Putting the pieces together: with property values so high, other real estate trusts may go the way of Arden.

Six months ago, Legg Mason analysts surprisingly raised Arden Realty Inc. to a "buy" rating even though little had changed at the L.A.-based company.

The only difference was in the value of Arden's portfolio of mostly Westside office properties. The buildings, according to the Legg Mason analysts, were worth 31 percent more than the company's value based on its stock price.

With Arden shares trading near $32 at the time, some other analysts privately scoffed at the valuation, but as it turns out Legg Mason would get the last laugh.

Six months after the prediction, General Electric Co. and Trizec Properties Inc. bought Arden for $45.25 a share--a price far closer to the Legg Mason value than elsewhere on the Street.

"Wall Street bases its estimate on the cash flow of a building," said Bert Dezzutti, a senior vice president in the L.A. office of Equity Office Properties Trust, the nation's largest landlord. "That doesn't reflect the real value of the building. Arden saw that and took advantage of it."

Arden is not the only company to find itself in that puzzle. With L.A.-area property values soaring, and REIT prices relatively flat, a situation is developing where more and more REITs could sell themselves, too.

Local REITs that specialize in Southern California real estate, like Arden, could find themselves at a similar crossroads.

Competition for new L.A. properties is fierce, sending prices skyrocketing and knocking down yields to historic lows. Meanwhile, the rapid run-up in prices has made the portfolios of some companies more valuable than their market capitalization. Under that scenario, numerous REITs could become the target of cash-rich pension fund advisors and private equity firms, among other potential buyers.

And if 2006 is anything like its predecessor, there will be no shortage of investors flush with seemingly endless cash willing to pay a huge premium to take the companies private.

"The companies that buyers are looking to take private are trading at a discount to what the real estate is worth," said Jim Sullivan, a senior REIT analyst at Newport Beach-based Green Street Advisors. "That way they can pay the share price but get real estate they perceive to be worth far more."

Rare discounts

In the case of Maguire Properties Inc. and Kilroy Realty Corp., two large office REITs that specialize in Southern California properties, the companies are worth more as real estate portfolios than operating companies.

While shares of Maguire Properties are trading near $32, the company's real estate is worth more than $40 a share, according to Banc of America Securities analysts Ross Nussbaum and John Kim.

And while Kilroy Realty--which posted some of the top returns of any office REIT last year--is trading at $65 a share, the BofA analysts believe the company's real estate is worth up to $70 a share. "We do not believe these companies will necessarily trade at (those values), given neither are for sale," the analysts wrote in a Dec. 21 report.

Elsewhere across the nation, Sullivan said few REITs find themselves in the same situation in which the real estate is worth more than the company. Of the 70 REITs tracked by Green Street Advisors, few have stock prices trading at a discount to their real estate. "The average company we cover trades at a modest premium to what the real estate is worth," Sullivan said.

The strength and resilience of the local economy is one of the reasons companies that focus in L.A.-area real estate find themselves in this relatively rare predicament.

Southern California is among three markets nationally--the others being New York and Washington, D.C.--where strengthening office market conditions have caught the attention of international investors.

A recent study by CB Richard Ellis Group Inc. found that of the prime office markets worldwide, once-moribund Los Angeles had shown the most improvement. By the end of 2005, average annual L.A. office rents had risen to $29.76 a foot--a 15 percent increase. Only Hong Kong and Tokyo had steeper rent spikes.

Also during 2005, the average L.A. office building's vacancy fell to 13 percent--a 1.5 percentage point drop. Only four office markets worldwide--none in the United States--posted larger occupancy improvements, according to the CB Richard Ellis study.

While properties in San Diego and Orange counties have led in price appreciation, L.A. County--with quadruple the number of office towers--has remained highly sought after for its diverse economy.

Several of the industry's larger REITs are selling off properties in what they deem non-core markets--essentially metropolitan areas with lackluster or flat rent and occupancy growth--to reinvest in more lucrative areas. Last year, Equity Office sold off a large Texas portfolio and the company announced it planned to use the money to increase its concentration in better-performing markets, including Los Angeles.

"The strategy that we have is to concentrate capital in 15 core markets in the United States that have the best prospects for employment and growth," Dezzutti said. "The strategy is similar for other REITs, which is why Southern California stands out as one of the top markets to be in."

Betting big

More than any other REIT, Chicago-based Trizec Properties has increased its concentration in Southern California.

After the deal with Arden closes, Trizec will nearly double the amount of buildings it owns in Southern California, which will become the company's largest market in terms of both square footage and revenues.

In Southern California, Trizec will own 8.6 million square feet of office buildings, which will generate more than 30 percent of the company's revenues. By contrast, Trizec has about 6 million square feet of properties in New York and Washington, D.C., where each market generates about 15 percent of the company's revenues.

At the Howard Hughes Center, which Trizec is buying from Arden, the company will also get land with entitlements for 490,000 square feet of office buildings and the right to build up to 600 residential units.

"We are big believers in the Southern California market as a whole," said Patrick J. Lacey, vice president and general manager of Trizec's L.A. office. "We still think there is a lot of embedded growth in the market here."

During the last three years, Trizec ramped up its presence in the downtown market, striking deals to buy three trophy office buildings: Ernst & Young Plaza at 725 S. Figueroa St., Bank of America Plaza at 333 S. Hope, and the Figueroa at Wilshire building at 601 S. Figueroa St.

"We consider those three to be our centerpieces and base of operations in L.A.," Lacey said.

The big question now, though, is what will be the ripples from the Arden sale? Flush with cash from the sale, many Arden shareholders are expected to plough their returns back into companies with Southern California portfolios. Most Wall Street analysts expect shares of Kilroy and Maguire to benefit the greatest.

Arden shareholders could also put their proceeds into Douglas Emmett & Co., a Santa Monica private real estate firm with a premium portfolio of L.A.-area office buildings that plans to take itself public this year.

Additionally, Younan Properties Inc., a Woodland Hills-based real estate firm that owns a geographically diverse collection of properties, may also go public this year.

A copy-cat deal is also possible. The abundance of deep-pocketed real estate firms--including public companies, REITs, private equity firms and syndicates of wealthy investors--are on the prowl for another Arden-like transaction.

Of the local public real estate companies, Kilroy Realty has been rumored as a prime buyout target, especially due to the premium the company could fetch because of its high-quality portfolio.

Sullivan, the Green Street Advisors analyst, believes Kilroy Realty won't put itself up for sale because the company is performing well and posting strong growth. Sullivan said while there could be talk of more transactions, he expects few to consummated.

"We are going to see a lot of attempts at Arden-like deals, but there's a short list where it's actually possible," he said. "There will be more talk than action."