DENVER-In a major restructuring of its portfolio, UDR Inc. has shed 86 communities for $1.7 billion. A joint venture of DRA Advisors LLC of New York City and Greensboro, NC-based Steven D. Bell & Co. bought the assets, which consist of 25,684 units in 10 states.

The transaction reduces UDR's holdings by nearly 40% to 40,183 units in 146 communities, and brings it from being the third-largest apartment REIT in the country to the fourth. The firm also announced it is moving its headquarters here.

In the REIT's fourth-quarter earnings call, UDR president and CEO Thomas W. Toomey said the decision to move forward with the transaction was driven by three key factors. For one, the firm wanted to take advantage of the valuation arbitrage that exists between the public and private markets. "We sold a hand-picked portfolio of assets that we would classify as below-average compared to the remaining portfolio at a 6.5% cap rate, when the stock was trading at a greater than 7% cap rate," he said.

The executive revealed that work on the sale actually began several months ago. The field of potential buyers was narrowed down from 15 select players to about six, and then finally to four contenders¬--two foreign investors, one pension fund advisor and one levered buyer.

"We really tried to create a marketplace for this transaction," Toomey explained. "We enlisted Fannie Mae to help us underwrite each individual asset, and in fact fronted the dollars to have them do the title work and physical survey. We wanted to present to this final auction group a prepackaged loan with Fannie and, in essence, put them on equal footing because they knew where they could get their financing, since in today's market, without the financing, no deals are going to get done.

"In the end," he said, "I think we had pricing power. We were running the four bidders against each other and we picked the group that we thought had the highest degree of certainty and a good price. We feel good about the process."

According to Toomey, DRA's financing probably consists of a Fannie Mae loan with 75% to 80% LTV at a locked rate of 5% or less, with a six- to seven-year term, in addition to mezzanine financing. "For a company that uses a lot of leverage, I think they've got a good deal," he said.

The transaction, meanwhile, was a strategic move by UDR to "right-size" the organization and enhance its financial position. "In a period of time when liquidity is hard to come by, financial flexibility is critical," he said. "We wanted to create more financial flexibility in our future, particularly to acquire assets, complete our development and redevelopment efforts and certainly repurchase shares." Shedding the portfolio also better focuses the company, which in Toomey's view is important in executing its long-term strategies.

Indeed, UDR will have a pared-down portfolio of assets when the transaction closes, which is expected early next month. Most of the sold communities are in North Carolina (27 assets) and Texas (22); followed by Ohio (nine); Florida (eight); South Carolina (seven); Virginia (three); Arkansas, Delaware, Maryland and Tennessee (two each); and Oregon and Washington State (one each).

Those assets, which traded at about $66,578 per unit, had an average occupancy of 94.4%, age of 24 years, operating margin of 62.3% and brought in an average of $744 per unit a month. The transaction factors out to a 6.56% cap rate. The communities, said Toomey, "had a disproportionate amount of capital being spent on them."

After the deal, 90% of UDR's holdings will be concentrated in Pacific Coast (accounting for about 47% of NOI), the Washington, DC Corridor (24%) and Florida (19%) markets. "These are the areas in which we see long-term growth and job formation," says Toomey." They're all in positive territory." The rest of its communities are in Washington State, Tennessee, Texas, Arizona and Oregon. The revamped 40,183-unit portfolio will have a mean age of 15 years, operating margin of more than 70% and bring in an average monthly rent of about $1,200 a unit.

UDR executives revealed that on a cap rate basis, the spread between the sold assets and the remaining portfolio is about 170 basis points. Had the REIT held onto the communities, its NOI would have been reduced by 100 basis points.

The purchase price includes $1.5 billion in cash and a $200-million note with a rate of 7.5% and 14-month term. UDR will funnel some $500 million to $600 million into new acquisitions, about $320 million of which are already under contract in select markets. Those properties, Toomey stated, have cap rates in the 5% range. All of the transactions, he said, will be 1031 exchanges. "We're being disciplined, not trying to go out and lock up assets. We've known this transaction has been in the works, so we've been going out and shopping for the past few months," he added.

Another $500 million to $600 million will help repay debt, while the balance of the cash proceeds as well as the note is expected to be used to fund additional acquisitions, repurchase stock and for a potential special dividend. The company has the option to repurchase up to 22 million shares.

In addition to growth through acquisitions, UDR has a healthy development pipeline, with nearly $2.6 billion worth of assets. The majority of those are in Texas, California, Metro Washington, DC and Washington State. Expect $500 million to $600 million in deliveries annually, with targeted returns in the 6.5% to 7% range. In this transitional point in the cycle, Toomey said, "We feel very comfortable that our pipeline is being delivered to the right markets at the right time." Some 97% of the pipeline is either generating NOI, under construction or in lease-up, he said, and the REIT also has six communities with 1,900 or so units in various stages of redevelopment.

MJC Associates LLC served as UDR's broker in the deal and Merrill Lynch and Co. provided portfolio strategy. Both firms also served as financial advisors.

As part of its corporate realignment, UDR will shift its headquarters to Denver. Its former base of Richmond, VA will house its redevelopment and backroom support functions. The firm will also operate its development efforts out of Dallas.

Despite UDR executives' efforts to transform the company, Wall Street analysts didn't change their outlook for the firm. The REIT, like its counterparts, will face several headwinds this year, including a slowing economy, declining job growth and competition from failed condominium projects (shadow space)--all of which will make rental rate and occupancy gains difficult.

Analysts at FBR Inc. said that while UDR has been successful in boosting the portfolio's internal growth prospects, on a short-term basis, the firm will likely run into some problems in some of its top markets. "Orange County, Washington, DC and Tampa and Orlando, FL remain in the cross-hairs of the housing slowdown," researchers write. "In light of this exposure, we believe management's outlook for 2008 revenue growth could prove too optimistic at 4% to 4.5% (versus 4.7% in 4Q07). For now, we remain on the sidelines as the potential dilution from the transaction shakes out, and in light of the instability of UDR's RE3 income, which fell well short of guidance in 4Q07."

Observers at Baird also reduced their estimates, taking the 2008 reported FFOPS down 52 cents to $1.45, bringing the core FFOPS to $1.39. The firm's 2009 FFOPS is estimated at $1.55, with core at $1.49. This change in valuation resulted in an unchanged outlook on UDR, which due to the repositioning of its portfolio will no longer trade at a discount to its peers. Baird analysts maintain their $24 price target and reiterate its Neutral/Average Risk rating.

Likewise, Dustin Pizzo of Bank of America repeated its Neutral rating for UDR and lowered estimates for the company. The dilution from the sale, he says, brought 2008 FFOPS to $1.60 from $1.93. While the portfolio's concentration in supply-constrained markets is a positive in the long term, "we believe the stock will have trouble moving appreciably higher near term in the wake of moderating growth, continued for-sale housing woes and little visibility on earnings."

Still, Pizzo remains more bearish on UDR this year. Though the REIT's management expects revenues to slow by just 50 to 75 basis points, the analyst doesn't expect Florida markets to recover until the second half, and slower conditions will strain growth in Metro DC and Southern California as well. Therefore, BofA is forecasting 4.5% average same-store NOI growth in 2008, down from 7.5% in 2007.