Avalonbay Communities Inc (AVB) — Q3 2022 Earnings Call Transcript

Thank you, Doug, and welcome to AvalonBay Communities Third Quarter 2022 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. The 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 will turn the call over to Ben Schall, CEO and President of AvalonBay Communities, for his remarks. Ben?

Thank you, Jason, and thank you everyone for joining us today, here with Kevin, Matt, Sean, and after our opening comments, we will open the lineup for questions. In many ways, Q3 continued our strong momentum from the first half of the year with significant year-over-year increases in our earnings and operating metrics. As referenced on slide 4 of our quarterly investor presentation, core FFO for the quarter increased 21% as compared to a year ago. Same-store revenue increased almost 12% from last year, and 2.2% sequentially compared to our strong Q2 figure. Before progressing further into the presentation, I wanted to emphasize a number of AvalonBay specific drivers of future earnings growth. First up and as Sean will describe more fully, we expect to head into 2023 with an earn-in above traditional levels. In short, just a simple roll through of our existing rent roll creates positive earnings momentum, which can then be further enhanced by our underlying loss-to-lease. There are then three other drivers of earnings growth, which we estimate should generate in the range of $200 million of incremental NOI over the next several years. The most significant of these drivers is the development projects we have underway, which we refer to as projects with yesterday’s costs and today’s rents. Our current lease-ups continue to outperform, currently yielding nearly 7%, and we expect our current development activity to deliver $130 million of incremental NOI upon stabilization, which Matt will cover further. The other two significant drivers are further margin improvement from our operating model initiatives, which we’ve targeted for $50 million of NOI uplift and expect to have delivered about 40% or $20 million of this NOI uplift to our bottom line by year-end and the return on our structured investment program as we build that book of business up to $300 million to $500 million. In a potentially recessionary environment, the $200 million of incremental earnings generated from these activities collectively serve as a ballast for our future earnings. Turning to slide 5. While our Q3 performance was strong, it was short of guidance. Q3 core FFO per share was $0.02 below guidance, and we reduced our full year core FFO per share figure by $0.07, updating our estimate of full year core FFO growth to 18.5%. For the full year, on the revenue side, while we contemplated the return of rent seasonality, the seasonal trend line has been slightly greater than historical norms. On the expense side, turnover has been slightly higher than we forecasted, leading to higher repairs and maintenance costs to turn apartments, and utility costs are projected to be higher. Slide 6 highlights how we’ve been actively adjusting our balance sheet and funding strategy during the year based on the changing capital markets environment. Based on the steps taken by Kevin and Joanne Lockridge and our Capital Markets team, our balance sheet is stronger than ever. Recently, we increased our line of credit by $500 million to $2.25 billion and extended the maturity date out to 2026. Additionally, we have an interest rate swap in place for our next $150 million of debt borrowings and our $500 million equity forward proactively addressed the bulk of development funding through the end of 2023. On the transaction front, we shifted our strategy earlier this year to a posture of selling assets first and locking in the cost of that capital before selectively deploying capital into acquisitions in our expansion markets, which given cap rate movements has worked to our benefit. As part of this shift, we also pivoted during the year from expecting to be a net buyer of approximately $275 million to being a net seller of $400 million or nearly $700 million total swing. In an environment where profit margins on new development are likely to come down and the costs associated with that incremental capital have increased, we’ve also reduced new development starts. For 2022, we reduced our starts from $1.15 billion to a projected $850 million. In 2023, while we haven’t provided guidance regarding new starts, our expected start figure is trending lower than we previously anticipated as we use the flexibility we have with our development rights pipeline to manage our land contracts and the timing of potential starts. We will continue to make adjustments based on trends in rent and construction costs, the spread between potential development yields and underlying market cap rates with a continued target of 100 to 150 basis points to spread and our cost of incremental capital with a laser focus on making the appropriate long-term value-creation decisions. And with that, I’ll turn it to Sean to more fully discuss the operating environment and our approach.

