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AvalonBay Communities, Inc. (NYSE:AVB)

Q1 2010 Earnings Call

April 29, 2010 1:00 pm ET

Executives

John Christie – Director IR

Bryce Blair – CEO

Thomas Sargeant – CFO

Tim Naughton – President

Leo Horey – EVP Operations

Analysts

Paul Morgan – Morgan Stanley

Alexander Goldfarb – Sandler O'Neill

Michelle Ko – Banc of America

[Eric Walsh] – Citigroup

Jay Haberman – Goldman Sachs

David Bragg – Unspecified Company

Rich Anderson – BMO Capital Markets

Jeffrey Donnelly – Wells Fargo

Michael Salinsky – RBC Capital Markets

Paula Poskon – Robert W. Baird

David Harris – Gleacher

Andrew McCulloch – Green Street Advisors

Operator

Good afternoon ladies and gentlemen and welcome to the AvalonBay Communities first quarter 2010 earnings conference call. (Operator instructions) 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

Welcome to AvalonBay Communities’ first quarter 2010 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 AvalonBay Communities for his remarks.

Bryce Blair

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

Last evening we reported operating results that were stronger than our prior guidance. The stronger results were primarily attributable to improved portfolio performance. In our comments today we’ll be focusing on what is driving the improving fundamentals, and the implications to our portfolio and investment activity.

For the quarter we reported EPS of $0.88 which is up almost 50% from the same period last year, an increase that was driven primarily by the gains on two asset sales during the first quarter. FFO per share for the quarter was $0.96, which is down approximately 20% from the prior period after adjusting for non-routine items yet was above the previous guidance that we provided.

Now of the outperformance during the quarter the majority came from stronger portfolio performance with the balance coming from timing of various overhead expenses some of which will reverse themselves in the coming quarters.

In my comments last quarter I said we expected 2010 to be a year of transition, transition in the economy, from job losses to job gains, and transition in both apartment fundamentals and portfolio performance.

In our prior guidance we had expected this transition to begin around mid year, however recent economic data, corporate profits, and our first quarter results suggest that this transition is already underway.

So the transition we anticipated is happening a quarter or two earlier than expected. In terms of the economy the positive GDP growth that began in the second half of last year is now favorably impacting the employment picture.

The job market began to stabilize late last year, with essentially flat job growth from November through February and with the March job’s report, is now beginning to show positive growth. The current projections for job growth while still modest are ahead of prior forecasts used in our outlook at the beginning of the year.

And the current forecast of about 800,000 for the year is about double the original projection. Now the job growth in March while helpful is certainly not by itself sufficient to explain the recent improvement in apartment fundamentals.

The improvement is likely due to a combination of factors, first the household surveys of job growth suggested actual job growth may be stronger than is what has recently been reported. And this is likely true particularly in the younger age segment which disproportionately benefits renter demand.

Secondly, the improvement in fundamentals is undoubtedly driven in part by generally rising consumer confidence. The recent released consumer confidence index rose in April to its highest level since the beginning of the financial crisis in September of 2008.

I think its fair to say that most feel the worst is behind them and probably feel the job situation is likely stable. Many had delayed making a major housing decision over the last year or two because of the prior uncertainty regarding the economy and the security of the job market.

Historically this is particularly true in the younger age segments where household [formations] declined disproportionately during a recession. Now with the generally brighter outlook and the likely strained patience of their parents or roommates, the unbundling is likely beginning as the typical 25 year old recent college grad is deciding to finally leave mom and dad’s home or his friend’s couch and get his or her own apartment.

Now this factor is hard to quantify but is consistent with what we have experienced coming out of prior recessions and is even more likely now given the size of the GenY age cohort. Another reason for the increase in renter households is the continued weakness in the for sale market which is continuing to reduce homeownership rates and increasing renter households.

As additional evidence of the weakness in the housing market home prices remained flat to down and inventory levels remained historically high. And all of this is despite unprecedented government support for the for sale market.

Our results for the first quarter provide additional evidence that apartment fundamentals are improving and are doing so earlier than anticipated and I want to share a few data points with you, many of which Leo will elaborate on during his comments.

Year over year revenue declines in our portfolio peaked in October of last year and the rate of decline has continued to moderate each month since. One third of our market showed positive sequential revenue growth this quarter despite a seasonally slow period.

For the portfolio as a whole renewal rates turned positive during the quarter and overall most of our leading portfolio metrics have or are returning to pre-recession levels. So while the economic recovery this year will likely still be modest, at least in terms of job growth, it is a recovery, and its taking hold earlier than originally anticipated.

And while our year over year revenue numbers will likely continue to be negative for most of the year we expect to see sequential positive growth during the second quarter. Overall as we indicated in last evening’s release we now expect that revenue and NOI for the full year will be better than our prior guidance and will fall outside of the original ranges.

We also expect that FFO for the year will likely be at the high end of the prior range. As has been our practice we’ll be providing specific updated ranges during our mid year update in conjunction with our second quarter release.

The earlier than expected recovery affirms our decision to restart our development activity late last year. In anticipation of the recovery cap rates on existing assets have continued to decline and are now in the mid five’s with some of the West Coast even lower.

We believe that beginning developments now while we can lock in attractive construction pricing and delivering into stronger fundamentals in 2011 and 2012, is an attractive use of capital particularly when compared to current cap rates.

