Avalonbay Communities Inc (AVB) — Q3 2018 Earnings Call Transcript

Thank you, Brandon, and welcome to AvalonBay Communities' third quarter 2018 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, this 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. This attachment is also available on our website at www.avalonbay.com/earnings and we encourage you to refer to this information during the review of our operating results and financial performance. And with that, I'll turn the call over to Tim Naughton, Chairman and CEO of AvalonBay Communities, for his remarks.

Great. Thanks, Jason, and welcome to the Q3 call. Joining me today are Kevin O'Shea, Sean Breslin and Matt Birenbaum. Matt and I will provide management commentary on the slides that we posted last night, and then all of us will be available for Q&A afterwards. Our comments this morning will focus on providing a summary of the results for the quarter,an overview of economic and apartment fundamentals, and their impact on current portfolio performance, a review of investment and portfolio management activity where we were very active this past quarter. And finally, we'll share some progress on our Columbus Circle mixed-use development. Starting now on slide 4, our highlights for the quarter include the core FFO growth of 4.1%, which was $0.03 per share above the midpoint of our Q3 outlook. You'll note that we've increased the midpoint of our full-year 2018 outlook by $0.03 to $9 per share. Same-store revenue growth came in at 2.3% and the same-store NOI growth was 3.1% for the quarter. The midpoint of the range for same-store performance, revenues, expenses and NOI, remain unchanged from our mid-year updated outlook. You'll note, however, we did provide additional ranges for a revised same-store basket that excludes the New York JV assets, assuming that deal closes prior to the end of the year as expected. We completed $315 million in new development for the quarter at an average initial projected yield of 6.2% and have now completed $740 million at a 6.4% projected yield for the year. We also started two new communities totaling just over $200 million in Q3. Lastly, we raised $170 million of external capital through the sale of one community at an average cap rate of just under 4.5%. Turning now to slide 5 and an overview of fundamentals, I'll just go through this quickly. As all of you know, the U.S. economy is very healthy currently with the GDP growth running around 3.5%, corporate profits surging by double digits, labor markets one of the tightest we've seen so far this cycle, and household wealth recently reaching record highs before the recent pullback in the equity markets. Turning to slide 6, the economy is being driven by both the business sector and the consumer. Strong business and consumer sentiment is translating into increased levels of capital investment and household formation, both of which are good signs for the housing market over the next few quarters. While these and most other leading indicators are still pointing up, there are some potential risks that are worth watching, including rising geopolitical tensions, the threat of trade wars, and the normalization of interest rates through continued Fed tightening. But, overall, it appears we'll have a solid macro environment in which to operate over the next few quarters. Turning to slide 7, this favorable macro environment is supporting apartment fundamentals, which are showing signs of renewed strength with several drivers of rental demand turning up, including young-adult job growth, which is running above 2% again; wage growth reaching a cyclical high; and housing affordability actually hitting a cyclical low; all positive trends for apartment demand. These drivers are all further supported by demographics as the young-adult age cohort, or those under 34, is projected to experience decent growth for the next five years and not peak until 2024.

All right. Thanks, Tim. Turning first to our current development activity. As you can see on slide 11, our completions this year have continued to meet our initial underwriting and deliver very healthy value creation with yields of 6.4% compared to estimated cap rates for those same assets of roughly 4.5%. In addition, our development portfolio is generating lease-up NOI as expected, contributing to earnings in 2018 right in line with our initial guidance. This quarter we completed Avalon Dogpatch, our largest development completion of the year. This wood frame community which is uniquely positioned in an emerging neighborhood of San Francisco that offers mainly high-rise product was delivered at a very compelling basis, which in turn contributes to its 6.2% yield, a remarkable result for the Bay Area. Turning to slide 12, we have an excellent long-term track record of delivering new communities in accordance with our initial budgets. This is in large part due to us acting as our own general contractor in most cases and having a majority of our trade costs locked in at the time we start a new project. This is particularly important given the increasing cost base in our industry. As Tim indicated, construction inflation is running well ahead of rent increases, a particularly acute issue in the tech markets on the West Coast.