All right. Thank you, Ben. Before I start, I’d like to give a big shout out to all the AvalonBay associates who are out there working hard to provide our customers with a high-quality apartment home and service experience. I’d like to thank you for your efforts with our customers and the performance you deliver for our shareholders. Moving to slide 7. Our strong Q3 revenue growth of 11.8% was primarily driven by higher lease rates, which increased 9.5% year-over-year, the reduced impact of concessions, which contributed 240 basis points and other more modest contributions from other rental revenue and underlying bad debt trends. As noted on the chart, rent relief was a 140 basis-point headwind for the quarter as we recognized $5.7 million versus the $12.7 million from Q3 2021. Turning to slide 8. Same-store trends during the quarter remained quite strong relative to historical norms. Starting with chart 1, turnover increased a little more than we anticipated as we pushed through healthy rent increases, but was still well below pre-pandemic levels. As a result of the increased turnover, physical occupancy ticked down to 96%, but remained roughly 20 basis points above our typical experience during the quarter. Additionally, as noted in the two charts at the bottom of the slide, while our availability increased relative to the last few quarters, we realized a double-digit rent increase on the unit inventory we leased and occupied during the quarter, a very favorable outcome that sets us up well for 2023. Moving to slide 9. I thought I’d provide an overview of some of the key revenue drivers for our portfolio as we think ahead to 2023. Beginning with chart 1, given the very strong rent change we’ve experienced this year, we’ll likely start in 2023 with built-in revenue growth of roughly 4%, the second highest level in our history, and more than 100 basis points stronger than our starting point of roughly 2.5% entering 2022. In addition to the baked-in revenue growth outlined in chart 1, our loss-to-lease is currently running at roughly 6% and is depicted in chart 2, providing plenty of opportunity to benefit from renewal rent increases as leases expire throughout 2023. Shifting to the bottom of the slide, chart 3, our collection rate from residents continues to improve. At the beginning of the year, bad debt was trending in the high 4% range but has declined by roughly 200 basis points as the year has progressed. As eviction moratoria have expired and the courts are continuing to make progress processing new cases, we expect the overall downward trend to continue as we move into 2023, providing a tailwind for revenue growth. Of course, as indicated in chart 4, we’ll likely experience immaterial amounts of rent relief in 2023 as compared to the $35 million we’ve recognized in 2022, presenting a headwind for ‘23 revenue growth. Now, I’ll turn it over to Matt to address development. Matt?

Great. Thanks, Sean. Turning to slide 10. In our current development communities, all of which are in suburban locations that have seen very limited new supply and strong demand over the past few years. These developments are benefiting from today’s higher rents while having a basis based on yesterday’s lower construction costs, resulting in an exceptional yield on cost, as Ben mentioned earlier, of nearly 7%. As these communities reach stabilization, they will contribute strong growth to both NAV and core FFO. As shown on slide 11, the vast majority of our development NOI is still to come. The $2.6 billion in development currently underway is mostly still in the earlier stages of construction and generated only $19 million in annualized NOI this past quarter. As these assets proceed to lease-up and stabilization, we expect another $130 million in NOI, which will drive further earnings growth over the next several years. It’s also worth noting that this future growth is based on our conservative underwriting with untrended rents that are set when construction starts as we typically do not mark rents on these projects to current market levels until we’ve achieved roughly 20% lease status. And again, with only four of these assets currently at that level of leasing, the vast majority of our development underway should benefit from a further lift in NOI when they do open for business as evidenced by the $385 per month lift in rents shown on the prior slide on those four deals that are currently in lease-up. In the transaction market, we’ve also been ramping up our disposition activity in the past quarter, using the asset sales market to source attractively priced capital to fund this development. We were able to close on the sale of five wholly-owned assets in Q3, which were priced before the most recent increase in interest rates, generating $540 million of proceeds at a weighted average cap rate of 4.1% and pricing of $480,000 per home. We also completed the sale of the final assets in one of our private investment fund vehicles last quarter, generating additional capital, with pricing of $470,000 per home and a 3.6% cap rate. Since the start of the year, as best we can tell, cap rates have risen roughly 75 to 100 basis points in our established coastal regions, where we’ve been trading out of assets, while cap rates in our expansion regions have risen more on the order of 100 to 150 basis points. Strong growth in NOI has offset some of this rise in cap rates. But on balance, as values might be down roughly 10% to 15% in our established regions and maybe 15% to 25% in these expansion markets, we think this bodes well for our future portfolio trading activity as the relative value of what we are selling has been less diminished than what we are buying. And with that, I’ll turn it over to Kevin to review our funding position and the balance sheet.