Now during the quarter we began construction on one community in Long Island, this is a 350 apartment home community with a total cost of about $110 million. Given the improving fundamentals and the current soft construction market we elected to build this community as a single phase, versus a two phase community as previously planned.

The combination of attractive construction pricing and the added scale efficiencies of the single phase allowed us to reduce our total budgeted cost for this job alone by about $20 million or about 15% from our prior budget.

We currently have seven communities under construction which included the two communities which we started late last year. You’ll notice on attachment eight of the press release that we reported additional savings of about $3 million this quarter which brings our total savings from our original budgeted costs to approximately $50 million on the communities under construction.

We have and are clearly benefiting from a soft construction market. During the quarter we completed the sale of two communities for proceeds of about $83 million, and during April we sold the first phase of a large two phase community in New Rochelle, New York.

The proceeds from this sale totaled about $107 million bringing the total sales for the year to about $190 million. For the second quarter we provided FFO guidance of $0.93 to $0.97 which reflects the positive effect of the improving fundamentals offset in part by the dilutive effects of the recent sales.

Now with that I’ll pass it to Leo who will provide more color on our portfolio performance.

Leo Horey

Thanks Bryce, I will focus my comments on three areas, first reviewing the financial performance of the portfolio during Q1, second highlighting the operating trends or certain West and East Coast markets, and third providing some general comments on the expanded disclosure in our earnings release.

During Q1 portfolio performance exceeded our expectations driven primarily by better than expected revenue performance. Year over year revenues declined less than expected and sequential revenue improved from the minus 2% reported in Q4 to minus 0.3% for Q1.

Importantly sequential revenue turned positive in March and early indications are that this pattern is continuing into April. This is the first sequential revenue increase since Q4 of 2008 and is occurring a couple of quarters ahead of our original expectations.

Occupancy averaged 96.2% for the quarter which was slightly better than the previous quarter and 1% greater than the same period of the previous year. These results were ahead of our expectations and allowed us to push rents more aggressively than anticipated.

Occupancy increased through the quarter and in April this figure is trending to approximately 96.5%. The change in new move in rent improved from approximately minus 6% in Q4 of last year to approximately minus 4% in Q1 and was just over minus 2% in March.

This pattern was consistent in varying degrees across all AvalonBay regions. Turning to renewal rents the portfolio average increased approximately one half of one percent for the quarter. Turnover was 42%, the lowest level in the last four years. These results are encouraging when you consider that renewal offers are extended to residents approximately 90 days prior to the expiration of their lease and as a result, the improvement in renewal rents often lag the improvement in markets conditions by a couple of months.

Our expectation is that these renewal rent increases will continue to accelerate in the second quarter. Given the upward momentum we are seeing in both the economy and the apartment market, our current operating strategy in most regions is to push rents more aggressively.

So don’t be surprised if you see us come off of these high occupancy levels as we find the optimal pricing points. This is important as we enter the seasonally stronger spring and summer leasing periods when 60% of all expiration occur.

Occupancy comparisons during the second half of 2010 will be more challenging but continued improvement in the year over year results is dependent on continued growth in rental rates. Looking more specifically at individual regions, the West Coast continues to lag the East Coast from a performance perspective, but all regions show signs of improvement.

In Northern California internet and technology companies are hiring. Occupancies are solid at approximately 96.5% in the San Francisco and San Jose markets and new move ins and renewal rents are stable or beginning to increase.

Similar patterns are evident in Southern California and Seattle, although from a more modest occupancy platform that increased substantially from the same period last year to approximately 95.5% for the first quarter.

Moving to the East Coast, average rental rates are flat to up slightly on a sequential basis and occupancies are almost uniformly in the low to mid 96% range. This is generally being driven by job markets that are stabilizing sooner than on the West Coast coupled with declining new supply.

On the jobs front the cutbacks in the financial services sector are not as significant as originally anticipated. In addition employment trends in the education and healthcare sectors have remained stable through this economic downturn and most of our East Coast markets have a higher share of that employment pool than the US average.

Looking at individual markets, the New York Metropolitan area has experienced some job gains over the last several months and this has helped drive improvement in new move in and renewal rent change. In Boston recent job growth and limited new supply allowed occupancy to increase to almost 96% by the end of the quarter with few concessions being offered.

New move in rent change improved throughout the quarter and renewal rent change was positive in each of the three months averaging approximately 2.5%. The DC Metropolitan area continued to perform well. Continued job growth produced positive rent change on leases that expired but this was tempered by pockets of new supply.

Before concluding I want to highlight the two new schedules in our earnings release, attachment four provides visibility into the contributions of the different operating components from assets not included in the same store sales portfolio.

Attachment seven provides additional detail on the components of operating expenses for the same store sales portfolio. Expanding on the information provided in the new attachment seven, severe winter weather on the East Coast contributed disproportionately to the increase in repairs and maintenance.

For example approximately $550,000 of the million dollar increase in this category is attributable to snow removal in the Mid Atlantic alone and we expect some residual costs related to the winter weather will extend into Q2.

Office operations is driven by bad debt which was higher than the same period last year but continued to trend down to more normal levels.

So in summary we expect four factors to continue to support the more favorable revenue trends that we experienced during the quarter. First, improving job growth will boost household formations. Second, demographics will continue to increase rental demand. Third, home buying remained out of the reach for many renters in our markets, and finally, new supply is being absorbed and future supply is very limited.