Thanks, Matt. So, in summary, a healthy U.S. economy is supporting stronger apartment market fundamentals in most of our regions, with same-store rent change improving over the last two quarters and so far in Q4. Development activities generally tracking expectations in terms of lease-up and yield performance, although we are experiencing some cost challenges in certain markets, as Matt mentioned. We continue to make progress on our portfolio management objectives through activity in the transaction and joint venture market. Lastly, as Matt just mentioned, we're making really solid strides in retail leasing at our Columbus Circle mixed-use development where we're also evaluating a condo execution on the residential component. We'll certainly continue to share our thinking with that as we explore this opportunity further over the next couple of quarters. So, with that, Brandon, we'll be happy to open the call for questions.

Thanks. On Columbus Circle, when do you need to make a final decision on condo execution versus rental?

Yeah. Matt, why don't you walk Nick through kind of the timeline there?

Sure. Yeah. So, Nick, what we're thinking is that we would start some early pre-marketing shortly in the next month or two, just to start building a prospect list. Then, if we're feeling comfortable with it, we would open a sales center onsite probably in March. One of the things we have to offer that most other new condos don't is that we would have the product to actually show. We think by March or April, we'll have a floor in the tower with four different unit types complete and kind of white-glove-ready, which would provide – so we're not thinking pre-sales before we actually have product to show. If we open on that schedule, we'd open in kind of March, April. If we were going to do that, we would just see how it goes. We would establish internally a minimum threshold percentage of units that we would want to have under contract before we locked in. That might take anywhere from two to four months, depending on how sales go. It wouldn't be until after we reach that threshold, whatever it would be 30%, 40%, 50%, whatever we want, that we would then actually record the condo and start settlement. So we would have optionality all the way up until that point.

Yeah, Nick. And maybe just to add to that, it's probably obvious, but the opportunity costs would be potentially some lost lease-up revenue over the two to three or four months that Matt mentioned, as we're seeing the kind of traction that a condo execution would get.

Makes sense. And if settlements do begin in the back half of next year, what do you underwrite in, in terms of timing for a total sell-out?

To some extent, that's going to be a function of pricing and that gets into some of our tactics and strategy. I don't think we're really at a point where we want to throw a target out there yet at this point for that.

Thanks. And just, finally, given the progress made on the retail we've seen, what are the longer-term plans for the retail? Will you look to sell it once it’s leased or are you comfortable owning and operating longer-term?

Yeah. Hey, Nick. It's Matt again. I think we would probably expect to complete the lease-up of the retail space in the next year or two, and then we'll look and we'll see. Hopefully, there'll be a good NOI stream in place. But we may well turn around and decide to sell that in a couple of years because obviously it is a large retail asset and that's not our core business. But to get maximum execution on that, to go ahead and lease it up, and then we'll kind of see what it feels like at that time.

Hey. Good morning, everybody. Maybe just to quickly follow up on the Columbus Circle retail question there. Can you give us a sense of just how competitive the leasing process was for the space that Target took down and then also what is currently being offered to the market there?

Sure, Rich. It's Matt. I can speak to that a little bit again. There's been a lot of interest from a lot of different categories and for all different kinds of space. We have three very different priced spaces. We have the subgrade space, we have the Broadway frontage ground-level space, and then we have the second floor space. All the subgrade space, a little bit of the ground floor just for the entry for Target and the entry for the second floor tenant and about half of the second floor is spoken for. We're left with probably 85% of the ground floor and a little more than half of the second floor. We continue to see – it's different categories of users. Obviously, those are different rent levels, so they're different kind of tenants. We've had pretty good interest from a wide variety of tenants for the space Target took. We've had a reasonable amount of interest on the second floor. The ground floor space is the most expensive space and probably the space that – the thought was we needed to get the anchor tenant set first and that would generate more traction there. We are talking to folks, but we always expected that to probably be the last space to lease. So we're kind of not surprised with where that sits today.

All right. Thanks for the color there. And then my second question, I appreciate the detail in the earnings release surrounding the New York City JV portfolio impact on same-store results for 2018. Can you help us understand, I guess, in rough terms what the impact on 2019 same-store would be from those assets being excluded from the portfolio?

Yeah. Rich, this is Sean. To the extent that we complete the execution of the JV, whether it's December or January, those assets would be removed from same-store. There would not be an impact on same-store per se. It would be removed for both periods for both 2018 and 2019 in terms of the calculation of the same-store metrics for the calendar year 2019, if that's your specific question. The issues that led to the potential change in guidance as a result of the closing of the JV relate to two specific issues. One is the ground lease that we disclosed previously that we acquired; the fee for Morningside Park last December, that's about $2.3 million. Another roughly $700,000 that relates to the write-off of a retail lease from the third quarter of last year. Those are obviously a tailwind for the 2018 same-store results, particularly on operating expenses, and there was an impact on NOI. That's why it was necessary to indicate what the impact on the same-store performance would be by changing the composition of the basket with and without the New York JV assets.

