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AvalonBay Communities, Inc. (NYSE:AVB)

Q3 2008 Earnings Call Transcript

November 6, 2008, 10:00 am ET

Executives

John Christie – Senior Director, IR and Research

Bryce Blair – Chairman and CEO

Tom Sargeant – CFO

Tim Naughton – President

Leo Horey – EVP, Operations

Analysts

Steve [ph] – BB&T Capital Markets

Dustin Pizzo – Banc of America Securities

David Toti – Citigroup

Sameer Upadhyay – FBR Capital Markets

Karin Ford – KeyBanc Capital Markets

Jay Habermann – Goldman Sachs

Mark Biffert – Oppenheimer & Co.

Michelle Ko – -UBS

Michael Salinsky – RBC Capital Markets

Rich Anderson – BMO Capital Markets

Paula Poskon – Robert W. Baird & Co.

Alexander Goldfarb [ph] – The Goldfarb Family [ph]

Operator

Good morning, ladies and gentlemen, and welcome to the AvalonBay Communities third quarter 2008 earnings conference call. At this time all participants are in a listen-only mode. Following remarks by the company, we will conduct the question-and-answer session. (Operator instructions) As a remainder, this conference call is being recorded. I would now like to introduce your host for today’s conference, Mr. John Christie, Director of Investor Relations and Research. Mr. Christie, you may begin your conference.

John Christie

Thank you, Amanda, and welcome to AvalonBay Communities third quarter 2008 earnings conference call. Before we begin, please note that forward-looking statements may be made during this discussion. There are a variety of risks and uncertainties associated with forward-looking statements and actual results may differ materially.

There is a discussion of these risks and uncertainties in last evening’s press release as well as in the company’s Form 10-K and Form 10-Q filed with the SEC. As usual, the press release does include an attachment with definitions and reconciliations of non-GAAP financial measures and other terms, which may be used in today’s discussion. The attachment is available on our website at www.avalonbay.com/earnings, and we encourage you to refer to this information during your review of our operating results and financial performance.

Normally our calls run about an hour, but we are going to do a hard stop at 11:30 this morning to allow you access to other calls scheduled to begin at that time. Because of that, management comments will be a little shorter today in order to provide more time for your questions.

And with that, I’ll turn the call over to Bryce Blair, Chairman and CEO. Bryce?

Bryce Blair

Thanks, John. And with me on the call today are Tim Naughton, our President; Leo Horey, our EVP of Operations; and Tom Sargeant, our Chief Financial Officer. Tom and I will have some initial prepared remarks and then all four of us will be available to answer any questions you may have.

By way of overview, I think it’s fair to say that the weakness in the capital markets and in the economy are impacting how we and others are approaching both current and future actions. In this operating environment, we are being very cautious regarding new investment commitments and are being very focused on maintaining on a strong liquidity position.

Over the longer term, I believe the current events are setting the stage for an improved competitive position for AvalonBay in an environment with fewer competitors, with less supply, and with stronger apartment fundamentals.

I will comment further on these issues, but I first want to review with you our quarterly performance.

Last evening, we reported EPS of $2.98 and FFO per share of $1.28. The growth in EPS represents an increase of approximately 90% from the same period last year, and this driven largely from gains from our disposition activity during the quarter. The FFO per share of $1.28 represents a year-over-year increase of approximately 7.5%.

Our same-store portfolio performed in line with expectations and the portfolio remains well positioned with solid occupancy averaging over 96% for the quarter.

In terms of regional performance, Northern California and Seattle showed the strongest performance. Although similar to our overall portfolio the rate of revenue growth, as expected, continued to moderate from prior quarters.

I’d like to now touch on three of the key factors affecting our business, the three being the economy, home ownership trends, and the supply of new products. I’ll then highlight key actions that we have or are taking to respond to the current and expected operating environment.

Now first, in terms of the economy, it is weak and is expected to get weaker next year. So far this year the nation as a whole has been losing jobs at a rate of almost 100,000 jobs per month and forecast project the number of job losses to accelerate to roughly twice that amount in the coming months.

For AvalonBay, our strongest markets in terms of job growth this year have been Seattle, DC, and Boston, while our weakest market has been Southern California. So far, New York has held steady, but it is a market that is expected to lose a fair amount of jobs as a result of the ongoing layoffs in the financial services industry.

In terms of home ownership rate the trend continues to be favorable. Nationally, the home ownership rate for the third quarter continued its trend downward since its peak two years ago. This shift has resulted in approximately 800,000 additional renter households nationwide, about half of which are apartment renters. This decline has certainly helped apartment demand partially offsetting the effects of the weak economy.

Within our markets, the level of home ownership is consistently less than the nation as a whole, primarily due to the high cost of housing, but also the more urban nature of many of our markets.

For the third quarter, the home ownership rate for our markets dropped to 59.6% from a peak of over 61% two years ago. Now we can see the benefit of this weak housing market in our own data as the percent of move-outs due to home purchases dropped to below 20%, the lowest level in almost six years.

Finally, in terms of supply, multifamily permit activity continues to decline. Three months data through September showed the pace of multifamily permits down 22% on a year-over-year basis. Given the weakening economy and extraordinarily difficult financing environment, many expect the level of permits and starts to fall further through the balance of ’08 and into ’09.

Over the last nine months, the U.S. has experienced a period of unprecedented volatility in the capital markets and a continued deterioration in the economy. Despite these events we expect to end the year very much in line with our original outlook for revenue and FFO growth.

Last January, we gave an outlook range for revenue with the mid-point in the low 3% range. That’s still our expectation today. Last January, we gave an outlook range for FFO with a mid-point of $5.05 per share. That’s still our expectation today.