As a result we are actively increasing rental rates in virtually all AvalonBay markets to ensure that we capitalize on the improving demand supply conditions and secure the highest rents possible as we enter the peak leasing season.

With that I will turn the call back over to Bryce.

Bryce Blair

Thanks Leo, so given the recovery, apartment fundamentals appears to be taking hold a bit earlier than anticipated it has impacted some of our investment and operational activities. First it makes us feel even more confident regarding our decision to restart our development activity and it will likely result in our beginning a bit more than we originally planned.

Secondly while the recovery should and does make us increasingly interested in acquisitions unfortunately we’re not alone. As the economic has improved so too has buyer interest which in turn has pushed both cap rates and total return expectations down.

And while we’ll continue to focus on acquisitions we do expect the volume of purchases to be relatively modest. And finally as Leo mentioned we will continue to push our rental rates given the improving outlook and our high occupancies.

That concludes our remarks and we’d be glad to answer any questions that anyone may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Paul Morgan – Morgan Stanley

Paul Morgan – Morgan Stanley

You mentioned, did I get this right that your new revenue guidance is based on 800,000 jobs.

Bryce Blair

We have not given revenue guidance, we’ll be giving updated revenue guidance, we believe based upon the portfolio performance and our expectations of the year that we’ll fall outside of the original range we gave.

Paul Morgan – Morgan Stanley

So put another way the statement that you’d be above your range is that based on because you gave 800,000 number, is it based on that type of view, because I guess my point there is is that still relatively modest if you at what we did in the first quarter basically its sort of a flat job growth, how are you thinking, I guess as you’re rolling over some of the leases that were signed during a very tough period say in the second quarter, maybe another way of asking this is what kind of spreads on renewal activity do you think you can start to push for as we look at the second quarter.

Bryce Blair

The job numbers to clarify, the 800,000 is looking at the amount of gain throughout the year, we’ll be comparing in essence of fourth quarter of 2010 to the fourth quarter of 2009, but as my earlier comments mentioned, what we are seeing in terms of portfolio performance is driven by a lot of factors more than job growth and that is different than in past times where we’ve always talked and industry has seen such as very strong linkage between job growth and portfolio performance.

This time there’s lots of other factors effecting it, some would say more so than jobs. To the second part of your question in terms of strategy on renewals I’ll let Leo address that.

Leo Horey

As we’ve discussed in the past we push renewals as aggressively as we can and monitor our turnover and our reasons for move out to gauge as to whether we’re pushing too hard or to ensure that we’re pushing hard enough. As I mentioned our turnover for the quarter was 42%, was down about 5% from the previous year so we are testing much more aggressive rates on our renewals.

Maybe equally as important our reasons for move out in many cases are returning to historical norms and we haven’t seen that reasons for move out related to financial, in other words that we’re pushing too hard is coming forward. To try to give some perspective on the future, if you look back to 2004 when sequential revenues turned positive the first quarter of 2004 they were slightly negative and then they went positive and for the next four quarters the sequential revenues were roughly between a half a percent and a percent.

So does that answer your question.

Paul Morgan – Morgan Stanley

That’s helpful, thanks. My other question was just on development, obviously the acquisition environment is very competitive right now as you look at opportunities from the development side for actually new land rather than what you have in your inventory right now how competitive is the market for land deals and have you seen a significant move, residential land in some markets is up but how about for multifamily.

Tim Naughton

Our multifamily, we just really seen a lot of activity to date. I think you were mentioning what we’re seeing on the singe family home lot side where it has been competitive I believe, frankly just a lot of land just hasn’t come to the market on the multifamily side. We did put three new development rights under contract over the last 90 days, represents about $180 million in projected total investment but we’re lot seeing a lot of competition.

There’s some competition but clearly as Bryce mentioned a lot less than we’re seeing on the improved asset side.

Operator

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

Alexander Goldfarb – Sandler O'Neill

Just want to go to the two part on the development side first the increase in the development yields, its about 6% this quarter in the supplemental packet, last quarter it was about 5.5%, is that solely attributable to the new Long Island deal coming on board or have the NOI assumptions changed separately, because rents for those projects looks to be the same. So I’m wondering what accounts for the difference in yield.

Tim Naughton

Its just a function of mix, actually rents and NOI is relatively flat from last quarter. It’s a combination of the Long Island deal that you mentioned coming into the bucket but then also several communities leaving the bucket that had been completed last quarter.

Alexander Goldfarb – Sandler O'Neill

So going forward is the 6% something sort of reasonable or we should expect that number to bounce around as projects come into the queue.

Tim Naughton

We would expect that number to move around a little bit and gravitate probably upwards over time, most of the deals that we’re looking to start in 2010 are more on the order of 7% plus in terms of initial projected returns so assuming that rents at existing lease ups stay stable as they did this last quarter we would expect that to gravitate up a bit.

Alexander Goldfarb – Sandler O'Neill

And then how close do you think you are on restarting high-rise development.

Bryce Blair

Tim mentioned last time the deals that underwrite best right now are wood frame, northeast deals. That doesn’t mean they’re the only ones that underwrite, so we do expect during 2010 there’ll be at least one maybe two high-rises that we will start. But we haven’t given specific guidance on which ones those are yet.