Okay. Yeah. And I guess to be clear, I mean, obviously the pool will change in terms of the calculation next year. But I guess my question would be, let's assume they were in the pool for all of 2019 and then we compare that number to what the pool without them in 2019 would be, just to get a sense of growth across the rest of the portfolio, if that helps frame it a little better.

Yeah. We're not ready to talk about 2019 in detail just yet. But certainly New York is a market that we'd be talking about that there's a fair amount of supply this year. The supply starts to fall off somewhat next year. You might see some marginal improvement there. But we haven't run through all the metrics in terms of the calculation of what we expect from New York and those assets in 2019 yet to be able to give you enough insight into what the impact would have been if we didn't sell them and they remained in the same-store.

Got it. Okay. Thank you.

Thank you. So, your forecast for supply in 2019 is a little bit higher than this year. Could you break that down, the impact among some of your major markets where you see supply getting tougher or easier?

Yeah, Nick, this is Sean. Happy to address that maybe at a sort of regional level and then insight on a few markets. But as it relates to 2019, in terms of what we expect relative to 2018, we do see supply drifting down a bit in New England, primarily in Boston, up a little bit around 30 basis points in the mid-Atlantic, and then up about 80 basis points in Northern California. You look at the markets where there's some meaningful change to really talk about in terms of increases in supply in 2019 relative to 2018, D.C. is about 3,500 units and then the East Bay and San José are each about 2,400 units in 2019 and beyond what they projected to deliver in 2018. In terms of meaningful declines, what we can see for sure, Boston about 1,100 units, Baltimore about 2,000, Orange County about 1,200, about 2,000 in San Diego. We do expect to see a decline in New York City, but due to the nature of the construction and delivery cycle there, there's some question as to what's going to be delayed moving into next year. We expect some modest reduction there, but probably not what would have been anticipated mid-year when we saw it at that point, which is more meaningful, but we'll be scrubbing that pipeline later in the fourth quarter to provide good solid updates when we get into the January call.

Okay. That's helpful. And then going back to the potential condo sales now in New York, I get that the overall NAV impact may be higher, or the NAV benefit may be higher. But how do you weigh that versus taxes you'd have to pay on sales of units, economic risk for selling units rather than leasing them and, lastly, how this all sort of plays into FFO? And I'd say it feels like investors have kind of discredited condo sales income in FFO historically for REITs. So, how do you kind of weigh all that?

Yeah. Nick, Tim here. First of all, as an investment, when we first got into this, we had a sense that maybe condo may be the highest and best use, just given the fact that there are no affordables here and just the outstanding location. We programmed the community to give us some optionality. While the units are smaller than a typical condominium, they're larger than the typical rental. So we'd always sort of programmed this to provide some optionality. As we got further into construction and we saw what the potential differential was between a rental value, capital highs and condominium, we just thought we owed it to ourselves as good capital stewards to explore further. As Matt mentioned, we think the differential may be about $150 million on a pre-tax basis. Even if you calculate some tax in, that's probably still talking about a nine-figure differential. We think that we owe it to ourselves to explore that. Just the fact that this building is going to be ready for occupancy sometime next year, it is a unique advantage in that we have existing units that we can sell, whereas a lot of condos that are on the market today are on a pre-sale basis that are well beyond that kind of time period in which they can deliver. The cost here, the opportunity cost is a little bit of upgrades that we think would capture value on the rental side as well. If we decide that demand just isn't there at the kind of values that we thought, we can always turn the lease-up on this thing in really a couple of weeks. We don't really see where the extra risk is.

Okay. Appreciate that. Thanks, Tim.

Hi. Just a question on the strength or lack thereof of seasonality this year. Have you seen any benefits from an elongated seasonal lease-up period that may act as a headwind as we think about 2019 versus 2018?

Juan, this is Sean. Not really. I mean, things are pretty much falling within a traditional cycle for us in terms of seasonality. So I don't think there's any material impact if you look at it. There was some discussion around that topic a couple of years ago as it relates to some specific markets and what was happening and shortened durations to the leasing season, but nothing unusual in terms of what we're seeing this year that would bleed into 2019.