Great. Thanks, Matt. Turning to slide 13, as Ben mentioned in his opening remarks, with the shift in the capital markets this year, we’ve taken a number of steps to bolster our already strong financial position. These steps include having increased our match-funding and development underway with long-term capital to approximately 95% as of the end of the third quarter, up from about 80% at the beginning of the year. As a result, we have locked in the cost of capital on nearly all of the $2.5 billion of development underway, essentially with yesterday’s lower cost of capital, which in turn will help to ensure that these projects will provide earnings and NAV growth when they are completed and stabilized. In addition, as you can see on slide 14, another step we’ve taken is the recent renewal and expansion of our line of credit to $2.25 billion, which is up by $500 million from our previous $1.75 billion line of credit. As a result, we possess tremendous financial strength and flexibility. In particular, at quarter end, we enjoyed $1.9 billion in excess liquidity relative to our unfunded investment commitments of $300 million. Our leverage declined to 4.6 times net debt to EBITDA at quarter end versus 5.1 times in the fourth quarter of last year, and we remain comfortably below our target range of 5 to 6 times. Our unencumbered NOI percentage remained at a record level of strength at 95%, and our debt maturities are both relatively modest in size and well laddered with the weighted average years to maturity of just over eight years. Thus, as a consequence of our conservative approach to balance sheet management and the other actions we’ve taken recently, including the $500 million equity forward that we completed in April at a share price of $255, we possess tremendous financial flexibility and do not need to tap the capital markets to fund our business for an extended period of time. Finally, on slide 15, as you’re aware, AvalonBay has long maintained a commitment to being a leader in sustainability and corporate responsibility. It’s a goal that is consistent with our culture and our core values of integrity, spirit of carrying a continuous improvement, and it is of increasing relevance to our residents, to our associates and to our investors. On slide 15, we are excited to report that we received our highest score yet from the Global Real Estate Sustainability Benchmark, or GRESB. This year, we earned the 5-star designation for the eighth year in a row. We also earned the number one spot among the 11 listed multifamily residential companies and the number one spot among the 37 listed residential companies. We are grateful for GRESB for acknowledging our progress in this important area, and we are especially grateful to our own people for their efforts in making these achievements possible and for their ongoing commitment to making a positive difference in the lives of our residents and the communities in which we operate. And with that, I’ll turn it back to Ben.

Thanks, Kevin. And quickly to summarize, we’re pleased with our continued strong earnings and operating momentum with a number of AvalonBay specific earnings drivers in front of us. In this environment, we have and will continue to adjust our approaches to strengthen our position and to allow us to keep our focus on long-term value creation. We’re confident that we are well positioned for a broad range of potential economic paths and to potentially step into opportunities based on dislocations in the marketplace. And I’ll end by reiterating our thanks to the wider AvalonBay associate base for their commitments to our ESG leadership and their broader dedication to our mission of creating a better way to live. With that, I’ll turn it to the operator to open the line for questions.

Thank you. So, I understand the seasonality returning this year, but a bit surprised that impacted 3Q as much as it did. I was hoping you could provide some more details on when it really started to diverge versus your expectations? And then if there are any specific markets that drove it?