Alexander Goldfarb – Sandler O'Neill

No that’s fine, it was the color given the apartment recovery starting sooner than anticipated, just wanted to get a sense of how that filtered into your high-rise so that comment is helpful. Final question just going to the supplemental packet, appreciate the two new pages but we missed the JV page with the pro rata debt, so one can we see that page come back to the supplemental and two, can you just update us on your pro rata share of JV debt.

Thomas Sargeant

We’re going to put that schedule in the Q so you won’t miss it for long. So if you can just stay tuned for another week you’ll have it in your Q.

Operator

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

Michelle Ko – Banc of America

Good quarter, I was just wondering if you could help give us a sense for how much rents are off from historical peaks, I realize that this cycle is a little bit different then last cycle, but just to give us a sense of this by market would be helpful.

Tim Naughton

Off of historical peaks I can tell you that the rent levels right now and it’s a little bit challenging to do this because the bucket moves every year but the rent levels that we’re seeing right now are back in the, the market rent levels are in the 2006, 2007 timeframe and the actual percentage I don’t have in front of me, I’m sorry.

Michelle Ko – Banc of America

I guess just asked another way we’re just trying to figure out how much upside you could see from your current rent levels now, so given probably the effective rent levels of some of your private peers, maybe they’ve cut back on concession so you’ve seen some growth just from taking back that one month of free rent which would be about 8% and then maybe once you eliminate all concessions you get that 8% and then you have growth on top of that from job growth, maybe up in the mid to high single-digits just trying to get a sense for what the growth potential is over the next year or two.

Leo Horey

Maybe a way to look at it is I had mentioned over the next four quarters based on our experience previously the sequential ran at about a half to one percent, [inaudible] four quarters out last time so was running sequentially more like between 1% and 2%, so you know, a year out we could certainly be in the 5% range.

Bryce Blair

Maybe to add just a little bit more color we certainly appreciate where the question is coming from we have, our hesitant to offer much in the way of guidance a year or two out, I would though as we pointed to before Ron Whitten who I think is pretty well regarded in the apartment space does have projections nationally that shows run away growth in excess of 6% in 2012.

And if you just look at our performance coming out of the last downturn within a year and a half to two years of the turnaround we were seeing revenue growth in excess of 7%. So that may give you at least directionally orders of magnitude.

Operator

Your next question comes from the line of [Eric Walsh] – Citigroup

[Eric Walsh] – Citigroup

Just looking at your expectations now versus when you gave guidance in early February what has surprised you the most relative to your initial estimates that have led to this better than expected sequential improvement, is it lower turnover due to job losses, home purchases, increased traffic, less price [inaudible] from renewing renters.

Bryce Blair

Its certainly all of that as I mentioned in my comments, but I would just emphasize again just the improvement in consumer confidence that while the job numbers for the year are projected to improve they’re still pretty modest and none of that really yet translated into increased renter demand.

Having said that the household survey of job data which I alluded to has suggested there’s been job growth really happening since December so we wouldn’t be surprised to see the employment data get revised upwards to show that there has been more job growth happening.

But the simple fact of seeing such a spike in consumer confidence I don’t think we can underestimate how that impacts people’s decision to make bigger decisions and a rental decision whiles it’s a big decision its not like deciding to buy a home.

So a little bit of improvement in consumer confidence particularly in that younger age cohort which are 75% renters, does a lot to boost demand for rental apartments. So if I had to pick one factor for all of us analytical types you like to look for exactly where is the job growth and I think in this case it’s a lot more driven by improving sentiment and people willingness to feel good about their condition in order to make that rental decision which is not a huge decision but is an important one for so many people.

[Eric Walsh] – Citigroup

Just given the better environment that we’re in right now, the sequential improvement that you’re seeing as well as the soft construction market can you just give us a sense for how much development you could feasibly start later this year. You mentioned one or two potential high-rises as well as some other wood frames, just trying to think about the overall level relative to your initial expectation of $400 million.

Bryce Blair

Well as you mentioned we did give guidance of about $400 million initially, that number might be $100 to $200 million higher than that so to give a ballpark, its not going to be double that. There’s still a pretty significant process to get a deal ready to go in our markets. So while we have a large pipeline there’s probably as I mentioned maybe another $100 to $200 million above that $400 that we may start this year.

[Eric Walsh] – Citigroup

And just as far as the disposition guidance of $180 to $200 million you’ve already sold $140 million year to date given the strong demand that we’re seeing from institutional buyers do you think you might increase that a bit or are you pretty comfortable at that $180 to $200 million.

Bryce Blair

Just to clarify we actually have completed all of that with the sale of New Rochelle that I mentioned so the $190 million have all been closed. That was our original guidance, we have not made a decision to increase that although we might, our level of sales activity we have varied quite significantly from in the past just responding to market conditions.

But for right now we have completed all that is planned and I’d say wait for the second quarter in terms of any additionally guidance on that.

Operator

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

Jay Haberman – Goldman Sachs

Just a question sticking with the development theme given that the company has very low leverage today and rents are at trough levels you mentioned how costs have come down, labor costs are down as well, what level of development do you think makes sense in this cycle given that many of the apartment executives are talking about two to three years of sustained positive NOI growth.

