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AvalonBay Communities, Inc. (NYSE:AVB)

Q4 2009 Earnings Call

February 4, 2010 1:00 pm 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

Karin Ford – KeyBanc

David Toti – Citigroup

Michael Bilerman - Citigroup

Alexander Goldfarb – Sandler O'Neill

Michelle Ko – Banc of America

Jay Haberman – Goldman Sachs

Michael Levy – Macquarie

Michael Salinsky – RBC Capital Markets

Paula Poskon – Robert W. Baird

Rich Anderson – BMO Capital Markets

Anthony Paolone – JP Morgan

Swaroop Yalla – Morgan Stanley

Operator

Welcome to the AvalonBay Communities fourth quarter 2009 earnings conference call. (Operator instructions) As a reminder, this call is being recorded. I would now like to introduce your host for today's conference call, Mr. John Christie, Director of Investor Relations and Research. Mr. Christie, you may begin your conference.

John Christie

Thank you. Welcome to AvalonBay Communities’ fourth quarter 2009 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 yesterday afternoon'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.

And with that, I will turn the call over to Bryce Blair, Chairman and CEO of Avalon Bay Communities. Bryce?

Bryce Blair

Thank you, John. With me on the call today are Tim Naughton, our President; Leo Horey, our EVP of Operations; and Tom Sargeant, our Chief Financial Officer. In my comments, I will first be discussing our fourth quarter results and then I will provide some comments on lessons from the past few years and some summary comments on our outlook for the next few years. Tim will be addressing our portfolio performance, investment activity and our 2010 financial outlook after which all four of us will be available for any questions you may have.

Last evening, we reported EPS of $0.40 and FFO per share of $0.64. For the full year, our FFO was down approximately 11% after adjusting out non-routine items from both periods. The year-over-year decline in operating FFO was driven primarily by declines in property NOI and the weaker performance of our lease up communities. Our same store portfolio performance continued to reflect the weak economic environment with revenues down approximately 6% for the quarter and approximately 4% for the full year.

Before turning to our outlook for 2010 I want to take a few minutes to reflect back on the lessons of the recent past. In a year-end publication by Green Street they highlighted a number of lessons learned from the performance of REITs over the past few years. I thought a couple of the points from the article were especially worth emphasizing. First, they mention that companies with simple, stable and transparent business models outperformed those of their more complex peers and also that companies with strong balance sheets outperformed their more highly leveraged peers. Both of these have certainly been true for AvalonBay.

While we have evolved over the years. our base business model and balance sheet approach remain largely unchanged. Let me share a few examples. While others chase new markets both domestically and internationally, we remain committed to our high barrier to entry coastal strategy. While others pursued merchant building and condo development opportunities, we remained focused on acquiring and developing high quality apartments in our markets. While other grew disproportionately through debt, we continued to maintain the strongest balance sheet in the sector.

Many of the more highly leveraged REITs were forced to issue equity last spring as cyclical lows in their stock price causing long-term dilution. We avoided these dilutive and untimely equity raises ultimately issuing new equity later in the year when our stock price had recovered over 70% from its March lows.

Now while our portfolio could not escape the effects of the recession, our focused strategy, our consistent business model and our strong balance sheet served us well during this period. The strength of our stock price performance would seem to confirm the soundness of our strategy. In 2009, our total shareholder return was 44% versus 30% for both the RMS and the apartment sector. The last ten years show similar outperformance where our 10-year average total shareholder return was approximately 14% versus approximately 10% for both the RMS and the apartment sector.

I think it is useful to look back over the last few years as I think many of the past lessons will continue to be true over the next few years. I think we can be pretty certain the de-leveraging process that began last spring will be a long-term process for many. This process will be made even more difficult as the proposed increased regulation of financial firms will likely result in tighter credit overall. The de-leveraging process will likely favor public over private as most public companies are less levered and have greater access to a variety of capital sources than their private peers. This is certainly true in the apartment sector where the private developers are virtually shut down.

Among the public companies, those with the strongest balance sheets and the highest multiples will be less impacted by the dilutive effect of the de-levering process. So from a competitive point of view, I think AvalonBay is well positioned to respond to the emerging opportunities that will undoubtedly increase as the economy strengthens and fundamentals improve.

Given that we see 2010 as a transition year, a transition year for the economy, apartment fundamentals and our investment activity. In terms of the economy, we have already seen a transition to positive GDP growth and while job growth is still expected to be modestly negative this year, the expectation is for a transition from job losses to job growth in the second half. The modest improvement in the job front combined with the continued weakness in the for sale market and the steady decline in the supply of new apartments will help fundamentals begin to transition from very weak for most of 2009 to mostly positive by the end of this year.

Now to be clear for the year overall, we expect same store sales revenue to be down approximately the same as 2009. Yet as contrasted to 2009, where same store revenue eroded at an increasing rate as the year progressed, this year we expect the rate of same store performance decline to be at a decreasing rate.

Finally, we expect this to be a year of transition in terms of our investment activity. During 2009, we dramatically scaled back our investment volume. The combination of the extraordinary weakness in the economy coupled with the uncertainty created by the financial crisis argued for appropriate caution in terms of new investment activity last year.

Given greater visibility now for both the economy and capital markets and our positive outlook regarding the fundamentals in late 2011 and 2012, we will be increasing our acquisition, free development and development volumes this year to position us for the projected improvement in fundamentals.