And just going back to Nick's question about developments and kind of the earnings impact from an FFO perspective, is there any development – or should we think about any risk to FFO on developments coming online for 2019 kind of with and without going condo on the Upper West Side project?

Juan, this is Kevin. The only development that really is relevant here would be on the Circle. And as Tim alluded to, there would be as a consequence of pursuing a condo strategy, if we go that route, a couple of impacts as we've discussed. We wouldn't have the lease-up NOI, you'd have capitalized interest ceasing as it would for a rental but it would be stopped once those units were made available, and then probably be some marketing costs associated with the pursuit of a condo strategy that would probably be carved out of core FFO. Those are the main things.

When we give our outlook in January 1, we'll be explicit as to what our underlying assumptions are with respect to Columbus Circle and lease-up income as we have this year.

Juan, just one other thing to add to that. There was some discussion as we moved into 2018 that our deliveries in 2018 would be down a fair bit relative to 2017. As we move into 2019, we do expect deliveries to come back up to levels that are more consistent with what we saw in 2017. Obviously, you have to set aside the Columbus Circle which would have different use, but you'd start to see more deliveries coming through which would look different to us in terms of earnings impact in 2019 versus 2018.

Okay. Great. And do you guys mind giving the portfolio-wide new and renewals for the third quarter and what you're setting out the fourth quarter numbers at for renewals?

Yeah. In terms of portfolio-wide numbers as opposed to individual markets, as Tim alluded to in terms of October, we're running around 3% in terms of blended rent change for the entire portfolio. If you're looking at offers, offers are sort of in the mid-6% range for November and December.

Hi. Good morning. Thanks for taking the question. This is really the first quarter we've seen turnover increase in some time, and I'm just curious if this was necessarily by design or just a function of the higher rents on renewals starting to force tenants out? Did you see any notable increase in the regions for move-out?

Yeah, Austin. This is Sean. What you're seeing is a little bit of an anomaly. We had more expirations in the third quarter of this year relative to the third quarter of last year. Turnover as a percentage of expirations was actually down about 220 basis points, pretty consistent with what we've seen through most of this year in terms of reduced turnover. But there is a change to the expiration profile that moves the numbers a little bit from quarter-to-quarter. The trend has been down in terms of reduced turnover, and that remains the case. In terms of reasons for move-out, there's no material changes whatsoever in terms of what we've seen this year relative to last year.

Great. Thanks for the clarification. And then, as you evaluated the New York City joint venture, did you consider including any assets in the outer boroughs, considering that's where it seems like a significant portion of the new supply is being delivered over the next several quarters?

Yeah. Hey, Austin. It's Matt. We didn't. The portfolio that we brought to the market was all Manhattan assets and it was all stabilized assets. That was by design; for the types of capital we were looking to partner with and selling a partial interest sale, we wanted a portfolio that had a fair amount of consistency to it. We were advised by the folks who were working with on it, and I think appropriately, that the more consistent the portfolio could be the better.

Great. Thanks for taking the question.

Hey. Good morning. A question on New Jersey. It looked like revenue growth year-over-year decelerated a bit in 3Q relative to 2Q. Is that a market that you expect to be a bit softer going forward? Can you talk about Northern Jersey versus some of the properties you have in Central Jersey and what's going on there?

Yeah. Drew, this is Sean. Happy to chat about that. In terms of Northern New Jersey, we don't have a significant portfolio there. I'd say what's probably most exposed to this supply is our Jersey City asset. There's a fair amount on the Gold Coast being done, but we don't have a big presence there other than potential impacts on Jersey City. You will see some impact there. The rest of the assets in Bergen County are generally, at this point, in terms of their nature, they perform well without a lot of volatility. So, they tend to just chug along and perform quite well, same thing with the Central Jersey assets for the most part. They don't present a lot of volatility, but they tend to be stable environments.

And I guess a related question as you rotate around New York City, the Fairfield-New Haven market, it's not in the New York metro disclosures, doesn't really grow like Boston but also not a lot of new supply. How should we think about that market long-term? Is there potentially a point where that might make sense for harvesting some capital?

We certainly have been a net seller in the Greater Fairfield market over the last few years. I suspect we will continue that, but that market tends to perform just like the other ones that I mentioned. It tends to run around 2% year-over-year kind of numbers right now. It tends to hold between 1.5% and 2.5% historically in terms of revenue growth if you look at it over a longer period of time. To the extent that we find opportunity to sell some of those assets, we will consider that.