So, we’ve been able to meet our original outlook despite greater-than-expected declines in the economy and a virtual shutdown in the capital markets. The timing and magnitude of these events, however, does cause us to be increasingly cautious regarding our outlook for ’09.

We expect apartment fundamentals to deteriorate primarily because of fall off in demand. We expect supply to be held in check by constrained capital, but with job losses accelerating, demand nationally for virtually all products, including apartments, will be affected.

So, given this assessment, I want to highlight four key actions that we’ve taken this year, many of which we began very much at the beginning of the year in taking these actions in order to respond to the changing environment and to position us for continued out-performance in the future. And I’ll touch on four of them.

First, the slowing of our development expenditures. We have a large and valuable development pipeline for which we have considerable flexibility regarding the pace of our expenditures. Given the weakness in the economy and the capital markets, we have significantly reduced our level of 2008 starts. Originally, our financial outlook for the year called for approximately $1 billion of starts. We now expect to begin only about half of that amount.

This slowdown in the pace of our development activity was evident this past quarter as we completed seven communities totaling $450 million and began only two communities totaling $240 million, thus reducing our total level of development activity by approximately $200 million.

The second activity is we’ve been on hold regarding our acquisitions. Given our concerns regarding capital availability and cost as well as our concern regarding the recent cap rate environment, we decided to take a wait-and-see attitude regarding acquisitions. So far this year we have not purchases any new communities.

However, we have closed on our second investment management fund and are well positioned to capitalize on attractive opportunities that we expect to surface over the next few years.

Third, we have been aggressive with our sales activity. So far this year we have sold $600 million of assets, including $350 million just this quarter. As the year progress, cap rates are moving up and the general sales environment got much more difficult. The fact that we are able to get this volume of sales done at a weighted average cap rate of approximately 5.1% is a reflection on the quality of our assets that continue track (inaudible) of our markets and the fact that we got started early in the year.

The fourth action has been to be aggressive in building liquidity. We’ve been very proactive in sourcing a variety of capital to meet both our current and future liquidity needs. So far this year we’ve sourced $1.8 billion of capital through a variety of debt sources as well as from our disposition activity. Tom will provide some further details on our capital markets activity during his comments.

I believe each of these four actions reflects an appropriate response to the current difficult operating environment while not hampering our ability to act on future opportunities. A few examples. We are deferring many development deals, we are not shutting down our development program. We’ve held off on current acquisitions, but have raised a second fund for future opportunities. And we’ve raised a significant amount of capital to fund our investment needs and to ensure our balance sheet remained one of the strongest in this sector.

With that, I will turn the call over to Tom, who will provide some additional comments on our capital markets activity.

Tom Sargeant

Thanks, Bryce. My comments this morning focuses on our financing activities for the year, a review of our liquidity, and a discussion of the dividend. We’ve accomplished a lot during the year to build liquidity and to avoid market volatility, arranging about $1.8 billion in new capital.

About $1 billion of this year capital is debt, another $500 million is from asset sales and about $185 million is from is for our new investment management fund. Included in these numbers is a tax-exempt financing for $135 million, which is attractively priced capital, and a source of funding for future development. We used this liquidity to redeem higher cost debt and preferred stock totaling $360 million and to pay down our line and to fund development.

Bryce noted the steps we’ve taken to conserve liquidity through reduced development activity and we have a very clear vision of our capital needs and how these needs to be met, and I’d like to quickly go through this with you.

Using construction started as of September 30th, we would have $500 million of available capital at the end of 2009, after meeting our remaining 2008 commitments and all of our current 2009 commitments. And here is a quick recap of sources and uses.

First, our available committed liquidity is about $1.6 billion, which is comprised of the line, our cash on hand, our retained cash flow, sales that are already committed and have – and with contracts that are hard, and committed new debt. We will use about $1.1 billion of this construction underway, debt and preferred redemptions, and the preferred redemption already occurred, and the special dividend that we mentioned last night in our press release.

For 2010, debt maturities and remaining construction activity is fairly modest and we can meet these needs with the $500 million that would be available at the end of 2009. While we are comfortable with our capital outlook today, we continue to actively source additional cost-effective capital. For example, we are engaged today with Fannie and Freddie to put a secured credit facility in place, size up between $300 million and $500 million. We are also considering joint ventures and tax-exempt bond financing for qualifying development rates.

Our balance sheet supports the 2008 activity and our outlook. Today, debt comprises just 38% of our total market cap. Our fixed charge coverage is strong at our current ratings level. NOI from unencumbered assets is high and in fact we have 107 assets that are not encumbered with debt at all and we estimate we could raise well over $2 billion from these secured debt before we hit any of our debt covenant limits.

Finally, the dividend. Quality and the durability of our dividend is supported by the quality of our balance sheet and reported earnings such that we’ve always covered our dividend from recurring cash flow. We have the best dividend coverage in this sector and one of the best in the industry with an FFO payout ratio in the third quarter of about 69%.

The success of our disposition program does put upward pressure on our dividend policy and we noted in our earnings release the likely need for a special dividend of somewhere between $1.75 and $1.85 per share to meet minimum distribution requirements. If this dividend is approved by our Board, the distribution would occur sometime before September 15th, 2009. And our liquidity analysis provides for this dividend.

To summarize, we’ve arranged $1.8 [ph] billion of liquidity during 2008, redeeming higher cost debt and preferred stock, paying down our credit facility, recycling capital into a reduced volume of development. Lower development activity and identified liquidity sources prepare us for current economic conditions and for a prolonged absence of capital. The success of our investment activity benefits shareholders as we return additional capital through the special dividend.

And finally, our balance sheet is well positioned to help insulate the company from capital market and real estate market volatility.

That concludes my comments. And Bryce, I turn the call back to you.