Let me now pass it to Tim who will provide some more detail on our portfolio performance, investment activity as well as some details regarding our 2010 financial outlook.

Tim Naughton

Thanks, Bryce. I would like to focus my remarks on a review of operations and investment activity for the quarter and the past year as well as providing a little bit more color on the outlook for 2010.

Our portfolio performance continued to decelerate in Q4 with same store revenues down by 6% from last year and sequential revenues down by 2% from last quarter. Full-year performance was in line with our mid-year outlook as same store revenues were down 3.7% for the year and same store NOI down by 7%. Operating expenses were up by 4% for the year driven mostly by higher turnover related and bad debt expense resulting from weak economic and labor market conditions.

This past year, total job losses were more than two times higher than originally forecasted. Many of the additional job losses occurred in the first half of the year, which placed greater pressure on portfolio performance in the second half. While portfolio performance continued to decline in Q4, we are seeing signs that the rate of decline is moderating and is currently bottoming on a year-over-year basis. For the same store portfolio, economic occupancy is stable, turnover has returned to levels more in line with historical patterns after having been elevated for much of 2009 and concessions remain low.

During last quarter and so far in Q1, we have seen a reduction in the rate of decline for both new move in and renewal rents. Year-over-year revenue declines bottomed in October and have fallen at a lesser rate in each subsequent month since then. As a result, the rate of decline in the sequential quarterly revenues appears to have bottomed in Q4.

Regionally, the West Coast continues to underperform with Seattle experiencing the greatest deterioration over the last quarter followed by Northern California. On the East Coast, D.C. and Boston are holding up best in the current environment driven in part by the strength of the government and educational sectors.

Shifting to investment activity on the transaction front, we bought one asset in Q4 and another so far this quarter. Both of these acquisitions occurred in the D.C. market and totaled about $100 million, just under $150,000 per unit and a cap rate in the mid 6% range. Both communities were purchased from the acquisition fund. We sold three communities in Q4 totaling a little over $100 million. These communities sold at an average cap rate of 6.3%. For the full year, we sold five assets totaling $190 million at an average cap rate of 6.5% and an unlevered IRR of 13%. So far in Q1 we sold one asset for $45 million and have two others under contract totaling another $145 million.

Cap rates have been falling over the last three months as buyers are becoming increasingly confident and more aggressive in their underwriting and target returns. The greater near-term visibility in the operating environment combined with a very positive outlook for the fundamentals in 2011 and beyond has translated into lower cap rates and higher asset values. After cap rates had risen by 150-200 basis points last year from their lows, they have since fallen by as much as 75 basis points and now range from mid 5s to low 6’s across our portfolio.

Combined with declining NOIs, we estimate that asset value is up by around 5% to10% over last quarter but still about 25% off their cyclical highs. With a shortage of product to meet investor demand, bidding is becoming increasingly intense with plenty of support at market clearing prices. Clearly improved liquidity in the capital markets are supporting the multi-family transaction market, and as we begin 2010, buyers far outnumbered sellers which should continue to put positive pressure on asset values.

In terms of new development, our pipeline continues to decline after having completed almost half a billion in Q4 and over $800 million for the full year. Combined with modest starts of $65 million in 2009, current development underway is now around $800 million, down almost 2/3 from peak volume with only about a quarter billion remaining to invest. We did start two deals in Q4. Both of these are wood frame communities in suburban northeast markets where rental market conditions have generally been more stable, the projected returns are more compelling and construction costs have declined by over 20% since the peak.

In fact, one of the communities recently started as a second phase located in Northborough, MA which is budgeted to be built for around 15% less than Phase I on a per square foot basis for just the vertical construction or for the bricks and sticks. This represents only a portion of the cumulative decline that has occurred as we started Phase I just a year earlier.

Yields on current lease up and recently completed communities remain under pressure as we have had to use significant concessions and lower effective rents to maintain absorption, particularly at communities at higher price points and with elevated levels of new supply. This is most evident at Avalon Fort Greene in Brooklyn where effective rents are down significantly from initial pro forma. New move in rents have fallen throughout the New York City market but Brooklyn is particularly weak given the level of new supply being delivered there.

Turning now to next year and our 2010 outlook starting with operations, as Bryce mentioned, fundamentals should begin to improve with modest job growth projected to occur in the second half of the year, combined with dwindling supply from a reduction in new deliveries of both purpose built rentals as well as potential shadow supply from new condominiums. While our full-year outlook for same store performance isn’t that much different than what we experienced in 2009, the changes by quarter will be the reverse of what we saw last year.

2009’s quarterly performance was progressively worse during the year and in 2010 we expect quarterly performance to get progressively better on a year-over-year basis. On a sequential quarter basis we expect the decline in same store revenues to continue to moderate and be flat by year-end.

Regionally we expect that Seattle and Northern California will continue to underperform the average. The job picture should begin to improve in Seattle faster than most other west coast markets but supply will remain elevated particularly on the east side. Northern California is expected to continue to lose jobs in the first part of the year and be impacted by the weight of the cumulative employment loss in that region.

D.C. and Boston should outperform again in 2010. Job growth has already begun to turn positive in D.C. and the combination of private sector employment stabilizing and falling supply should help Boston outpace other markets. The outlook for New York and Southern California is a bit less clear as both of these regions appear to be in transition. Given the rebound in the capital markets, New York should stabilize quicker than we originally anticipated as job losses are almost 100,000 less than initially projected.