Bryce Blair

When you say level you mean in terms of relative to our—

Jay Haberman – Goldman Sachs

As a percentage of enterprise value. Do you think that the company will increase development as a percentage of total enterprise value similar to where you were in past cycles.

Bryce Blair

Certainly you should expect it will increase from its current level, we have said previously and I still feel that we will probably not get back to the same level that we were a couple of years ago where we hit, and were $2 billion. That in hindsight was probably a bit much and yet we do certainly are looking at development optimistically and do expect that we will have a big year in 2011 as well in terms of starts.

Tim Naughton

Its still opportunity driven as well, obviously that balance sheet and I think capacity to do more to the extent that it makes sense but even the deals I mentioned earlier that we’re starting this year that are projected to have initial yields north of 7%, that’s not true of the entire development pipeline.

And not necessarily true of any deal that’s being marketed today, new land so so much of its going to be opportunity driven at the end of the day.

Jay Haberman – Goldman Sachs

And just following up on the question on dispositions I think you mentioned in the past looking at possibly selling in California and perhaps Silicon Valley when you mentioned cap rates in the low five’s possibly even below that, is this a good time to start thinking about increasing dispositions there.

Tim Naughton

We actually have sold a fair bit particularly in San Jose over the last few years so we don’t feel as strong of a need just from a portfolio allocation standpoint to sell many assets there. Having said that interestingly in Northern California in particular there is nothing on the market. The things that we’ve seen sold on the West Coast for the most part have been in Seattle and Southern California so at least right now the market sentiment would seem to say no its not a good time and that just may be owners looking at the fundamentals, being more bullish about the fundamentals in that market than such that would justify selling today.

And I think most, many owners, volumes are still well, well down from both long-term averages and peak and I think most owners are looking at the same fundamentals that we’re all looking at in 2012 to 2015 which look like they’re pretty positive and have taken advantage of the refinance market and have chosen to refinance instead of taking the asset to market.

Jay Haberman – Goldman Sachs

When do you expect to see more supply come back to the market, i.e. the private market either from the recovery in credit markets or just optimism about rent growth going forward.

Bryce Blair

Well we certainly haven’t see it yet and the ability to attract construction financing for apartment development today is very very difficult, projections as I’m sure you all know of first starts this year to be less than 100,000 which would be around a 40 year low so we don’t see it picking up in the near-term but we also have learned to never underestimate the entrepreneurial spirit of the private developer and their ability to over build.

So, we think right now its going to be quite low for some time but its certainly not going to stay there forever.

Operator

Your next question comes from the line of David Bragg – Unspecified Company

David Bragg – Unspecified Company

On renewal rates could you tell us what you’re asking for today across the portfolio and then break it down by region.

Leo Horey

What we’re asking for what is it that you mean.

David Bragg – Unspecified Company

What increases are you asking for, a people renew.

Leo Horey

The rental rate increases are just going to vary from market to market and frankly its done by individual lease. As far as what type of renewal increases have we been seeing in the New England area I told you that its been averaging about 2.5%.

In the New York Metro area its been more or less flat. When you go to the Mid Atlantic its looking more like 4% to 5%. The Pacific Northwest is still down on a year over year basis but improving in the most current month it was just below 3%, minus 3%. And then Northern and Southern California also have been improving throughout the quarter and in the most recent month was down about a percent and a half.

David Bragg – Unspecified Company

I was just trying to get a sense for how things are trending versus the first quarter, just moving on to targeted return hurdles could you just discuss if those have moved since last call for both acquisitions and development and an IRR basis.

Tim Naughton

I’m glad we qualified that on an IRR basis because that’s increasingly how we’re looking at it, on the acquisition side I would say target returns are in the 8 to 8.5% range on an unlevered basis, I think that’s pretty consistent with market. The market may be a little bit less. On the development side some of which we talked about last quarter I would say target unlevered IRR in the 10 to 11% range which would generally back into an initial yield call it of 7%.

But that’s going to vary by market based upon the growth outlook for a particular market. For instance on the West Coast we would expect the initial yield to be lower because we expect higher growth over time on the West Coast over the East Coast.

David Bragg – Unspecified Company

So you’ve mentioned the 7% number a couple of times but its fair to say that you’re willing to go below that for certain markets where cap rates are lower and you see better growth towards the mid sixes or so.

Tim Naughton

Yes, I think that’s fair, again where we think we can get an unlevered IRR in the 10 to 11% range which would equate into in our view about 200 to 250 basis point premium over acquisition and our cost of capital.

David Bragg – Unspecified Company

Can you just talk about the New Rochelle sale and the decision there to sell that asset especially given the fact that you own, or you’ve built one pretty close to it and second any idea on pricing there would be helpful.

Leo Horey

Yes we did sell Avalon on the Sound, that was developed 10 years ago or so and we still own Avalon on the Sound East as you mentioned which represents about 60% of the number of units so we built about a total of 1000 units in that market. Relatively thin market for that number of units and so the decision to sell was somewhat strategic in the sense of trimming our position in that particular sub market.

In terms of pricing I’ll just say its low 5’s and I would tell you that that transaction was actually negotiated around the end of the third quarter early fourth quarter last year and obviously cap rates have moved since then, but that gives you a sense of pricing and reason as to exiting that first phase.