Yes. Nick, it’s Sean. Happy to address that. And you are correct that more of the impact is being felt is our expectation in Q4 as compared to Q3 if you look at the roadmap that we have provided. But for the most part, when we did our forecast, we expected and I communicated on the last call that seasonality would return, but our expectation based on what we have seen thus far is it would be about half the normal rate that we typically see. And we started to see that begin to shift in August, kind of late August for us. It impacted sort of late August and moving into September and then continues to bleed into the fourth quarter. So, that’s really how it played out. I mean, if you look at the rent change that we expected, July was pretty much spot on what we expected. But then, as you move through the balance of the last couple of months here, it has decelerated from what we anticipated, mainly on the move-in side. Renewals have held up relatively well. But on the move-in side, it’s decelerated, which corresponds with the adjustment in asking rents as you move through the season. So, that’s how that played out. And in terms of markets, for the most part, there’s really about three regions that are responsible for most of it: Northern California, the Pacific Northwest and to a somewhat lesser degree, the Mid-Atlantic. Those are really the primary three.

And then, I recognize you guys have been a bit tactical adjusting your approach being net sellers, slowing a bit on the start side. How are you thinking about now being the right time to grow the structured investment product program? And what changes are you seeing to the mezz market and yields there?

Hey Nick, this is Matt. Our entry into that space really was kind of a strategic decision that we made a year or two ago. And so, we’re just building the book. This is the first year we’ve originated investments. I actually think it’s probably a good time to be entering that market because capital is getting more and more scarce. So, for sure, our phone is ringing more and more. And some of that is some of the relationships we’ve established with some of the construction lenders, and some of that is just capital is getting harder to put together for new starts. So, we have the ability to be very selective and measured about the business that we take on, which we’re certainly doing. Our rates are rising a bit in terms of the coupon that we’ll be charging on those investments. And our underwriting will reflect what’s going on in the current market. So, we generally are looking at kind of where our lender basis will be on those assets when they’re completed and compare that to current spot values today. Again, everything kind of trended on the eyes. And then when we look at what the margin is between those two and we want to make sure that we’ve got an adequate margin there of safety in case asset values erode further. So, we think that it’s actually not a bad time to be in the business, but it’s going to certainly be harder for developers to get deals to work, and we may have to look at 15 deals for every 1 that we’re willing to commit to.

I guess on slide 9, if you were to combine the impacts of slide 3 and 4 or charts 3 and 4, kind of into a net bad debt number for all of 2022, what is that number? And what is your expectation for that trend in ‘23 broadly?

Yes. Steve, it’s Sean. Happy to take that one. So for the full year 2022, we expect our reported net bad debt to be roughly 1.7%, which includes the benefit of our estimation of $36 million to $37 million in rent relief that we’ve recognized or will recognize throughout the full calendar year. If you strip out the impact of rent relief, underlying bad debt is associated with our resident base essentially started the year in the high 4% range and is expected to end the year at roughly 2.7%. So, if you look forward to 2023, the way to think about it is, at this point, we expect really immaterial amounts of rent relief, if any, for 2023. As a result, underlying bad debt trends for the full year 2023 would need to average essentially that 1.7% that I mentioned to have a neutral impact on revenue growth for the full year. And so, we certainly expect continued improvement in underlying bad debt trends as we move into 2023. But it’s still early to provide a precise forecast. I’d say at this point, based on what we know, in terms of what’s happening with eviction moratorium in L.A. as an example, expiring in February and how things will play out in the courts and in markets like L.A. It’s probably more likely than not that net bad debt will be a modest headwind to 2023 revenue growth based on what we know today.

And then just secondly, maybe for Matt. I realize pegging construction cost is a little difficult. But if you were to kind of look at the projects that are maybe most near term on deck to start next year, where do you think those are sort of penciling out on a return basis? And is it that you need to see costs come down more to make those really work, or is it that rents need to keep going up to get them into the zone?