In Southern California, the sequential rate of decline has already begun to moderate. San Diego should be the first to recover of the Southern California markets while L.A. should recover roughly in line with the national average. Orange County with its dependence on the housing and mortgage industries figures to lag in its recovery.

In terms of investment activity, as Bryce mentioned, 2010 should be a more active year for us. Last year, the focus was on restoring and improving liquidity. As we start to bottom out during the correction portion of this cycle, 2010 could prove to be a good year to put capital to work in the form of acquisitions and new development in certain markets. We are currently active on the acquisition front and have purchased around $100 million over the last 90 days. Other than dispositions already closed or under contract, we don’t anticipate further asset sales this year.

With the broader capital markets continuing to recover, dispositions are a relatively less attractive source of capital than over the past couple of years when asset sales offered a balanced, neutral way to tap the cost effective GSC debt market.

We do intend to start some new developments in 2010 although the amount should be modest by historical standards on the order of $400 million. Most of the activity is likely to occur in the northeastern suburban markets where market conditions are more stable and wood frame communities offer better projected returns. In addition, we are beginning to look at new land opportunities as some land owners and lenders are starting to consider disposing of their holdings and many of our competitors remain on the sidelines.

Our financial outlook includes a range for FFO of $3.60 to $3.85 per share or about 16% below 2009 adjusting for non-routine items driven in part by a projected decline of same store NOI of 5% to 7%. Projected FFO declines are also being driven by stabilizing development activity from 2009 and 2010, much of which is leasing up at initial effective yields below pro forma. Our balance sheet is well positioned as debt to total market cap is currently under 40%. Liquidity is strong as we raised over $1.5 billion in 2009 and approximately $3 billion over the last two years. We currently have $300 million of cash on the balance sheet and all of our $1 billion credit facility available.

Finally, the capital markets are largely open which should continue to support our growth plans. Since the fall, we have raised capital through the issuance of common shares, secured and unsecured debt and asset sales. With most forms of capital readily available at reasonable pricing through the best of credits, our competitive position continues to strengthen as we move toward the expansion phase of the next cycle.

With that I will now turn it back over to Bryce for summary remarks.

Bryce Blair

Thanks, Tim. I just wanted to provide a few additional comments regarding our outlook for the next couple of years. As you know jobs, while not the only factor, are the principle driver of apartment demand. And also as we know from historical experiences, actual job numbers can be very different than initial projections.

One only needs to look at last year’s reminder of how far off job forecasts can be. In January 2009, the consensus forecast were for national job losses of about 2 million. Actual losses for 2009 were about 2.5 times as great. We look to a number of third parties, and for 2010, the forecast generally ranged from about 0.5% positive job growth to about 1.5% negative. We are using a baseline forecast of about 0.5% negative. Embedded in this estimate is the assumption of positive job growth in the second half of the year.

The timing of this forecast is similar to past recoveries as job growth generally trails return in GDP growth by 3-4 quarters. In any event, expected job growth is only one factor in how we assess expected revenue growth. It is primarily a bottom-up process where we look at each sub market, each property’s competitive position in building up our own revenue forecast.

So as I stated earlier, we see 2010 as a transition year, one where the economy transitions from job losses to job gains and where apartment fundamentals transition from weak to modestly positive and where revenue transitions from sequentially negative to flat later in the second half of the year. But ultimately sustained strength in all three of these being the economy, fundamentals and our portfolio, will not come until 2011 and 2012, a period where we expect to see very strong fundamentals. This has guided our decision to increase our investment activities as Tim outlined in anticipation of the expected stronger recovery.

With that, operator, we would be glad to take any questions.

Question and Answer Session

Operator

(Operator instructions) The first question comes from the line of Karin Ford – KeyBanc.

Karin Ford – KeyBanc

Could you just talk about your expected returns on the new development starts for 2010 and what the funding plans would be for that capital spend as well?

Tim Naughton

I will take the first part of that question and let Tom take the second part as it relates to the capital. In terms of expected return for new development, typically for new deals that we may be out in the marketplace looking for would be north of 7% on an initial yield basis, but just as importantly in terms of the – or the unlevered returns particularly when you have a transition going on in the cycle. We would look for unlevered returns somewhere in the order of 10% to 11% which compares to core unlevered returns right now in the acquisition market that are in the 8% to 8.5% range.

Tom Sargeant

We have provided in our outlook sources and uses of capital schedule. But I can just give you a thumbnail sketch of this. Basically in 2010, we will have net cash flow from dispositions after paying the related debt of about $150 million, capital markets activity of $200 million and then cash on hand and use of the line of about $300 million to $400 million. Then the uses would be investment activity which would be development, re-development and our portion of contributions to the acquisition fund, and that would total about $600 million. Then we plan to redeem debt, most of it as scheduled, but some of it earlier than scheduled at about $150 million. That is basically a thumbnail sketch of our sources and uses.

Karin Ford – KeyBanc

A question on Washington D.C. market, any concerns that the government spending freeze that may be coming could have an impact on the positive fundamentals you have seen there?

Leo Horey

We don’t see any evidence of that. In fact, what we have seen over the last couple of quarters as Tim has talked about is we have seen job growth and that is occurring both in the public and the private sectors. So we do feel pretty good about how Washington D.C. is positioned and the opportunity moving forward.

Karin Ford – KeyBanc

On bad debt levels, where were they in the quarter and how does the trend look there?