Tim Naughton

Just one other thing to add is because it may not have been clear, we do continue the first phase that’s been sold so while they are adjacent phases by us managing both gives us the ability to ensure that we’re acting smartly in the interest of both assets.

Operator

Your next question comes from the line of Rich Anderson – BMO Capital Markets

Rich Anderson – BMO Capital Markets

So the development yields again to David’s line of question a little bit the 7% is that on today’s rent or are you sort of projecting rents when those will be coming on line.

Tim Naughton

Those are on today’s rent, so when we’re quoting yields of 7% and cap rates of 5.5% its based upon today’s numbers, current rent.

Rich Anderson – BMO Capital Markets

And when you talk about those IRR what are you assuming as a terminal cap rate.

Tim Naughton

Obviously IRRs are sensitive to both growth rates and cash flows in terminal cap rate we typically use a terminal cap rate a long-term average. Cap rates over the last nine or 10 years [inaudible] experience so and most of our markets its going to be call it 6.25, 6.50 range roughly or about 7500 basis points above where cap rates appear to be trading today.

Rich Anderson – BMO Capital Markets

Just a question or two on the overall sort of movement in the space and a lot of you and your peers are saying a lot of the same things about improving fundamentals and what not but would you argue for or against Class A at this juncture. I’m going to guess Class A but the thought being when people are making this decision they may not leave the couch as you put it and go and spend $2500 a month but may spend $1200 or $1300 a month and sort of stepping stone into the business of multifamily. Is that a fair way of looking at it, do you think you can lag a little bit from the standpoint of your Class B peers or where do you stand on that issue.

Bryce Blair

Certainly the conventional wisdom has been that B’s are going to outperform in a contracting economy and A’s are going to outperform in an expanding economy and at an inflection point there’s a little bit of a static there. You’ve got it to potentially going in different directions when your turning which is about where we are right now.

I will say while that’s conventional wisdom our own experience in our portfolio and maybe less true than many think in that we should never forget that everything trades on a relative basis so if that guy comes off the couch and he helps out the B’s and the B’s get fuller and start to push up rents, well then what does that do to the relative difference between B’s and A’s.

It narrows it and then A’s get stronger and it pushes up, and so the so called rising tide would solve both and when the tide goes out it affects all boats so I don’t think there’s ever a necessarily just a winner and a loser, I think there are going to be differences relatively minor differences at different parts of the cycle and that’s been our experience as you know.

Within our portfolio while we are primarily A’s, we’re not exclusively A’s and so we’re increasingly tracking the relative performance of what you would consider B’s versus A’s and we see a pretty narrow difference between those asset types.

Tim Naughton

Maybe just to add to that is also what’s happening on the home ownership side, conventionally as you come out of a correction, home ownership rates expand, that’s not necessarily what we’re seeing this time around and in early 2000 I think the A’s were probably were disproportionately hit coming out of that correction as home ownership rates were expanding quite dramatically as we know and if anything we’re probably seeing a contracting on the margins so that that marginal renter maybe more affluent than we’ve seen in past corrections which might explain some of what Bryce was talking about.

Operator

Your next question comes from the line of Jeffrey Donnelly – Wells Fargo

Jeffrey Donnelly – Wells Fargo

Actually building on that last question in your respective markets where do you estimate the gap is between A and B asking rents.

Leo Horey

I’d say its anywhere between 10% and 15% I would tell you the gap between A’s and B’s.

Jeffrey Donnelly – Wells Fargo

Do you feel that’s widened in the last two three years or have they remained pretty constant.

Leo Horey

I think its beginning to widen more now and it depends on the market but if you were to follow what Bryce had said earlier, its going to start widening the market share in a stronger position that are deeper into the recovery, its widening faster in a market like Northern California or Oakland its probably still somewhat compressed because it doesn’t have the same strength.

Tim Naughton

I think it also depends what you call an A and what you call a B. If you just looked at our average portfolio rent relative to the average rent in the marketplace we’re about, we trade about 20% premium so if the average community out there is roughly it would be 25, 30 years old and our average community is somewhere between an A minus, B plus, call it 13, 14 years old, we’re trading at about a 20% premium, our average rent to the market.

Jeffrey Donnelly – Wells Fargo

A few of the projects in your development pipeline have seen average rents ratchet up from the fourth quarter not a lot but a little bit but where are those pro forma effective rents as they compare to market rents today I’m curious how you set them and should we expect continued growth there as we roll through the year as market rents continue to turn and maybe even concessions burn off.

Bryce Blair

You’re speaking to the rents on the list of development communities.

Jeffrey Donnelly – Wells Fargo

Correct.

Bryce Blair

Okay so let me just make sure we’re all on the same page of what that is, those are not projections, well when a community is started those are the expected rents, the current expected rents. As Tim mentioned and we’ve said for years, we underwrite on current rents so when a community is started that’s current rent.

That rent remains unchanged until we are materially into the lease up which we define as nominally about 30%. At the time it gets to be 30% or better leased we update that number to reflect the actual leasing performance that’s been in place. So as an example take Fort Green, community was started whatever, 18 months ago, we carried that number until we were about 30% leased then a couple of quarters ago you saw that number go down because that reflected the initial leasing experience at Fort Green given that the market had turned down for the past 18 months.

Now we moved it up this month because our actual leasing performance not our expectations for the future, but our actual leasing performance demonstrated we’re getting those higher rents. Just wanted to make sure we’re all on the same page of how that number is calculated. It is not a projection of where we think leases will be when the community is completed.

