.

“Boston fundamentally, long term, is one of the great markets in America and we are long-term investors,” said Helfand in dismissing any notion that the REIT’s ongoing sales program will extend into the Bay State. “We are committed to the [Boston] market.” Among Equity’s major Hub properties are 125 Summer St., 75 State St., 175 Federal St., One Post Office Square and 225 Franklin St.

‘Further Downside’

Helfand also insisted that there is no correlation at present between Equity’s active selling program and supposed concerns about any dividend shortfall. While the REIT has traded $560 million worth of buildings in the past 12 months, that initiative has been driven largely by having assets in non-core markets, Helfand explained, properties typically acquired through a merger or acquisition of another firm. While he declined to discuss Lehman’s downgrading action, Helfand said Equity believes that the office market will recover sufficiently that it will not have to sell buildings in order to fund a dividend shortfall.

In any event, Lehman certainly delivered an ominous outlook for Equity going forward in 2003, prompting it to downgrade the stock from a rank of “2-equal weight” to “3-underweight,” which essentially moves its recommendation from a hold position to advising investors to sell the stock. Among other things, Lehman said that “EOP is handicapped by having a portfolio with a high exposure to the still-troubled technology industry and to financial services, where the pain has only just started to be felt.” Lehman added that a willingness to sell properties and use the proceeds to buy back stock “is heartening,” albeit dependent on the real estate investment market remaining strong. The report was prepared by Lehman analysts David Shulman and David Harris.

Of the 1,496 companies covered by Lehman Bros. research, 73 percent have either a buy or hold ranking, while Equity is among the remaining 27 percent currently saddled with the sell recommendation. Such a listing indicates that sector fundamentals/valuations are deteriorating.

Lehman Bros. did acknowledge that Equity retains a strong balance sheet and that the REIT’s dividend payout of $2 per share should be safe for the coming year. Performance has been impacted by the slow economy, however, as indicated by the slippage of occupancy levels in Equity’s 128 million-square-foot portfolio for the third straight quarter. The occupancy dipped by 1.1 percent in the first quarter, 0.7 percent in the second quarter and 0.8 percent in the third quarter to a current mark of 89.2 percent.

At 92.3 percent occupancy, Boston’s Equity portfolio has outperformed the REIT’s national occupancy, but Lehman noted that number is down from 94.1 percent at the mid-year mark. Equity’s Boston rent levels in the mid-$40s has reflected the company’s resilience here, but Lehman warned that “there could be further downside in rents” in the Hub, as well as other markets where Equity is a leading player, including San Francisco, San Jose, Calif., and Seattle.

Overall, Lehman reported an increase in office vacancy rates in Equity’s top 20 office markets of 0.6 percent in the third quarter, bringing the vacancy mark in those markets to 15.6 percent. Of that, 3.7 percent is sublease space, compared to 4.3 percent in Equity’s portfolio. According to Lehman, “we could well find ourselves in the situation of improved market occupancy being accompanied by declining [Equity] occupancy as sublease burns off.”