Leo Horey

For the quarter, bad debt was about 1.3%, which is down slightly from the previous quarter, and through the quarter, bad debt actually declined. It came down through the quarter.

Operator

The next question comes from the line of David Toti – Citigroup.

David Toti – Citigroup

Just to go back on some of the development issues, did you drop the re-development deals from the supplemental this quarter? I wasn’t sure if I missed that.

Tim Naughton

We did, and frankly I think the reason for that is we were finding it was confusing as much as it was helping analysts and investors because the yields that we were quoting were based upon historical costs which in some cases some of these communities were 10-15 years old. We have held for more than 10 years. Oftentimes, an older community would have a higher yield even if the economics on the incremental capital wasn’t really any different than another community, which we may have just acquired.

David Toti – Citigroup

Going back to development again, at a sort of more strategic level, you are fairly alone in your peer set in still pursuing development. Internally how do you weigh choosing to allocate dollars to construction when many of your peers are buying theoretically below replacement cost and really focusing on acquisitions, how do you weigh those two?

Bryce Blair

I will touch on this and Tim may want to add a bit. I think Tim actually touched a bit on this when he was quoting our expectations for both initial returns, but total returns of development in the 10-11 range versus acquisitions it would be in the 8-8.5 range on a total return basis. So we continue to see development as an accretive use of capital. Clearly, there are some communities that we began a couple of years ago that are leased up in difficult time periods, which Tim addressed, which is causing a drag on our near-term earnings. But the decision to start now for communities that will be completed roughly two years from now and what we do expect to be strong fundamentals, we think is a pretty compelling opportunity and one that we have a significant competitive advantage in.

Tim commented and just to put a little meat on the bones, some of the assets we have marketed, there have been 30-40 bids on. It is hard to believe you are getting a terrific opportunity when the competitive market for acquisitions is so hot versus on the development side if we are one of the only ones building. I can assure you we are getting tremendous buys and we still have a pipeline of development opportunities we can bring to market in the coming period.

Tim Naughton

I would just add to that they are not necessarily mutually exclusive strategies from my perspective. In some markets it is going to make a lot more sense to acquire particularly where you are buying below replacement cost just given the underlying dynamics in that market. And in other markets, and I spoke to this particularly in some of the northeastern suburban markets, there is an opportunity to be able to develop today and add value in an accretive manner. Again, I think it is going to be a little bit different solution for each market and opportunity we see out there.

Michael Bilerman - Citigroup

If you think about the $400 million development fund starting in 2010, you are obviously thinking about what forward rents are going to be in 2011 and 2012 as you get comfortable with starting that development. What sort of trajectory are you assuming in terms of rents from the current basis as you compare that to a comparable acquisition in a market that you may have more confidence in?

Bryce Blair

Well, two embedded questions there. In terms of general trajectory, as we said, for 2010 we still see the trend as down just at an improving rate, if you will, as Tim mentioned, into 2011 as a flatter year and for 2012. We are certainly not here to give revenue guidance but if you look to third party forecasts whether it be Ron Witten or Axiometrics within our markets is calling for revenue growth in the 6% range in the 2012 time period which we don’t think is unreasonable.

In terms of acquisitions, acquisitions are going to experience the same revenue trends during that market period. And where we may be more confident, I think we are pretty confident, we understand all the markets we are buying or developing in, and we have given equal probability in terms of our forecast of how those markets are going to perform.

Michael Bilerman - Citigroup

When you are comparing, if you acquisitions are at a 6 cap, that is sort of where an acquisition yield would be and you are talking about development at a 7 yield. The 6 is current, that will potentially grow into a 7 versus the 7 being on a risk adjusted basis, you are taking a certain amount of risk in getting to that 7 at that point in time, aren’t you?

Tim Naughton

Just to be clear, in terms of we are quoting a projected development yield of 7, it is not intended to be a projection into the future. It is based upon how we are underwriting rents in today’s market. So the 7, and to use your numbers, the 7 and 6, I think if you use our numbers would probably be more like 150 basis point delta are based upon an assessment of today’s market. In both cases, clearly on acquisitions, it is a little bit easier to assess the risk just because there is an income profile in place. But by way of example, both these deals we started last quarter, Northborough and the deal in New Jersey, we just finished Phase I on the Northborough deal and the deal in New Jersey we just finished a deal a few miles away in the last year. I think in both those cases we felt pretty confident about the rents we are underwriting. To be clear it is on an apples-to-apples basis both in terms of the current yield as well as the trajectory of rents that we are projecting in the pro forma.

Michael Bilerman - Citigroup

On the land, are you assuming your historical land basis, impaired land basis or market land basis in quoting a 7% or north type of yield?

Tim Naughton

It is based upon what is on the book. So it is based upon cost. Neither one of those deals are impaired land and typically to get to the point where land is impaired it has been an abandoned deal. So I suspect you are not going to see many deals started particularly in 2010 that were just impaired in 2009. I think it is based upon our cost, not based upon new markets.

Operator

The next question comes from the line of Alexander Goldfarb – Sandler O'Neill.

Alexander Goldfarb – Sandler O'Neill

I just want to continue on the yield conversation. Thinking more about specifically New York where ground leases have been a way you have pursued development, what would you think that the current yields or the required yields for you to start a new deal whether it is fee simple and then if it is a ground lease deal in New York?