Leo Horey

Just kind of speaking to where things are at and what’s expected, I think I would highlight three things. Number one the rents have been basically flat and we’ve been absorbing apartments and that’s been going pretty well. In general the lease ups will follow how our same store markets are performing and obviously those are improving so our expectation is that rents will start to improve over time.

I will want to point out one fact though which is that when you’re leasing up a community all the leases are new move ins. You don’t have the benefit of the existing residents so that can put some downward pressure. Ultimately what we do is we set absorption expectations in each community and when absorption exceeds the expectation that we set then we start moving rents up.

In the first quarter we averaged about 17 net leases per month per community, that was basically consistent with the previous year and with our expectations. As we see more strength and that absorption accelerates then what we will do is we’ll raise rents accordingly.

Jeffrey Donnelly – Wells Fargo

Do you think a lackluster recovery in home prices helps not only the demand for rental products at the margin but could give you an edge particularly with multifamily developers an edge on land deals because single family developers can underwrite better margins in that environment.

Tim Naughton

I’m not sure, I think what’s maybe going on on the single family side with the land that you’re seeing trading I think is just finished lots for the most part but you’re not seeing right now is a lot of raw land where infrastructure dollars are required. In fact I’m pretty sure a lot of the public homebuilders are carrying a fair bit of raw land that they just can’t justify putting new improvements into the ground so I think what we’re seeing first on the single family side is that finished lot inventory sort of clear the market first.

So as a result on the multifamily for the most part is raw land. We’re not seeing much in the way of competition that does come to market from the single family guys for those kind of sites. Its going to be your typical apartment developer at least for the time being.

Operator

Your next question comes from the line of f Michael Salinsky – RBC Capital Markets

Michael Salinsky – RBC Capital Markets

Can you talk about where if you were to go to the market today where you’re looking at unsecured and also what you’re hearing from the agencies.

Thomas Sargeant

In terms of unsecured today on a ten year deal it would be right at 5.25. A similar deal from the GSC’s would be 5.50, and that is a pretty big reversal from this time last year when we were talking about that spread being 350 basis points this time last year, the markets have not recovered. Now we’re seeing unsecured 25 basis points inside the GSC secured. So I think it’s a pretty good indication of how robust the recovery in terms of the debt to capital markets for well capitalized companies has been.

Michael Salinsky – RBC Capital Markets

Just in light of that and given the prepayment you had during the quarter is there a thought given what we’re seeing in terms of pushing the ability to push rents and the theory is are you seeing inflation seeing interest rates rise, is there a thought to start to either swap or term out some of the variable rate debt if you can.

Thomas Sargeant

As you may know we are a big believer in having a certain level of floating rate debt during all times in the cycle. There are certain parts of the cycle you want more floating rate debt and there are parts of the cycle you want less. Right now we’re at about 25% floating rate debt to all debt. That feels about right.

Having said that these are remarkably good times in terms of long-term unsecured debt and you could see us trend that number, I’m not sure it would be as much by strategy, in fact its very hard to introduce floating rate debt in the capital structure but if it went down it wouldn’t be a bad thing at this part of the cycle.

Tim Naughton

We have nothing out on the line so its not like we can term out our line.

Thomas Sargeant

Exactly and its very difficult with nothing on the line its very hard to its really hard to regulate that number because you’re having to do it pretty much with permanent debt and floating rate bond debt is generally not available today.

Michael Salinsky – RBC Capital Markets

Just as it relates to redevelopment given what you’re seeing is there a thought to maybe increased redevelopment even more at this point with the ability to potentially push along those rent increases or do you feel comfortable with where you’re at.

Tim Naughton

I think I’ve talked to this last quarter we are, we are increasing it and we’re actually looking to actually double it this year relative to where its been so there’s only so much the organization can take on as well but all things being equal we could see it maybe increase at the margin but probably not dramatically higher than what we’ve indicated previously.

Operator

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

Paula Poskon – Robert W. Baird

Have you continued to utilize yield management software through the cycle and if so how has it performed particularly during the quicker than expected recovery.

Leo Horey

At the end of the year we had about a third of our portfolio on revenue management software. Today we have about half, we’ve gone from about 50 communities to about 75 communities and we’ve found that the software works well. Some of the benefits that we anticipated which is that it reacts more quickly are occurring.

All that being said there is still a lot of interaction between the centralized revenue management group that sits here in Alexandria and the people on the ground who can provide color and perspective. But I would tell you that the revenue management software has worked well throughout the cycle.

Paula Poskon – Robert W. Baird

How much would you say you’ve overwritten its recommendations.

Leo Horey

I would tell you most times we don’t override the recommendations, we typically go with those recommendations but we do take it into consideration. So I would tell you probably 10% of the time those recommendations get either altered a little or discussed but in general they don’t get overwritten very frequently.

Paula Poskon – Robert W. Baird

And just a housekeeping question, any expenses associated with your corporate headquarter move that might have impacted G&A.

Thomas Sargeant

No, that is not happening in the first quarter.

Operator

Your next question comes from the line of David Harris – Gleacher

David Harris – Gleacher

On the front page of your supplemental disclosures you made reference to the lead certification on the Mission Bay three can you talk about how much additional costs are associated with construction to achieve lead certification.