Bryce Blair

Well, thanks, Tom. So, given the current outlook, 2009 looks to be a challenging year for the economy and therefore a period of decreasing fundamentals for apartments. We also expect the current capital constraints to continue for some time. I believe the actions we have and are taking to reduce investment activity and to maintain a strong balance sheet are the appropriate actions both for the weaker expected fundamentals – the weaker expected operating environment in ’09, but also to ensure that we are well positioned to take advantage of opportunities as the cycle turns.

Now, with that, operator, we’ll be glad to take any questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Your first question is from Craig Kucera with BB&T Capital Markets.

Steve – BB&T Capital Markets

Yes, hi, good morning. It’s Steve [ph] on for Craig. Can you give us a sense of the depth and composition of the buyers that are purchasing your assets?

Tim Naughton

Steve, it’s Tim Naughton here. The market is not anywhere as deep as it’s been over the past few years. The – typical, going back to 2007-2006 we’d often get 10 to 20 bids on an asset when we took it to market. What’s more common today is more in the area of three to maybe on the high end eight or nine. So, the depth is – it’s quite a bit shallower than it’s been in the past. In terms of buyer profile, it’s typically been mostly funds and local players for the most part. It’s not been institutions. May be a smattering of REITS, but frankly they kind of disappeared the marketplace over the last 45, 60 days, I’d say

Steve – BB&T Capital Markets

Thanks. And then one other question, kind of operationally speaking, what markets are you seeing the highest level of concessions that you are having to offer or you are just seeing kind of market wide? What level of discretion are you giving your property managers to offer concessions and/or lower rents?

Leo Horey

Steve, this is Leo. For the quarter, our concessions per move-in over the whole portfolio stayed stable at about one week’s rent or about $500. The markets that we are offering the deepest concessions in are Orange County, where it’s running just over one month’s rent; Baltimore, where again it’s just over one month’s rent; and central New Jersey, which is just above about a half a month’s rent. So those are the markets where concessions are the most prevalent. One thing I would like to point out, Steve, is we really look at effective rents. Concessions are often used as a marketing tactic as much they are used for any other purpose.

And then with respect to the discretion that community managers have, the community managers don’t have any discretion. The pricing is handled by the offsite executives that are in those local markets. Clearly, they work in conjunction with the community managers and community managers make recommendations. But the executives that aren’t on the properties are setting those rents. They report up to VPs and they have discretion to move the rents as necessary. When they are doing that they are looking at things like what our traffic level’s been, what have our conversion ratio’s been, et cetera. And what we watch carefully is that our conversion ratios remain in the upper 20% to lower 30% range, which tells us that we have the rent set properly to attract and secure new leases.

Steve – BB&T Capital Markets

Okay. Thanks.

Operator

The next question is from Dustin Pizzo with Banc of America Securities.

Dustin Pizzo – Banc of America Securities

Thanks. Good morning, guys. Bryce, can you just talk on the development yields I mean how much of the decline there is due to the change in mix in the pipeline I mean new projects coming in and the ones that were completed versus the decline in rental rates? And also, I mean I guess where – I know it’s tough in this environment, but where do you see those yields ultimately kind of stabilize and potentially bottoming out.

Bryce Blair

Hi Dustin, (inaudible) Tim answer that.

Dustin Pizzo – Banc of America Securities

Okay.

Tim Naughton

Dustin, Tim here. The projected yields this quarter for that basket again on an untrended basis just upon current rents in the marketplace is just over 6% – 6.1%. And the change from last quarter is pretty much due entirely to the mix driven largely by the removal of Avalon RiverView North, which was a large deal in New York that had an outsized yield. So, almost entirely driven by that – as you probably noticed from the schedule, in a couple of communities rents went down, in a couple of communities rents went up this past quarter, more or less canceling out one another.

In terms of where they might bottom, I would tell you, I think it depends where the market goes from here as opposed to the prospective mix of development right. Generally, I would say that the group of development rights that we have and development right portfolio will be north of this number, benefiting from reduced construction cost. So I would expect over time that yield will go up as it relates to construction cost. However, that’s for the (inaudible) in place obviously with net operating income and rent levels.

And I guess the last thing I say, Dustin, for the communities that have completed this year, which is just around $900 million the average projected yield again on a current yield basis with the current rents underwritten is right around six-seven so and about 60 basis points north of the current development portfolio that’s under construction.

Dustin Pizzo – Banc of America Securities

Okay. That’s helpful. And then can you also just comment on what you’ve seen in the Metro New York – I know commented on Central Jersey, but what you’ve seen in the sort of Metro New York area recently? I mean the results held up obviously pretty well during the quarter, but given that most of the dislocations occurred after September 30th, I think, everyone’s had a quite a bit of focus on what’s happening there given your exposure.

Leo Horey

Dustin, this is Leo. With respect to the Metro New York area, things continue to hold up. Occupancy has remained fairly stable. I will tell you though in Manhattan it’s become very commonplace to be offering one month concession and it’s now the standard that owners are paying for broker fees. So I wouldn’t want to suggest that things are completely stable. We’ve certainly had some pressure on rents. But we’ve been able to hold occupancy pretty well in the properties and these properties don’t show up in the same-store numbers. But the Manhattan properties and the surrounding burrows, our occupancies are still just slightly north of 97%. We are mindful of the projections for next year, which is that New York is going to lose quite a few more financial services jobs in the order of – the most recent numbers I’ve seen is around 100,000 jobs in ’09.

Bryce, do you have something to add.

Bryce Blair

Well, I’ll just offer the perspective that we’ve mentioned some time or a number of times that of our – in our portfolio it takes a number of quarters before you really see the result of changes in economic conditions really falling through to the property performance. Clearly some early signs you can look at in terms of traffic and conversion and things like that, but in terms of when you look at the revenue performance of the portfolio, by the time someone loses a job to the time that you have a downturn in the rents to the time it flows through we are given roughly 60% turnover. It’s really time that we look – we look out about six months and really start to anticipate that when you really see it flowing through the numbers. But Leo was talking to some of the early indicators, which – it certainly what we are continuing to watch.