Tim Naughton

Generally, we would look to try to get a higher yield on a ground lease deal just given it is not as attractive as owning the property fee simple generally. It depends on the terms of the lease. Today it just doesn’t make sense to start a deal in New York based upon the economics. We are generally looking for, as I mentioned before, around 7% on a going in basis and maybe a little bit less in a market we think has got a better growth profile over the next 4-5 years and somewhere in the 10-11% on an unlevered return.

We would have to convince ourselves based upon a reasonable set of underwriting that is what the economics look like on a go forward basis.

Alexander Goldfarb – Sandler O'Neill

What about the return if it is a ground lease? So if it is 7% on fee simple, on a ground lease, you would be looking for what?

Tim Naughton

I don’t want to parse it too much but a little bit of a premium to that. I think typically we look for 40-50 basis point premium on a ground lease. It depends on whether there is buyout rights, whether there is reappraisal rights, it is a function of the terms of the ground lease in terms of what the economic impact of that ground lease is to the deal.

Alexander Goldfarb – Sandler O'Neill

Given your proximity to D.C. and how important financial services are to your tenant base, have you stepped up your government relations program?

Leo Horey

Do you mean, are we targeting more the marketing to…

Alexander Goldfarb – Sandler O'Neill

Just sharing with some of the politicians down there trying to balance out the populist versus the economic drivers of your markets, specifically New York, Boston, San Francisco, where there is a lot of financial services that drive those economies and the comments that come out are certainly not helpful.

Leo Horey

I think the honest answer is no, that is not something we are personally taking on as a challenge. Obviously, through a number of industry groups, we participate in lobbying efforts that are intended to help our industry and help the markets we are in. AvalonBay as an individual, we are not out pounding the pavement trying to affect public policy to help our individual markets.

Operator

The next question comes from the line of Michelle Ko – Banc of America.

Michelle Ko – Banc of America

I believe you mentioned earlier over the last 90 days you have closed on $100 million in acquisitions. Can you comment a little bit more on the details around that? Also I believe you mentioned you were interested in some land opportunities. Can you tell us what markets you are interested in?

Tim Naughton

In terms of the two deals, as I mentioned in my prepared remarks, they both were in the D.C. area. One was in Fairfax County and one was in Montgomery County, both wood frame communities. The one in Montgomery County is four years old. The one in Fairfax is in the Fair Oaks sub market, just a 20 year old community that has been renovated a number of years ago. Those were priced in a different market. As I mentioned, cap rates have moved. They wouldn’t trade in the mid 6’s today. They would trade at something probably 50 basis points south of that would be my guess. Anything else that you were interested in hearing specifically on those two deals?

Michelle Ko – Banc of America

I guess if you could comment on are you seeing more assets for sale today versus over the last month or two also?

Tim Naughton

A few more. Sort of going back to 2009, the first half of the year was dead. Nothing happened. It really wasn’t until the fourth quarter that you started to see some activity actually go to closing. Some deals were brought to market in Q3 and then some closed in Q4. Looking back at the multi-family transaction market in 2009 to give you a little bit of perspective, peak volume was in 2007 about $90 billion. We closed just a little over $10 billion in 2009 and most folks’ projections are that 2010 and 2011 will probably be more in the 20 to 30 or 40 billion range, below the long-term average and still 60-70% below the peak but relatively consistent with what we saw back in 2002 and 2003 or the last correction time period.

Michelle Ko – Banc of America

Where are you looking for land opportunities?

Tim Naughton

We are looking at really most of our markets right now, most of our markets. Now, it is not every sub-market within that market. Most high rise or concrete construction is something that doesn’t underwrite. It is tending to be wood frame, garden or wood frame with some parking structure element to it. It tends to be a little bit more of a suburban or suburban in-fill type locations that are underwriting the best right now. That is a function of the wood frame we have seen construction costs come off more than we have seen that happen in the concrete. In addition, land values have traditionally been a bigger percentage of your total development costs, so as land values has started to correct, you are starting to see more improvement in the economics of those deals earlier in the cycle.

Bryce Blair

One thing I would just add to clarify when we say we are looking for land, please remember, even if we found a piece of land that had been permitted, we would likely be replanning it, which would take a year to two process. If it is unentitled, it would take, average in our markets is 3-4 years. So we are talking about delivering product that is five years out.

Michelle Ko – Banc of America

One of your peers recently purchased some properties in New York City at a 5.5 cap rate. I was wondering what you thought about the pricing of the deal and if you could give us a general sense for what replacement costs are today in your mind?

Tim Naughton

I am not really going to comment on the valuation. In terms of replacement cost, I will say in terms of cap rate that is what you are seeing in the market, mid 5. In terms of placement cost, I think that was below replacement cost. As I recall, it is a little over $500 per rentable foot, which I would think replacement cost would be north of $600 in that market today.

Operator

The next question comes from the line of Jay Haberman – Goldman Sachs.

Jay Haberman – Goldman Sachs

Can you talk about which of your markets you think rents have effectively bottomed at this point or actually you might even see an increase by the end of the year?

Leo Horey

I will give you generally a sense of the markets. The markets we feel the best about are the major markets we are in. We kind of group the markets into three buckets. The ones where we can see more positive results are basically Boston and D.C. Moving to stuff that is more average to the outlook we gave would be in the New York metro area and the markets that are more challenged would be the west coast markets.

Jay Haberman – Goldman Sachs

Can you comment on renewals by market? Is the trend similar in terms of flat to modestly higher renewal rates in Boston and D.C. and obviously continued pressure in Northern California and Seattle?