Yes, it really depends on the market and the region. Our target yields have been increasing. Currently, our development underway is achieving high-5s yield, and many of these projects will exceed 6 when they begin leasing, as they are not yet marked to market. The projects in the pipeline that haven't started are underwritten to an average in the mid-5s, which is a slim margin based on current cap rate trends. Some of these projects will likely yield returns above existing cap rates and our targets, leading to substantial value creation, even considering today's hard costs and rents. However, some projects might need assistance regarding hard costs, which may need to stabilize or decrease. Some could also require us to reassess the land, as we've only purchased land for 7 out of over 30 development rights we hold. This provides us the opportunity to negotiate with land sellers if needed. It's a combination of factors. We're starting to observe hard costs leveling off with improved bid coverage in many regions, and there's a reasonable possibility for some trades to see reductions in hard costs. Certain commodities like lumber and copper have decreased, but overall, total hard costs remain significantly higher compared to last year, if not sequentially as well.

Steve, this is Ben. I want to add that was well expressed by Matt. I would like to highlight a few points. This really underscores the underlying flexibility we have in our development rights pipeline. One aspect is the potential to reacquire land at today’s values. The other, which may not be as significant, relates to timing. This allows us to manage the timing of our pipeline, which could facilitate some of the normalization you mentioned concerning the trends in rents and construction costs.

Great. Just one last one for Sean. Just are you seeing any sort of behavioral trends, doubling up, roommates, folks moving out just in any markets that creates any sort of concern going into ‘23 from a demand perspective?

Yes. Steve, nothing at this point, no. I mean, the trend that we talked about as we move through COVID, was the fewer number of adults per household. We looked at that carefully in the third quarter that sort of remains a tax. So, we’re not seeing the behavioral elements as you talked about that relate to people feeling pinched if you want to describe it that way. I mean, new lease income for our residents moved in, in the third quarter was up 11% compared to last year's move-ins in the third quarter, move-in values were up around 10%, 11%. So it sort of matches, things are kind of running equal. And then, the only other thing I’d say is we continue to see good movement into our markets in terms of what we call these big moves I mentioned in the past, which is people moving in from greater than 150 miles away. That was up roughly 20% in terms of volume in the third quarter as compared to kind of pre-COVID norms, solid trend in the urban environment, solid trend in the suburban job center environments. Same trend, but not as strong in some of the more outlined suburban areas. So, that trend continues, which I think is a function of a number of different things, but certainly, people being called back to the office on a more consistent basis, probably has something to do with that.

So, I appreciate all the detail you guys gave on seasonality, but the guidance reduction was a bit of a surprise given the loss to lease position you were in back in July. And I’m just curious if at any point you considered providing an intra-quarter update for operationally about what was happening more real time through your portfolio?

Yes. That’s not our practice overall. So, we didn’t feel like there was necessarily the need to do that. And if you look at the breakout of the roadmap for the third quarter, the revenue where things came in relative to our expectations was $0.01, and that’s it. So, we didn’t feel like it was material enough to preempt the normal process that we go through.

Understand. And then, just going to development a little bit. You guys have historically targeted development in the 10% to 15% of enterprise value, you’ve been running below that for various reasons in recent years. But over time, I guess, what’s the right level of development that you think kind of gets the benefit of value creation and also manages the earnings impact throughout a cycle without really getting dinged for the various risks associated with being in that business?

That's an excellent question and one we've discussed strategically. I want to make a few comments about it. As we consider opportunities in our expansion markets, we're increasingly focusing on our type of customer and knowledge-based worker in those areas. This enhances our capabilities, particularly our development platform, and expands our marketplace. That’s part of our initiative. Regarding our current percentage compared to our goals, you're correct that we've been in the 4% to 5% range. Last year, we were actively working to build our development rights pipeline to seize opportunities. However, when our cost of capital shifts, we will adjust our return expectations and the scale of our activities. In the long run, we aim to increase our development portfolio as a percentage of our operations from its current level, but we acknowledge that in the short term, we will be more cautious due to the broader economic climate.

And then, just last part. So, when you kind of look at the development pipeline today, I know there are moving variables specifically in the owned versus option land portion. But what percentage of those deals would price based on the 100 to 150 basis-point spread you outlined in your prepared remarks?