Dustin Pizzo – Banc of America Securities

Okay. So, at this point I mean as you guys look out to 2009, I know you are not giving guidance, but I mean are there any markets where you are concerned about growth potentially turning negative? I mean do you think that’s a realistic scenario.

Bryce Blair

This is Bryce. We are not prepared to give guidance either overall or by market for 2009. But the answer to that I think is somewhat similar to the answer Tim gave earlier, it really depends upon how deep the recessionary environment is that clearly the fundamentals have continued to deteriorate in 2008 and it’s likely to accelerate at a greater degree into 2009, but the depth of which we’ll be able to comment more on our fourth quarter call.

Dustin Pizzo – Banc of America Securities

Okay. Thanks guys.

Operator

The next question is from Michael Bilerman, Citigroup.

David Toti – Citigroup

Good morning guys. This is David Toti here with Michael. Just a couple of questions around development. Can you talk about what’s going in your shadow pipeline, is there a similar pull back – has been reflected in the construction starts and is there any danger of write-offs coming out of that?

Tim Naughton

David, Tim Naughton here. In terms of the development right pipeline, for the most part we’ve been fairly selective over the last year or so. I think we had talked about since the beginning of the year we had anticipated we’d start to see – we thought better opportunities in the latter half of the year. We are seeing a lot deal – very little bit still makes sense. What we have seen some correction in land values, I’d say we are still in the early adjustment phase. So I would expect that except for a couple of markets like a Boston where we think the fundamentals are a little bit better and the opportunities a little bit more attractive than the average market, we are going to continue to be pretty cautious with respect to bringing new deals on only because we think land markets still have a way to adjust.

I think you’d asked something about prospective – about the potential for write-offs. I guess I’d say we are always assessing the development right portfolio. We wrote off one deal this past quarter. I think in Q2 we actually wrote off four. That’s just the normal course or business and we’ll continue to be diligent with respect to investing any new (inaudible) cost capital and any of the development rights relative to what we believe the opportunity is.

David Toti – Citigroup

Great. And then I am just moving over to rents. Are you seeing any difference in activity relative – and this includes concessions and pricing – relative to your sort of higher price point product versus the more price points?

Leo Horey

David, this is Leo. I would tell you that typically when we go in to a downturn the lower price point product does perform better. I can give you any specific examples at this time, but overall that’s typically what happens when you head into the early part of a downturn and then it equalizes as you get further into the downturn.

David Toti – Citigroup

Okay. And then just lastly, I am not sure, I might have missed this, but did you talk about the expected dispositions that your special dividend is based upon? In other words, how you are going to stack up against your targets for the remainder of the year relative to the $700 million to $1 billion projection of dispositions?

Tim Naughton

David, Tim Naughton again. The dispositions on the order of $650 million, which is down a couple of 100 million from the guidance that we’ve given at the beginning of the year.

David Toti – Citigroup

Great. Thank you.

Tim Naughton

Yes.

Operator

The next question is from Sameer Upadhyay from FBR Capital Markets.

Sameer Upadhyay – FBR Capital Markets

Are you seeing any sort of trends in people sort of trading down the smaller units doubling up in light of the difficult economic times?

Leo Horey

Hi, Sameer, this is Leo. With respect to doubling up, we’ve heard – I’ve heard some anecdotal stories from properties. It is something that I am watching pretty carefully. What I mean by that I am watching reasons for move-outs to see if people are moving within our communities are even going to other communities. I haven’t seen any evidence to that. Further, I have also been watching what our occupancy looks like between our studios, ones, two, and threes. And there is no evidence that our larger apartments are more occupied. In fact, our larger apartments, the twos and threes are slightly less occupied than our studios and ones. So while I have heard anecdotally from properties that in certain markets there is some doubling up, to give you specific evidence of that it’s just not coming through the numbers.

Sameer Upadhyay – FBR Capital Markets

Okay. And what about the DC market, it looks like there was a bit of a deceleration and I know that DC is sort of one of the markets that people are kind of positive towards. So can you provide some color into that?

Leo Horey

Sure David [ph]. With respect to DC, first thing I need to do is dis-aggregate that number, because that includes the Baltimore market as well as DC. If you take out Baltimore, DC was actually up 2.3% for the quarter so not as much of a deceleration. Now lets’ talk specifically about DC. There still is quite a bit of product coming through. It’s coming through in sub-urban Maryland, it’s coming through in Northern Virginia. And as long as we continue to have job growth, that market will continue to be healthy, but the real issue with DC is getting all the supply absorbed.

Sameer Upadhyay – FBR Capital Markets

Okay. And LA turned negative. It’s –what’s – what happened there?

Leo Horey

LA is just a difficult market where there is job loss and there is some supply coming through and my expectations are it could more difficult, so the projections for next year is for further job losses.

Sameer Upadhyay – FBR Capital Markets

Okay. Thank you.

Operator

The next question is from Karin Ford with KeyBanc Capital.

Karin Ford – KeyBanc Capital Markets

Good morning. I wanted to ask on the two new development starts this quarter what your return expectations are in those two and how do you view the risk weighted returns on capital allocation to those versus equity, debt, acquisitions?