Yeah. Drew, this is Matt. I'll just add to that a little bit. We do think of Fairfield and New Haven as two separate MSAs. We're pretty much out of New Haven at this point. We sold Milford last year, which was our last asset in the New Haven MSA. But of what we have left in Fairfield, a lot of it is much further down county, closer to New York City with better train connectivity. We do have a few assets that are a little more far-flung that we are likely to sell there in the next couple of years.

Okay.

Yeah. Drew, this is Matt. I'll just add to that a little bit. We do think of Fairfield and New Haven as two separate MSAs. We're pretty much out of New Haven at this point. We sold Milford last year, which was our last asset in the New Haven MSA. But of what we have left in Fairfield, a lot of it is much further down county, closer to New York City with better train connectivity. We do have a few assets that are a little more far-flung that we are likely to sell there in the next couple of years.

Drew, it's Kevin. Yeah. I think for now, probably thinking about our leverage target in the low 5x net debt-to-EBITDA turn level seems to make sense. Certainly, we're tracking where capital costs are today and we have been able to sell some attractively priced assets to help support our investment activity. But I think we're pretty comfortable with where our leverage is right now.

Great. That's really helpful. Thank you.

This is Ronald Kamdem on for Richard Hill. Just two quick ones from me. Looking at the projected long-term goals in terms of New York, and given that that's going to be one where you continue to sell, do you guys have a sense of where some of the low-hanging fruits are? Is there going to be more sales in New York City, or is it Jersey or all around?

Yeah, sure, Ronald. This is Matt. As I've mentioned in the prepared remarks, we had been selling more in the suburbs than the cities, but this is really the first time we've sold wholly-owned asset in the city this cycle. The balance right now, which is roughly a third, a third, a third, feels pretty good. We may lighten up a bit more in the New York metro area, but I would look for those proportions to the extent we do. Central Jersey, we might be a little heavy still because we have a lot of development coming in Central Jersey.

Got it. The other one, when you mentioned the two communities in Northern California where construction costs increased, is there any other market where you're seeing that sort of pressure? And can you just talk about maybe some long-term benefits in terms of reducing supplies to those areas?

Yeah, it's interesting. The flip side of the pain, right? Certainly, in terms of hard cost pressure, Northern California would be the most extreme right now. Frankly, Denver is also seeing quite a lot of it. We're not building anything in Denver, but that is one thing that's informed our approach to partnering with others and frankly laying off some of that risk to partners, and through potential capital JV-type structures that we've been looking at. Seattle has seen quite a bit of pressure. It has a little bit deeper labor market and subcontractor base. While it's seen great ramp-up in supply, it hasn't responded quite as aggressively as Northern Cal, but that would be the other region where we're seeing still very strong hard cost growth. The impact on supply, we'll see. As Tim mentioned, we're starting to see it in the start numbers in our markets in general, perhaps more so in Northern Cal. We've certainly seen it in our behavior. You would think at some point it would start to impact starts there.

Helpful. Thank you. That's all I got.

Hi. Thanks for taking my question. On Columbus Circle, when you think about the catalysts more near-term, when you have the flexibility over time to think about condo versus rental, is there something that happened more recently that would tilt this towards condo?

Dennis, maybe I'll start and let Matt jump in if you like. One thing we maybe underestimated was the value of selling a new condominium versus a conversion. Just from a pure value and execution standpoint, we probably underestimated that as we thought about our options when we made the investment in the first place. That’s informed our view a bit in terms of exploring it now rather than saying let's just lease up and see it when the market is white hot. That's probably been the biggest factor. From a rental standpoint, the market has been pretty flat to slightly up, I think Sean mentioned. That really hasn't changed in terms of our view of the rental economics at least on the revenue side.

Okay. And then as you think about just the backdrop of the market, noted a couple of stats there on contract activity being down and pricing incentives being up. What would you be assuming over the next 18, 24 months as far as the backdrop of the market?

Well, I guess the way we're thinking about it is we're going to go into this pre-marketing period and see how strong the market is and let the market tell us. To the extent we get a great response through the broker network, we think we can start converting some of those prospects to contract within that second milestone to actually try to start building contracts. But if the weakness is stronger than we think, we can always turn the lease-up on this in a couple of weeks. We don't really see extra risk.