Tim Naughton

First of all welcome back and with respect to Mission Bay that is our first lead certified deal that we’ve built. Its really going, any incremental costs is really going to depend upon the jurisdiction in which you’re building. In the case of San Francisco, Seattle, Montgomery County, Arlington County in Virginia, the incremental cost is actually quite negligible.

I think in those four cases would be somewhere on the order of 1% to 1.5%.

Bryce Blair

And to clarify the reason that and maybe its clear in Tim’s comments is because those new sellers require such a high level of energy efficiency to begin with so they require in some cases, an approval may even require you to be lead certified so therefore I guess there’s no incremental cost because you’ve got to do it anyway.

So what we do we like many many companies today have a sustainability initiative within the company and on each and every development we look at what are we required to do and then what do we want to do electively and in some cases we do only what’s required because to do any more electively is very punitive and it can be upwards of 10% of costs.

In other cases we elect to go the extra mile because its only a few additional percent. We and others in the industry have done some research on this with residents and unfortunately today residents are just not willing to pay, this is a general statement, but its borne out by survey of 50,000 renters, are generally not willing to pay the additional premium and so that certainly does impact our willingness to invest.

It isn’t just driven on that metric but that is an important metric. Our focus in the area of sustainability is looking first and foremost is what’s going to reduce utility expenses for us and for our residents. A lot of the green initiatives go beyond that to other areas of sustainability which are harder to quantify and some cases are quite costly.

David Harris – Gleacher

Do you have, I know this is a relatively new space, do you have any sense that investment pricing is firmer for lead certification buildings in the apartment area then otherwise.

Bryce Blair

At this point no, but it is something that impacts us as you start to think how might that be five or 10 years from now. In other spaces I understand it is in terms of Class A office but in terms of apartments not in any measurable sense at this point.

David Harris – Gleacher

And again maybe a difficult question to answer but do you get the sense that municipalities are getting more aggressive in terms of asking you to achieve a lead certification or just status as the way we see it today.

Bryce Blair

More aggressive, more municipalities are getting on that bandwagon and unfortunately it’s a very politically in vogue thing to require and sometimes without a clear understanding of what the costs are.

David Harris – Gleacher

My final question relates to your underwriting of interest rate related to development activities, heartening to hear obviously that construction costs are working in your favor but one thing that’s likely to probably go up over the next couple of years is your cost of debt associated with construction, can you talk about that.

Thomas Sargeant

In terms of the cost of construction I think there is a general view that you seem to share that interest rates are moving up and its hard to argue that when you’re at LIBOR is 25 basis points, so there’s certainly not much room for it to go down and to the extent most construction financing is going to be floating rate LIBOR based, yes, its likely to go up.

In terms of our position we have a line that prices at LIBOR plus 40 and that rate will be reset sometime next year so clearly our floating rate debt cost will go up as well. I guess the other point to make though is long-term what we capitalize as a cost of development is based on a weighted average interest rate of all of our debt outstanding unless there’s specific debt to a property.

So I wouldn’t expect that you’d see a big increase in capitalized interest, its just a big base to move over time and you’re not likely to see it. But our true costs, it would be hard to argue they’re not going to go up in the next couple of years.

Operator

Your final question comes from the line of Andrew McCulloch – Green Street Advisors

Andrew McCulloch – Green Street Advisors

On the cap rates you talked about in the low to mid 5% range are those for average quality assets or for higher quality stuff in better sub markets.

Tim Naughton

I think that really represents I would say an average transaction that’s occurring in the market today. Having said that most of the transactions that have occurred in the last three quarters have been core deals and haven’t seen a lot of value add or what you might think of as opportunistic deals.

But there’s plenty of 15, 20 year old core that’s been included in that.

Andrew McCulloch – Green Street Advisors

On your development deals pipeline you have 29 deals with a total capital cost of $2.3 billion I think, how many of those can you hypothetically start within the next 12 months if you concluded the deal did make sense.

Bryce Blair

Half.

Andrew McCulloch – Green Street Advisors

You were active on the CEP program in 1Q and I think the weighted average price was about in the mid 80’s, how do you think about additional equity issuance with your share price now above 100 and can you also share with us how active you were in the CEP program subsequent to the end of 1Q.

Thomas Sargeant

Well the second question first we were largely inactive, we may have issued a small amount in the beginning of April, most of that was issued during the first quarter before the end of March. The whole purpose behind this CEP program as we call it is really to match fund our investment needs, our investment allocations with our sources of capital.

And so over time I think you can expect that we’re going to be probably more closely aligned with the expenditures as they go out as opposed to the past where we had a very, we generally did post debt and equity offerings in very large discrete formats. So I think over time you could expect that as we are developing new assets, we’re going to blend that cost of capital and match it at the time that the development is starting or sometime during the development activity based on capital market conditions.

In terms of what we’ve programmed for the year we’ve said overall that we’d have about $200 million of capital markets activity for the year and we’ll give an update at the end of the second quarter in terms of any additional capital market activity we might expect and that could be debt, it could be equity, it just depends on what the current market conditions are at the time.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Bryce Blair

Thank you all for your time today and we look forward to seeing many of you at NAREIT in Chicago in early June. Thank you.

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Source: AvalonBay Communities, Inc. Q1 2010 Earnings Call Transcript
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