Tim Naughton

Karin, Tim Naughton here. First we don’t disclose projected yields on individual deals or one or two collectively, but I think I mentioned in my earlier remarks that the yields on unlevered [ph] deals you are going to expect to generally be higher than the average basket today just based – largely based upon some construction cost relief that we are seeing in the markets. In terms of how we look at development relative to further opportunities, it’s something – it’s a pretty dynamic process right now just given the swiftness of movement in the capital markets for something we ask ourselves all the time the – and look at all the time. We are seeing – you are weighing movements in the real estate markets against movements in the capital markets. We are starting to see, as I mentioned before, some relief on the construction cost and in laying cost, but it’s not enough yet to frankly beat – meet our target yields or watch you are moving into the mid-sevens and higher. We are maybe a third of the way there with respect to land and construction cost adjustment today. And a decision to start a deal is a function of a number or things, it’s function of the relative health of the market. Frankly, whether – in our view continue to create NAV and then lastly to your point just the alternatives for capital whether it’s repurchase debt or otherwise – Tom, you want to comment on that a little bit further

Tom Sargeant

Well, I think and the only thing I’d add – and Karin, it’s a great question, Bryce has already outlined a lot of the steps we’ve taken to reallocate capital away from new development. We are still developing, but we’ve reduced our development activity and we’ve allocated that capital towards redeeming debt. We’ve redeemed the preferred in October, and earlier in the year we even bought back common stock. So, certainly their balance sheet – so many ways to reallocate this capital balancing our liquidity needs with secured debt, unsecured debt, leverage considerations, fixed charge considerations. Our goal is always to allocate capital to achieve the highest risk adjusted returns, but we have a lot of stakeholders and our goal is to achieve the highest risk adjusted return as we balance the needs of the various stakeholders.

Karin Ford – KeyBanc Capital Markets

Helpful. Another question related to development, you said in your comments that you were not shutting down the pipeline. Have you guys taken a look at what the impact would be on earnings if you were to shutdown all the – all future at least prospective new starts and what carrying cost would be, what the overhead impact would be? Do you guys – have you guys ever estimated that?

Bryce Blair

Karin, it’s Bryce. I mean it’s a relatively simple – I mean we know what our – our capitalized overhead would be, so I mean it’s – what you are asking is I think a pretty theoretical question. I do not see a scenario of us eliminating all the development and eliminating the whole development group. But if you did that, now you would eliminate all the capitalized overhead associated with it. What we have been doing is the same thing we did in 2002, in 2003 and that is to try to make prudent steps that deal with both the current situation but do not undermine the going concern ability for AvalonBay to create value throughout all elements of the business cycle. And if we had overreacted in 2002 – in ’02, in ’03, we wouldn’t have enjoyed the terrific value creation that we saw in ’05, in ’06, and into ’07. And I think the same is true today. While this cycle is different than ’02 and ’03, it doesn’t necessarily make it better or worse it’s different, but the actions we are taking are similar in that we are allocating capital to the deals that are the most attractive for reducing the levels of development activity and consequently will be reducing the levels of overhead associated with it. But it’s a matter of degree. It’s not an on or off switch. Acquisitions can be very much an on or off switch, development is not. Not if you expect to be able to be able to create value as the cycle turns.

Karin Ford – KeyBanc Capital Markets

Thanks. Last question, Tom, can you just talk about the $9 million potential excise tax payment that may be due?

Tom Sargeant

Yes, Karin, let me – yes, let me take a step back first and review briefly what we are required to do as a REIT. We re required to distribute 90% of the taxable income, but to avoid any tax, on an ordinary income basis, you have distribute 100%. There are elections available for us to use future distributions to cover prior year taxable income and we’ve used those. There is also a very little know test – cumulative test that requires all taxable income to be distributed to avoid an excise tax. The success of our investment disposition programs have – and especially given this year’s heavy disposition volume, has created a situation where our cumulative income exceeds our cumulative distributions unless a special dividend is declared. We are reviewing the timing but depending on the declaration day we may incur this excise tax, which is equal to 4% of the excess earnings over amounts distributed. I guess I’d say that we haven’t really been stingy with our dividend increase as we’ve increased our dividend 80% over the last 10 years compared to about 30% for the multifamily sector average. The compound annual growth rate of our dividend is about twice that of the multifamily sector. So we haven’t been stingy on the dividends. We’ve just been very successful in our investment activity and we view this excise tax, if it’s incurred, as a part of our successful investment program. Some could argue that it’s part of the disposition program and therefore should be netted against gain on sales. I can see how that argument has merit, but it’s not exactly the cleanest way to treat it. So we would treat it, if it’s paid, as an extension of reduction in FFO.

Karin Ford – KeyBanc Capital Markets

And that would hit in – potentially in fourth quarter?

Tom Sargeant

It would hit – if it were incurred it would probably be accrued in the fourth quarter.

Karin Ford – KeyBanc Capital Markets

Okay. And would you consider paying any of the special dividend in stock?

Tom Sargeant

We would consider that. It depends on the stock price, it depends on our available liquidity. We have liquidity available to pay the special dividend an that’s included in our liquidity analysis I’ve provided in my opening remarks.

Karin Ford – KeyBanc Capital Markets

Okay. Thank you.

Operator

The next question is from Jay Habermann with Goldman Sachs.

Jay Habermann – Goldman Sachs

Hi, good morning. Looking to ’09 and just trying to get a sense of the development pipeline I guess as it would stand toward the end of that year, can you give us a sense of your expected spend say for instance what will be delivered? I mean would you expect the pipeline to decline in terms of normal value?

Bryce Blair

Jay, this is Bryce. What Tom talked about was the level of development expenditures through 2009 for everything that is under construction today. We have not yet commented on and are not prepared guidance on the volume of development starts for 2009.

Jay Habermann – Goldman Sachs

Okay. Fair enough, but would you look to – therefore would you think you’d keep anything close to the existing level? You talked about $500 million this year?

Bryce Blair

It’s to be decided, cut certainly we’re going to continue, as I said in my opening comments, be cautious in terms of the new starts. I mean there will be – the best ones will get through the pipeline and start and the other ones will be dropped or delayed.