Okay. That's helpful. And then just one last question on the supply outlook. Today you're looking for relatively stable deliveries in your markets 2018 versus 2017, and then 2019 to be up a little bit. If we go back to earlier in the year, I think 2018 was going to be up more and 2019 would have been a sizable drop. Can you just maybe explain kind of the shifting between the years?

I think – Dennis, it's Sean. When we talked about earlier this year, I think we said we expected some mild reduction for 2019. To the extent that we see more delays than what has been normal the last two or three years, those numbers could even out. The same assets are under construction, and what's actually getting delivered in 2019 is increasing as a result of some movement from 2018. We'll be scrubbing the pipeline hard here in Q4 before we finalize our guidance for 2019. Just based on where we are in the cycle for construction and labor availability, you can say that 2019 number, should expect that probably to come down some as you move through 2019. It's hard to get visibility on exactly where it's going to be and how much.

But net-net, as you sit here today, is that collective 2018, 2019 in your markets higher today than earlier in the year, or distributed differently?

Distributed differently based on what we know.

As a nearby resident, thanks for bringing Target to the neighborhood. On your developments, with the pullback in starts among your competitors, is your strategy now to increase your pipeline going forward or elevated costs kind of keeping you at current levels?

Yeah. John, it's Matt. Our pipeline is driven by two things: Bottom-up, where are the opportunities, where are we seeing the opportunities, and are we getting appropriate risk-adjusted returns based on our underwriting? Right now, I would say the bottom-up constraint is probably at least as significant as the top-down constraint. We don't look at it and say, well, if the other publics are developing less, we should be developing less or more. We really look at it in terms of what deals are out there that are underwriting that provide reasonable returns. We've only signed three new development rights all year this year. Interestingly, three in this past quarter, but these were the first three for the year. One of those is a joint venture on a mall site with GGP/Brookfield, so that's a deal we've been working on for a long time. We're looking at an opportunity in Southern Cal now to do the same.

John, just to put some numbers to it. If you looked at the 2013 to 2016 period, we probably averaged somewhere around $1.3 billion in starts. It was our expectation in 2017, 2018, and 2019 that that was probably going to be down kind of commensurate with what I said, the overall REIT sector is down about 35% to 40%, more in the $800 million, maybe $900 million range.

And is the 6.4% yield that you've had on completions year-to-date, is that representative of your overall pipeline at Columbus Circle, or when you're underwriting for new projects?

The development rates that haven't yet started, the basket as a whole is probably in the low-6s, so it is probably just a little bit under that. But it varies quite a lot based on where you are in terms of geography and product type.

Okay. And just one quick one on Columbus Circle.

No, I mean, the residential address is actually 15 West 61st Street. Whether rental or condo, that's where the front door to the residential is. It's not on Broadway, which is the prime retail space. The retail address is probably a Broadway address. There may be a second floor tenant who technically has a 61st Street address as well, but the retail engages with Broadway, the residential really engages with the side street.

Got it. Thank you.

Great. Thank you. A bit of an oversimplification, but on the condo conversion, looks like about $110 million profit after tax, 172 units, about $650,000 in additional value created after tax. What happens to the retail that we're assuming that you get out of that? Can you make any money on the retail or would the retail offset the value created on a condo?

John, we don't expect to lose money per se on the retail. As Matt mentioned, it's not our core business area, so we're probably a little less confident in our projections here. Based upon our pro forma and the kind of rents we are currently renting at, we think it probably contributes modestly to the profitability of this project.

Great. And then a second question. What's your crystal ball look like for hard costs over the next two or three years, assuming the economy remains reasonably healthy? Is it the north of 5% annual increases or more inflation-esque at 2% to 3%?

No, it's a great question, John. We are seeing a drop in starts in our markets. So, that's the first canary in the coal mine where it might actually see some relief on pricing. You are starting to see builders reporting order volumes being down, so that might help a little bit. We're not betting that it's going to be 2% or 3% or in line with rents, and it's one of the reasons why we're trying to maintain as much optionality on the development portfolio as we can.

Last question, any effect on land prices or are land prices sort of remaining sticky?

