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Vornado Ready to Rumble

The REIT intensifies the fight for Equity Office as it eyes becoming the nation's largest office owner.

Updated from 11:25 a.m. EST

Vornado Realty Trust

(VNO) - Get Report

stepped up the stakes in the bidding war for

Equity Office Properties

(EOP)

, increasing its buyout offer above an already bolstered price from Blackstone Group.

If the new bid is accepted, the deal would transform Vornado into the country's largest office real estate investment trust, with a focus on the strong markets of New York City, Washington, D.C, Boston, Northern California and Southern California.

The proposed transaction marks a departure from Vornado's previous strategy of making smaller, off-the radar bets that have produced stellar returns for shareholders in recent years.

"I think the merits are questionable, but this is a management team that has earned a lot of benefit of the doubt," says Michael Knott, an analyst with Green Street Advisors, an independent REIT research shop. "It presents a big bet at a full price."

Vornado, along with partners Starwood Capital and Walton Street Capital, offered $56 a share in cash and stock for Equity Office, plus dividends accrued since Dec. 29. Equity Office currently has a deal in place to be acquired by Blackstone for $54 a share in cash.

Blackstone said Thursday that it will not raise its bid again.

"We do not believe that the true value of Vornado's proposal is anywhere near $56 per share and Blackstone has no intention of increasing its all cash price," Blackstone spokesman John Ford said in a statement.

The Blackstone deal for Equity Office, valued at $38.3 billion, is already set to be the biggest real estate transaction ever.

Equity Office said in a statement that it will evaluate Vornado's proposal in due course.

Vornado said it is in discussions to sell up to $10 billion of Equity Office assets at closing to Starwood Capital and Walton Street Capital, and to sell an additional $10 billion of the company's assets within the first year after closing. Vornado also expects to sell or co-venture other assets of the combined portfolio.

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Vornado didn't specify which properties it will sell, but did say the divestitures will target noncore assets and markets. The company will keep the Equity Office properties in New York City, Boston, Southern California, San Francisco and Washington, D.C.

Starwood and Walton, as opportunity funds looking for turnaround properties, will take the Equity Office assets in secondary markets, such as Indianapolis, and cities in Florida.

One person close to Vornado CEO Steve Roth says he has been talking up the Equity Office purchase as a way to buy properties below the cost of replacing them. The thinking is that the properties could not be built for a cheaper price.

The Vornado offer equates to a cap rate, or initial yield, of 5.3%, according to Green Street, which pegs the offer at fair value for the assets.

Although the idea of buying assets below replacement cost is attractive, it also can be murky. As

Boston Properties

(BXP) - Get Report

CEO Ed Linde mentioned on the REIT's earnings call Wednesday, buyers of office assets who argue they're buying buildings below replacement cost often don't factor in the high level of capital expenditures.

Initial maintenance costs, for example, are higher on older assets than newer ones. As well, if there are below market rents, broker commissions and tenant improvement costs for new tenants can eat away at the projected long-term return of the property.

Vornado likely sees some upside on the leasing front and expense management of the EOP assets. "This is an unquantifiable upside that Vornado brings to the deal," says one real estate source.

Vornado and its partners have secured commitments covering $30.5 billion of debt financing provided by Lehman Brothers, JPMorgan Chase Bank, Barclays Capital, Greenwich Capital and UBS.

"I think it is not very surprising that Vornado came back with the higher bid," says Knott, the Green Street analyst. "I think it is uncertain who will be the winner."

For its part, Blackstone said the true value of Vornado's offer should reflect a discount for stock, plus the three- to four-month time delay before the deal would close and the risk of VNO's share price declining.

"When combined with the risk to EOP shareholders that VNO shareholders could vote the deal down for any reason in 3-4 months, we strongly believe that our binding agreement with EOP is clearly superior and we are proceeding with a Feb. 8 closing, following the Feb. 5 EOP shareholders meeting," Ford, the Blackstone spokesman, said.

Blackstone boosted its buyout offer from $48.50 a share late last month after Vornado swooped in with a $52-a-share bid. The Blackstone deal carries with it a $500 million termination fee.

Vornado's latest offer allows Equity Office to continue paying its regular 33-cent quarterly dividend and includes pro rata dividends to the closing.

Knott calculates that Vornado's stock would need to fall to $105.80 in order for its bid to equal Blackstone's $54-a-share offer. In midday trading Thursday, Vornado shares rose 1.7% to $124.46. Equity Office fell 1% to $54.98.