Jay Habermann – Goldman Sachs

Okay. And then for the assets delivered in the most recent quarter, the roughly $450 million, is that yield on those roughly at 4.5%? I realize they are obviously in lease-up, but is that fair enough in terms of the range?

Bryce Blair

I am sorry, you said 4.5%–

Jay Habermann – Goldman Sachs

Yes, for the assets that were delivered in the most recent quarter I mean can you give us a sense of what the return is for those assets as they stand?

Bryce Blair

It was consistent with the rest of the bucket on a stabilized basis. Are you asking what the current return is based on—?

Jay Habermann – Goldman Sachs

Current return, yes, just based on the 75%, roughly, sort of occupancy level, economic occupancy?

Bryce Blair

Yes, I can't tell you that off the top of my head, I am sorry.

Jay Habermann – Goldman Sachs

Okay. And then in terms of the question on NOI growth, the – in terms of expecting it to get negative in the near term, if roughly half of your markets are now about flat, and you think unemployment moves up to 8% perhaps by year-end, next year, you would probably have to see some portion of your markets go negative, is that fair?

Tom Sargeant

We are jut not prepared to comment on it, Jay, I mean we are – you are hypothesizing into 2009 and as we’ve said it’s been our practice for the last umpteen years to get into the guidance on the fourth quarter call.

Jay Habermann – Goldman Sachs

Okay. And then I had a question on Fund II. It sounds like it has exclusive acquisition rights and I am just wondering why you would put the REIT in a position to perhaps not benefit if cap rates move up materially, say to 7-8% over the next two years. I mean is that – am I misinterpreting that?

Tom Sargeant

Yes, I think you are, Jay. We – one, this is the same provision that we gave in the first fund and we haven’t taken ourselves out of play. We are a big investor in that fund. So we balance the attractive source of capital with our ability to invest that capital and create value and we took a big stake in Fund II, so I think we participate pretty well. We just – we are taking a measured bet or a measure risk, but I think it’s consistent with the risk that we’ve taken in our other investment management programs.

Jay Habermann – Goldman Sachs

Okay. And then lastly, can you just give us an update on Freddie and Fannie, I know you talked about the loan that you are looking to secure, the $300 million to $500 million but where is pricing today and where do you think pricing will ultimately be when you secure that loan?

Tom Sargeant

Well, pricing today – we’ve actually locked in on another $115 million that will fund in the fourth quarter and that was priced at around 6.05 roughly. So – and that’s a seven-year term so you can do the interpolation. That’s basically where our debt pricing on a secured basis is. It’s interesting to know that we did a debt deal this time last year and it was almost exactly the same price. So, in terms of secured debt, certainly the USD level was higher then, it’s lower now. But overall the pricing level we are achieving now on secured debt from Fannie and Freddie is the same as we achieved this time last year.

Jay Habermann – Goldman Sachs

Okay. Great. Thank you very much.

Operator

The next question is from (inaudible) with Credit Suisse.

Unidentified Analyst

Good morning. Two questions, first one, what was the worst NOI declines in some of your markets in the last recession? And number two, what cap rates and LTVs were you getting in your most recent mortgage financing?

Bryce Blair

Tom, why don’t you take the second one first and then—

Tom Sargeant

Yes the – on the $115 million that we just locked, the loan to value was 65%. The debt service coverage was 1.2 and—

Unidentified Analyst

What was the cap rate?

Tom Sargeant

Cap rate? Cap rate for the debt, we really don’t look at it that way, we look at the – the interest rate was 6.05, but we didn’t sell these assets. We are just financing them. So–

Unidentified Analyst

Right, what I mean is the loan to value is 65%, but there was this cap rate that was used to capitalize NOI get through the value–

Tom Sargeant

Yes, I am sorry, I don’t have that off the top of my head.

Bryce Blair

In terms of – this is Bryce – in terms of your first question, NOI for our portfolio the low point was the third quarter of 2002 where we were just into the double digit territory for NOI declines. One of the things I alluded to earlier is that this decline is – that we are experiencing today while not – while still painful is far different than what we saw in 2002, in 2003, and in at least two notable cases. One is that the economic downturn, the job losses in that environment ’02 and ’03 where really the epicenter was technology based companies particularly Northern California in which we had a significantly – significant portfolio. But also markets such as Boston as well that were dependent upon high tech, and Seattle.

The second factor that was happening in that time period was the housing market was quite strong. So we were not only seeing job losses but we were also seeing renters become home owners. This time around the economic downturn the job losses are much more widespread and are non-technology based primarily of financial services base. And secondly the housing market is weak and we are actually gaining share, not losing share. So, I think there is reasons to believe that this will not be a reoccurrence of ’02 and ’03, but as I said earlier, really will depend upon just the depth of the job losses.

Unidentified Analyst

Okay. In your current markets, which markets are you seeing the most competition from shadow supply, from home owners renting?

Bryce Blair

John?

John Christie

Just to give you some background, in general, we don’t run into a lot of people that are renting homes, in other words, not typically choosing between us and renting a home. They go – really they are going to chose professionally managed or they are going to the papers. But there are some markets, and I would point to markets like Chicago, Central New Jersey, and Connecticut, where we might see some more home rental and where it may impact. And it’s typically where we have some larger apartment homes as well, but that’s not – the shadow market is not our greatest competitor. Our greatest competitor is when some of the condominiums that were being built are switched to rental and are run as rental properties.

Unidentified Analyst

Okay. Thank you very much.

Bryce Blair

And if I can interrupt before the next question, we – as John mentioned, we will do hard stop at 11:30 Eastern Time. And we have a number of people in the queue, so if your questions are limited to one or two, and just minimize the follow-up question in fairness to others, we’d appreciate it.