Yeah. I think it's still too early. John, this is Matt again. We do get that question every quarter. We're waiting, but land prices are sticky. For the most part, they probably stopped going up. There are some deals that aren't trading. There are land deals that aren't trading. So, in terms of maybe getting a little more favorable, people don't always expect to put it under contract today and close tomorrow. We haven't seen any material decline in land prices that would make up for the increase in hard costs yet.

The thing to remember, John, is land costs are generally 15% to 20% of total capital costs; whereas, construction is probably 65% to 70%, and soft costs maybe another 15%. Land costs will have to come down a lot to make up for the kind of appreciation and escalation we're seeing on the construction side.

Great. Thank you.

Hey. Good morning down there. Two questions. First, as far as the condo and the retail at Columbus Circle, are those now both in a TRS? Or as far as the retail goes, is there some sort of holding period to allow that to be good REIT income versus having it be taxable?

Yeah. Alex, they actually are both in TRSs.

Okay. That's easy. And then the second question is, just as far as New York State goes, with the rent control coming up for renewal next year and the possible change in the Senate and Albany composition, is there any concern that if they change the rent control laws that that would impact your affordable units that are part of your 421-a or those are separate from any legislation changes they may consider?

Yeah. Alex, this is Sean. A good question with a whole lot of speculation around it. Whether the impact would be on affordable homes specifically or more of the market rate homes that are subject to rent stabilization because of the 421-a program, I suspect anything that would be related to the 421-a program would probably be very difficult to get through. I'd be surprised if it was on the market rate units that are subject to stabilization because of 421-a, as opposed to technically affordable units that are set aside. I think we'd likely be okay, but even if something came through that affected the piece that we'd be worried about, it wouldn't be a material impact on the assets.

Okay.

Yes.

Thanks. On Columbus Circle, if you had kept it or if you do keep it for rental, what was the unlevered IRR expectation over the long-term for this site?

Hi, John. We typically don't provide disclosure on projected long-term IRRs, but I think we gave a sense that we thought the economics here on a development basis were in the mid-4% range, including the retail. You'd have to kind of input your own assumptions there in terms of growth and reversion at cap rates, as to what that would translate into an unlevered IRR.

Yeah. Understood. Could you share the contracted retail rents per foot and what's under negotiation? How does that compare to initial underwriting?

Yeah. Hey, John. It's Matt. We're not going to disclose what the actual rents were in the lease. But as I mentioned, the two deals that we have either signed or very close to being signed are both at or better than the economics we had underwritten both in terms of rent and also in terms of TIs and free rent. So, so far, we're tracking a little ahead of our program.

Okay. That helps. Thanks a lot.

Yeah. Hi, everyone. Just want to go back to those East Bay developments. I think you mentioned you had a $40 million cost overrun. Did the subcontractor eat the $10 million? If you have costs locked in ahead of time for the developments, was this driven by increased labor costs or did the whole thing just have to be reworked?

Yeah. Wes, it's Matt. You're right, what we recognized this quarter across those two projects compared to last quarter was $30 million higher. There was an additional $10 million in cost increases we had already recognized on Emeryville. So, relative to what we thought of our initial budgets, that's where the $40 million came from. You thought you had your costs locked in, the subcontractors failed to perform. If they're not making money doing it, they thought they could get labor at a certain price, they couldn't. This is not this kind of market right now, particularly in Northern California.

Yeah. Wes, just to add a couple of general comments. I think they do apply to what's happened in the East Bay. As you get late in the cycle like this where we have a lot of production going on, the lack of skilled labor adds to the pressure. What we experienced is a very low margin of error. If one sub fails, it tends to have a cascading effect on all the subs behind them. In a normal market, if one sub fails, you can oftentimes replace them quickly without an impact to schedule or cost to the other subs. That's not this kind of market right now.

Okay. And then last one for me. We heard that Sears filed bankruptcy and we're hearing from a lot of the retail landlords that this can unlock some densification opportunities. So, have you noticed an uptick in inbound calls to Avalon looking at potential multi-family on retail sites?

Yeah, Wes. It's Matt. That's something we've been working on for a while. In fact, the new dev right this quarter which is at the Alderwood Mall outside of Seattle was a former Sears box. We're working with GGP on it. We assigned a senior development person to work on those opportunities. We continue to talk to mall owners, and we do view that as a great opportunity. I don't think we're seeing anything just because of the Sears bankruptcy yet, but as a general macro trend, absolutely.

Thank you, Brandon. And thanks to all of you for being on today. I look forward to seeing you in the near future. Take care.