Leo Horey

I would say generally that is the way it works is that when we have more pressure, where the new move in rents are under more pressure, then it puts more pressure on the renewal rents. But we continue to see a situation where the renewal rents are more favorable than a new move in situation on a year-over-year change basis. And bringing information current, in January renewal rents across the portfolio are almost flat.

Jay Haberman – Goldman Sachs

How does that compare versus new leases?

Leo Horey

New leases are down about 6% which speaks to that same kind of balance I talked about last quarter which is historically the difference between a new move in and renewal historically has averaged about 6% but in the most difficult market conditions it was much higher than that. In the strongest part of the market, they were one on top of another.

Jay Haberman – Goldman Sachs

You see that closing by the end of the year?

Leo Horey

Don’t know for sure. Certainly, we see the markets improving in the back half of the year, towards the end of the year we move to flat sequentially and we will continue to push both new move ins and renewals as appropriate.

Jay Haberman – Goldman Sachs

A question on the value add fund, can you talk about the cap rates for the transactions? You mentioned 6.5% dropping to 6% but can you speak to the dollar investments today in terms of are you investing in these assets in terms of enhancing yield on a go forward basis?

Tim Naughton

About the assets we purchased, in one case it is only four years old, so it really doesn’t require any capital. In the other case, it was renovated about 6-7 years ago, and just a modest amount of capital just in terms of remerchandising some of the common area spaces.

Jay Haberman – Goldman Sachs

I was thinking about your investments going forward. Do you see that as a better use of capital versus paying what we are seeing now, mid-size for some of the higher quality assets?

Tim Naughton

It is hard to say because most of what has been marketed today has really been poor. It hasn’t really been on the need of capital. I think there is a general sense in the marketplace by sellers that buyers aren’t as interested in that kind of investment. I think that could change in 2010 as there is more demand for product that people will be more aggressive in terms of looking at more value added opportunities. It is really going to be on a case by case basis in terms of what we think is the better use of capital.

Bryce Blair

Maybe to add one thing to that, and Tim you may just want to comment generally, that our redevelopment activity overall has definitely ramped up in 2009 and has continued to grow in 2010 because in general whether it is in the fund or just our own portfolio, we do see that as a good use of capital, particularly given our outlook over the next couple of years. So our volume of redevelopment activities from 2009 to 2010, could you summarize, Tim?

Tim Naughton

We anticipate redevelopment about doubling in our own portfolio in 2010 relative to 2009. So where the focus in 2009 was largely in defensive investment given where we are in the cycle right now, we are looking to invest in more offensive opportunities even within our own portfolio. That is largely what is driving the doubling of redevelopment activity in 2010.

Jay Haberman – Goldman Sachs

You mentioned turnover rate higher last year. What specifically was that rate?

Bryce Blair

The turnover rate for this quarter was 46%. For the year, it was 57%, so it was down quarter-over-quarter about 6%. For the full year, it was up about 4%. So first half of the year, and I think I talked about this on the last call, for about a year period, it was up 5% plus or minus. Starting in the third quarter, it started to return to more historic levels and in the fourth quarter we see it that way also. Taking it even a step further, the reasons for move out have returned to more historic norms which bodes well for the earlier discussion about what is going on with renewal rents and potentially new move in rents as well.

Operator

The next question comes from the line of Michael Levy – Macquarie.

Michael Levy – Macquarie

Did you say 46% for the fourth quarter of 2009 and 57% for the full year 2009?

Tim Naughton

That is true. Just to be clear, that is typical patterns because we structure our lease expirations in almost a bell curve pattern where there are more lease expirations in the second and third quarter. And when I give you a number like the fourth quarter number it is just the number of move outs annualized. Typically it is down much less in the first and fourth quarters and typically higher in the second and third quarters.

Michael Levy – Macquarie

What was the fourth quarter 2008 number?

Tim Naughton

52%.

Michael Levy – Macquarie

If I understand correctly what you said earlier, it sounds like a big reason why expenses moved higher for the year was the increase in turnover. Expenses are also projected to be flat in 2010. So if turnover is now closer to historical levels, why is Avalon not more bullish on its abilities to reduce expenses? Is there something else going on or am I missing something there?

Tim Naughton

For 2010, the outlook we gave I believe was minus 1 to plus 1 where the midpoint is zero, so flat. I can tell you the factors that are driving those expectations are; one, we expect bad debt which was up during 2009 to decline as the job market improves. Secondly, we expect maintenance and turnover related costs to come down and that is going to be offset by some concerns that property taxes are working against us. The other categories are plus or minus.

Michael Levy – Macquarie

So the turnover and the taxes sort of negate one another it sounds like. Regarding the assets you have in the pipeline to be sold, was the location of those assets mentioned earlier in the call and can you mention them now if not?

Bryce Blair

No, they were not. We typically don’t disclose specific assets.

Operator

The next question comes from the line of Michael Salinsky – RBC Capital Markets.

Michael Salinsky – RBC Capital Markets

A quick question, as you were putting together the guidance for 2010, how sensitive is your NOI forecast to fluctuations in employment growth or lack thereof?