Operator

The next question is from Mark Biffert with Oppenheimer and Company.

Mark Biffert – Oppenheimer & Co.

Hi guys. Tim, maybe for you first. When you looked at the starts that you did during the quarter in Norwalk, in Walnut Creek, I mean what do you guys use in terms of an assessment of going into a market and doing a start, when you look at job growth and being able to achieve the rents that you expect to get on the properties?

Tim Naughton

Well, Mark, we look at everything. We look at the underlying fundamentals of the marketplace. I think we’ve mentioned the Northern California I feel like it’s got a little bit (inaudible) than the average market. So in the instance of Pleasant Hill, we think that’s still an attractive market particularly at a BART station location like the Walnut Creek area. Certainly look at the underlying economics of the deal. The direction of NOI in the marketplace, our view in terms of the construction cost trends in the marketplace. For example, if we thought construction cost were going to correct by 20% in the case of marketplace we might decide to defer that and to wait so there is a number of factors that go into it in terms of the specific marketplace both on the – both the factors that affect NOI as well as capital cost.

Mark Biffert – Oppenheimer & Co.

Okay. And then, Tom, on the fund that you guys did, part of it you took a much larger ownership stake in the fund. Was that partly due just for the partners? You didn’t attract as much capital as you thought or you just wanted a larger stake in it?

And then also when you look at acquisitions, are you looking to look to buy more distressed type acquisitions and – in your targeted markets or what’s your focus for the fund?

Tom Sargeant

Let me take that first part of that question and then I will turn it to Tim, but the – I think one of the good news is we got a fund raised this year and that was no small feat. And we are very pleased that we were able to arrange that especially given the opportunities that we think can emerge over the next several years. We were not able to attract as much capital as we targeted and ended up stepping up to the plate and contributing more to the fund than we as a percentage than we originally thought we would. So, yes, it was a difficult market environment. Good news is we got it done. And frankly, we are happy to put more capital in because we think there is a great set of opportunities that will come out of all this over the next several years.

Tim, in terms of acquisitions?

Tim Naughton

Yes, Mark, on the acquisition side, the reality is we are not very active right now. As Bryce had mentioned we hadn’t bought anything in 2008 yet despite having closing the fund. Yes, to the extent we are underwriting or looking at deals that tend to be distressed type situations, generally where there is an upcoming maturity event and you are having a conversation with the lenders as much you are the sponsor of the deal.

Mark Biffert – Oppenheimer & Co.

Okay. Thanks guys,.

Operator

The next question is from Michelle Ko with UBS.

Michelle Ko – UBS

Yes, I was wondering given your success with asset sales this year, do you plan some more assets to – in ’09 and can you give us a sense of how much more or less than this year?

Bryce Blair

Michelle, that is something we’ll provide in our ’09 guidance. Clearly, the disposition market, as I mentioned, is very fragile today, and Tim commented on that, but as – it will really depend upon the strength of the markets and the ability for us to execute it at what we think would be fair pricing. But we will comment on that on our fourth quarter call.

Michelle Ko – UBS

Okay. And also can you give us a sense of how cap rates have moved over the last three months between the A&B assets and – it was impressive that you sold to five communities in 3Q at a 5.1 cap rate. But have things changed since then and what do you think is a realistic cap rate to assume for 4Q?

Tim Naughton

Michelle, Tim Naughton here. In terms of the deals that we sold, frankly most – those were all priced really before Labor Day. So you are looking at 60 days ago. And I would tell you cap rates have moved probably on average between – in my view cap rates have moved on average between 50 to 100 basis points in the market. Maybe on average 75 basis points across our markets, but really since Labor Day there has been very little activity and it’s – resembling what’s going on in the rest of the capital market. You know that it’s mostly anecdotal. There just really hasn’t been assets clearing the market at this – in the last 45 days or so. But may be before that point I’d say we’ve seen a rise around 75 basis points on average across portfolios sort of from peak to trough – I mean peak to current deal.

Michelle Ko – UBS

Okay, great, thank you.

Operator

The next question is from Michael Salinsky with RBC Capital.

Michael Salinsky – RBC Capital Markets

Tom or Tim, can you talk to the hurdle rate or target IRR on the new fund? And also on new development project where are the hurdles rates you guys looking at right now?

Tom Sargeant

Yes, this is Tom. In terms of the hurdle rate on the new fund, we don’t have a hard requirement. We did target certain returns and that probably today is higher than when we originally raised the fund. But I would say somewhere in the 12% to14% range.

Michael Salinsky – RBC Capital Markets

Okay. And for new developments?

Tim Naughton

For new development, I think I mentioned this earlier, on a cash-on-cash basis, Johnny looking for something, in the mid-seven, which would translate into unlevered IRR should be north of 10.

Michael Salinsky – RBC Capital Markets

Okay. Then finally, looking at development starts, I know you are not giving guidance, but as you think out to second half of 2010, 2011, 2012, it looks like a better – looks like a better operating environment for multifamily. When would you expect to begin ramping back up the development pipeline?

Bryce Blair

Let me take the first part of that and Tim may jump in because we definitely – I think the point you made is a good one and one that I tried to make in my comments as well is that we can all get very focused on the lay-offs today. We can all get very focused on the capital markets today, but we are a going concern and we look forward in terms of an environment where supply will be less. I mean the amount of the – the amount of new developments that will be started in ’09 will be pittance of what people expected. Private companies are virtually unable get anything started. Many of them have shut down their development operations totally. So you have a situation a few years out where you are going to have a real reduction in the supply. We continue to have the benefits of positive home ownership and we’ve been talking about that – I’ve been talking about that for a couple of years now. And I think it’s real and it’s showing up in our numbers, which I commented on earlier.

The – and finally, certainly, you would expect that the economy will turnaround, they do. Economies have cycles to them and so as we think about development deals that we would begin even deals we begin in ’09 wouldn’t be stabilizing for a three-year period. Basically you have a couple of year construction period and then the stabilization period. So that’s why we are trying to be prudent in terms of staying in the game albeit do it in a prudent way by reducing our level of expenditures.

In terms of how much we start in 2009 will be a function of the economy, also a function, as Tim has alluded to, our construction cost. We are seeing considerable savings right now in construction cost and we think that will only get better into 2009 as a subcontracting community and the material cost internationally as well as nationally we start to see some relief. And one of the things that we’ve said before is you only build it once, you lease t every year. So the timing of when we start deals, we are extraordinarily thoughtful about in the sense of trying to lock in at an advantageous cost basis, even if the market seems weak today because we are building into a future period. So that’s – there is a lot judgment involved there, but it’s not just a function of what the job environment is today.

Michael Salinsky – RBC Capital Markets

Okay. Thank you.

Operator

The next question is from Rich Anderson with BMO Capital Markets.

Rich Anderson – BMO Capital Markets

Good morning. With regard to the fund to 45% AvalonBay equity, could that be reduced in the future if you go out and seek other investors or are you locked in at 45, for now, forever?

Tom Sargeant

No, we could be reduced if other investors come in, but we really aren’t allowed to really talk about additional capital coming into that because of SEC rules. But, yes, it could come down over time.

Rich Anderson – BMO Capital Markets

Okay. And second quick question I guess this is for Leo, I mean you guys mentioned you are on look out for things in New York City Metro area and the rest and sort of expecting a deceleration, of course. But can you talk about what you are doing specifically in preparation for that? I mean what steps have you taken in New York to sort of mitigate some of the downside?

Leo Horey

Sure, Rich, this is Leo. I guess there is few things that we do. One is we try to position the portfolio from a high occupancy platform. As you know, it’s in the 96% range. Secondly, we have reduced our corporate apartment home exposure dramatically. Our corporate apartment home exposure during the last downturn probably was in the high-single digits, right now it stands below 3%. So, as businesses contract, and furnished apartment homes are no longer taken, we are not exposed that way. I will tell you also that we’ve reduced our month-to-month leases, so that we have more leases in a turn basis. A year ago our month-to-month leases would have been approximately 5%. Right now it’s in the mid- to upper 3% range. So again we have people in place.

And then lastly, and this is something we started years ago, we just have strict expense controls, because the market is going to give us what the market gives us with respect to revenue to some extent. If there is job contraction and what not, and we can get very mindful and focused on making sure that we keep our expenses under control to deliver as high an NOI as we possibly can.

Rich Anderson – BMO Capital Markets

Great. Thank you very much.

Operator

The next question is from Paula Poskon with Robert W. Baird.

Paula Poskon – Robert W. Baird & Co.

In keeping with the expense discussion, the G&A dollars are up considerably year-over-year and also as a percent of revenue. Can you talk bout what’s driving that and also what you plans you may be considering in terms of reigning that back in particularly relative to some of your competitors that have already announced some (inaudible).

Tom Sargeant

Yes, this is Tom. Most of the – almost all of the increase is due to fund formation cost for the second fund, which we have to run through the G&A line. So that’s the increase for the third quarter. In terms of – our plans for taking it down – we are involved in our budgets, we are kind of in the middle of that now. We are planning for 2009, so we can't really speak to what our current plans are but we are in the budgeting process. And we’ll give you outlook for G&A in January when we announce fourth quarter earnings.

Paula Poskon – Robert W. Baird & Co.

Thank you.

Operator

The next question is from Alexander Goldfarb [ph] with The Goldfarb Family [ph].

Alexander Goldfarb – The Goldfarb Family

Yes, hi, good morning. Just a quick question on – the economy has worsened, are you guys noticing towns becoming more flexible in the approval process or in their willingness to facilitate financing?

Tim Naughton

Alex, Tim Naughton here. In terms of the willingness to facilitate finance, there will probably be more relevant with respect to taxes and bond deals as capacity starts to open up with the volume falling. So we do anticipate – on certain deals where that kind of financing makes sense given the affordable housing requirements that we have on that individual deal that that might make some sense. In terms of ease of the entitlement process, it’s very much linked to cycle. And I would tell you we are probably just at the beginning stage of that where we would expect to see towns and I mean it’s probably not the quite (inaudible) with respect to their conditions, (inaudible) approval may be they have been in the last two to three years.

Alexander Goldfarb – The Goldfarb Family

Okay. And then as far as development this is going back to David Toti’s development question, I believe last cycle you actually abandoned a site where you were already underway. What would have to happen for that to occur this time around.

Bryce Blair

Alex, you are referring to a deal we had in Seattle, which – we stopped construction versus calling it abandoned. We did stop construction. We were very concerned at that time about –this is immediately after 09/11 we were concerned about both the economy but in particularly the Seattle market because of the dependence on aerospace and obviously the events of 09/11 being linked to that. So we thought that was a prudent step there. we ultimately sold that site and did not continue to develop it.

In terms of what would it take for us it’s a very unique situation like the situation in Seattle was, it’s not something we are currently evaluating on any of our deals, but we don’t know what the future holds, either.

Alexander Goldfarb – The Goldfarb Family

Okay. Thank you.

Bryce Blair

I think with that to respect the commitment we’ve made to have a hard stop at 11:30, we are going to stop the call at this point. I want to thank everyone for the time and also we’ll be seeing many of you at NAREIT later this month. So thank you for your time today.

Operator

Ladies and gentlemen, thank you for your participation in today’s call. This concludes the program. You may now disconnect.

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Source: AvalonBay Communities, Inc. Q3 2008 Earnings Call Transcript
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