Tim Naughton

It is actually not as sensitive as one might think. We run it, I gave you the range of forecasts from mildly 0.5% or so positive to 1.5% or so negative. That certainly moves it but not as much as you might think in that a lot of the rent streams for 2010 is baked in leases that were signed in 2009. And then secondly as our experience has proven out, similar to a lag between GDP and job growth, there is a lag between job growth and revenue growth. So if jobs were to start to turn immediately now versus in the second half of the year, greater growth in the second half of the year is really going to be felt in 2011, not in 2010. So it might affect the revenue number by 50 basis points or 75 basis points. It is not going to make the range that we gave of negative 3-4.5%, it is not going to make that positive if the job numbers moved by a percent or so.

Michael Salinsky – RBC Capital Markets

Of the $380 million in development starts, are those pretty well evenly weighted throughout the year. And in terms of mix, is there any particular market that you are bullish on at this point starting your development versus you are going to shy away from or is it pretty much across the board?

Bryce Blair

I think as Tim mentioned, the developments that make most sense now typically have been the suburban, wood frame communities and in the markets that are currently feeling the least pressure. That typically is the northeast. So that is where a disproportionate number of our starts will be. They are more back ended than front ended, both just trying to not get too far ahead of ourselves in terms of the recovery as well as just the timing of getting the deals ready to start.

Michael Salinsky – RBC Capital Markets

In terms of the excise taxes, is that an issue in the past? I mean there is no excise tax issue potentially for 2010?

Tom Sargeant

Correct, we don’t anticipate an excise tax in 2010.

Operator

The next question comes from the line of Paula Poskon – Robert W. Baird.

Paula Poskon – Robert W. Baird

I might have misheard this, I thought I heard Tim say in his prepared remarks that you contemplate no further asset sales this year?

Tim Naughton

That is correct. Other than the $145 million that is currently under contract, that has not yet closed.

Paula Poskon – Robert W. Baird

So in the attachment 15 where it says 180-200, is that something else?

Tim Naughton

I think I mentioned in my remarks, we have already closed $45 million. So 190, and that’s the midpoint.

Paula Poskon – Robert W. Baird

What are your expectations for acquisition volume getting done in 2010?

Tim Naughton

We didn’t give formal guidance. Part of it is a little bit of, it is going to be a function of how much product comes to market. As I mentioned in an earlier question, volume is down by almost 90% in 2009 from 2007, so while we expect it to go up, it is hard to say by how much. But trying to give you a sense in that we were able to close $100 million in the last quarter. Whether that is going to be an appropriate run rate is really going to be a function of market opportunity and total volume.

Paula Poskon – Robert W. Baird

Given your view on the D.C. metro area how are you thinking these days about your parcel in Tysons West given the metro extension activity is well underway?

Tim Naughton

It is an attractive site relative to where one of the new metro stations will be. As you probably know, the metro is three years away. Frankly that site is probably nearly three years away from delivering. So from a timing perspective, we feel pretty good about it. For now, we are just continuing to run it and lease it as an improved property.

Paula Poskon – Robert W. Baird

Just curious being here in the same backyard, what impact is in your first quarter guidance for snow removal and the obvious spike we have had in severe weather?

Leo Horey

My kids celebrate every time a snowstorm comes. I am just not thrilled about it. It is one of the markets that we do not have basically a contract where we do time and materials. To give you some perspective in the fourth quarter, we were in excess of budget by about $135,000 based on that big storm we had. Obviously, if this weekend produces a similar type storm, we are likely to have similar type results.

Paula Poskon – Robert W. Baird

On this call last year you indicated expectations for CapEx for home to be in a range of about 600. But attachment seven came in at probably about half of that. What do you expect for 2010?

Leo Horey

That is a great question. In 2009, we focused our efforts and made sure we took care of all the deferred maintenance that was out there, but there were certain asset enhancements that we didn’t do, we did the planning but we didn’t accomplish in 2009. Also if you look at the expenses, the expenses for the year were up 4% and that was driven a lot by maintenance related costs which were higher on a year-over-year basis. So when you take both of those things we did a good job of taking care of the communities. In 2010 we expect the CapEx number to be around $700 per apartment home and when we combine 2009 and 2010 you get back to that run rate of around $500 that we talked about. I believe that 2007 was around $400. 2008 was around $500 so in that general area.

Tom Sargeant

Parsing this a little bit, we were behind a little last year. We are going to catch up in 2010. Long-term average has been in the $500 per unit range. We are reinvesting in our assets expecting that we will recover, our revenues will begin to grow in 2011. So in terms of looking at long-term averages, that $500 per unit has been a pretty good number, if you just balance out the years over time.

Operator

The next question comes from the line of Dave Bragg – ISI.

Dave Bragg – ISI

Could you help me reconcile a couple of things on development spending? First on page 18, you have total capital costs invested during 2010 of about $228 million. I am just trying to reconcile that with page 22 your $450-550 million of cash disbursed for development communities and land. Is the difference between those two numbers potential land purchases or am I missing something else?

Tim Naughton

On page 18, the $228 million, I think that is really just capturing what has already been started and committed whereas the guidance for the full year would also include the deals we anticipate starting in 2010 along with land purchases.

Dave Bragg - ISI

Trying to get a sense of the magnitude of potential land purchases, could you talk about that and also your view on discounts to peak land pricing?

Tim Naughton

In terms of land purchases we have in the budget it would really just be for deals, really twofold for deals that we have under option or we intend to start this year along with the remaining land we have under a lease agreement in Brooklyn where it converts at the seller’s option. I think in total we are talking about maybe $100 million including the Brooklyn land. In terms of new lands, relative to peak pricing, it depends on the market. We have seen land correct by well over 50% in some markets. In other markets, it has held its value at 20-30% off.

Operator

The next question comes from the line of Anthony Paolone – JP Morgan.

Anthony Paolone – JP Morgan

You touched on some of the drivers to your expense growth for AvalonBay but I was curious if I look at your 2009 expense growth it was higher than most of your public peers. I was curious if you had stepped back and looked at how you all performed on that front relative to them and had any sense as to what the difference was?

Leo Horey

With respect to looking at our peers, absolutely we do. Expenses for the year were 4%. That is going to be above the industry average but if you go back five years I think what you would see is our expenses have run in the low 2% range whereas our peers have run on average at 3% plus. So for 2009, ours were higher. They were higher due to a couple of issues. One was bad debt. The other was the maintenance related expenses. Then frankly, some one-time issues that occurred in 2008 that elevated our 2009 results. For example, there were two big tax appeals that were successful in the fourth quarter of last year, which depressed the 2008 and forced 2009 up. Then I think if you look forward, assuming we perform consistent or relatively consistent with our outlook, and you take 2009 to 2010 together, we would still be in that low 2% range. And over a 7-year period, I would say those results are as good as anyone has produced.

Anthony Paolone – JP Morgan

My other question was in the press release you made a comment about the potential for future impairment charges resulting from the fact you are in the development and value creation business. I am curious, I haven’t seen that before, what compelled you to put that in there considering you have been in those businesses for a while now?

Bryce Blair

Tom, you may want to add something, but just as a general comment, yes we have been in that business for a long time. We expect to remain in the business. It is just really a reminder that nobody in our sector has as large a development pipeline as we do and while there are including this quarter other companies who are announcing additional impairments, it is just a reminder that it is the nature of the business we are in. When you have another couple billion dollars of potential development rights, we know of nothing today that would have to be impaired and announced but as we work through these deals over the coming years, it is just part of the business we are in. We are a believer that disclosure is our friend and we felt that was an appropriate reminder.

Operator

The next question comes from the line of Swaroop Yalla – Morgan Stanley.

Swaroop Yalla – Morgan Stanley

Some of your peers reported an increase in move outs due to home purchases in the fourth quarter. I just wanted to see what trends you have been seeing on that and any specific markets?

Leo Horey

I had some difficulty hearing your whole question. I believe what you asked is, what percentage of our move outs were attributable to home purchase. In the fourth quarter, that was the number one reason for move outs. It was slightly over 18%. Just to give you a perspective, historically it has run between 20-25%, so it is on the low end of the range right now.

Operator

The next question comes from the line of Michael Billerman – Citi.

Michael Billerman – Citi

In terms of the same store pool, I know I guess that is going to be reset for 2010. What percentage, if we looked at fourth quarter NOI of $135 million, what percent of that is now considered same store for 2010?

Tim Naughton

I am not understanding the question.

Michael Billerman – Citi

You reset the same store pool once a year.

Tom Sargeant

Why don’t you call me offline and we will get you that number. We don’t have that in front of us but I understand the question. We would be happy to answer that, we just don’t have that information in front of us.

Michael Billerman – Citi

You talked a little bit about in prior quarters about evaluating whether just given how large the non-same store pool has been about providing some additional disclosure. Where are you in terms of that thinking today?

Tom Sargeant

We are considering expanding our disclosure in 2010 for the first quarter to give more color on that. So I would just say stay tuned for additional disclosure in 2010.

Michael Billerman – Citi

Is there a way to think about, to put the down 5 to down 7 to context, I assume now that assets have stabilized in 2008 that are now going to be part of the 2010 pools, that all the assets that stabilized in 2009 are still not part of it yet because they wouldn’t have been there as of January 1.

Tom Sargeant

Correct.

Michael Billerman – Citi

Is there something in the 2008 stabilization or the size of the amount that stabilized in 2008 that is having a depressing or to the other effect it may be because of leases you have to induce people to get in at that point is actually helping same store?

Tim Naughton

Based on the 2010 buckets, if you were to quote Q4 2009 and our results for revenue, for instance the minus 6.1, when you go to restate it under Q4 under 2010 buckets, it is slightly improved. So it is improved on a year-over-year basis slightly.

Michael Billerman – Citi

So the 2008 stabilization are not showing as big of a decline than the other part of the same store pool -- part of the 2009 same store pool?

Tim Naughton

It depends on where those assets are located. It is all in a variety of markets, etc. So it is hard to make that generalization.

Tom Sargeant

It is a very marginal difference. Also just to clarify it is not just the leases haven’t stabilized. The communities that are undergoing redevelopment and therefore we don’t feel it is a fair comparison. We don’t want to have the “bought revenue” in that same store basket. As our redevelopment activity increases, as Tim mentioned, it also prevents that same store bucket from increasing because it is not an apples-to-apples comparison.

Michael Billerman – Citi

The development piece, you had almost $800 million of development complete in 2008, and the redevelopment was a much lower amount. As we are trying to think about the negative 5 to negative 7 for 2010, just trying to understand the dynamics of total portfolio versus same store portfolio. Tom, we can follow-up off line on that.

Operator

We have no further questions in queue. I will turn our call back over to Mr. Blair for closing remarks.

Bryce Blair

As always, we appreciate your interest and attendance during a busy earnings time. We know we will see many of you in the upcoming investor conferences. Thank you.

Operator

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

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Source: AvalonBay Communities, Inc. Q4 2009 Earnings Call Transcript
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