I can't provide a specific percentage at this time. Many of the deals currently undergoing an entitlement process are still a few years away from completion. While we are skilled at navigating that process, the results can be uncertain, leading to a wide range of possible outcomes. It's difficult to determine exact figures, but I can say that a significant number of projects are viable in the current market. Additionally, many projects will likely need some adjustments, whether related to cost or land value. We will continue to address these changes within the dynamic environment we are in.

First question, can you talk about any differences you’re seeing between your urban portfolio versus suburban assets?

Anything specific, Jeff, just in terms of performance trends overall or…?

Yes, exactly regarding performance trends. Can you expand on move-ins compared to turnover and rent trends? Are you noticing any differences between urban and suburban areas, or are they behaving similarly?

Sure. I appreciate that. Regarding rent changes, we've reported that in the earnings release. I mentioned earlier that the rent change for the quarter was around 11%. As expected, urban areas experienced a slightly higher rate at about 12.5%, while suburban areas were around 10.2%. However, I noted some weaknesses in urban regions, particularly in Northern California and Seattle, compared to places like New York City or Boston. Overall, rent income is increasing with new lease agreements. Additionally, we're seeing more move-ins from locations up to 150 miles away into our urban and suburban job centers as opposed to more remote suburban areas. Those are the main points I wanted to highlight.

Jeff, regarding the comparison between suburban and urban areas and the overall strength of our portfolio positioning, let's discuss supply. Two-thirds of our business is in suburban coastal markets. New supplies of stock have been around 1.5%. Looking ahead to next year, this figure is likely to decline slightly. In a potentially softening or recessionary environment, we believe that markets with lower supply will demonstrate greater durability and resilience.

Thank you. To clarify, are you saying that’s suburban versus urban or you’re saying in all, lower as a percentage…

So, that’s our 1.5% of stock. That’s in our suburban markets. And supply is higher in our urban markets. The other third of our portfolio is obviously also higher in the Sunbelt markets, right? So, as we look out on overall portfolio positioning, we think we’re in a relatively strong place from that perspective.

Thank you. I have a follow-up question about turnover. I believe you conduct surveys to understand the reasons for employee departures. Could you provide some insight on that?

Yes, we track that and monitor various relevant factors. Regarding turnover, the third quarter was the first quarter this year where turnover was not significantly lower compared to last year. Looking back at the data we provided in the earnings release attachments, turnover in previous quarters showed a year-over-year decrease of around 500 to 800 basis points, while in the third quarter, it was essentially flat year-over-year. We experienced slightly more turnover than we expected. One reason is an increase in people moving out due to rent hikes, which is expected given our rent increases. Additionally, I previously mentioned an improvement in the underlying bad debt trend, influenced by several factors, including more evictions as we progress through the court system or individuals leaving before their court dates. These are the main reasons for the increase in move-outs. Other reasons, such as relocation, have decreased, particularly regarding home and condo purchases.

Thank you. Just curious on the move-outs because of rate, do they comment on if they’re going back to live with parents or do they comment on what they’re doing? Are they going to a lower-priced unit elsewhere?

Yes. That’s usually anecdotal. We don’t always have that data that we track it well. We track the ZIP code, so we have that kind of information. But in terms of what they’re actually doing and the reasons behind it, it’s kind of behavioral things and various things like that, that tend to be anecdotal as opposed to real data that you can count on.

I just wanted to ask about rent-to-income ratios in the portfolio, kind of the latest metric that you have and maybe how that compares to a year ago, two years ago or maybe kind of pre-COVID?

Yes, that's a good question, Adam. The best way to understand it is to look at the new move-ins during the third quarter this year compared to last year. The household income of these new move-ins has increased by about 11%, and the value associated with these move-ins rose by approximately 10%. Essentially, people are moving in at a consistent level in terms of rent to income ratio. We have individuals moving in with significantly higher incomes, and our rents have also increased correspondingly. It all aligns well. Of course, some people are moving out due to rent increases, which is to be expected given the adjustments we’ve implemented. However, we are still attracting demand from individuals who can comfortably pay our expected rents, and their income levels seem to support that.

Got it. That’s really helpful. And then, just in terms of the kind of loss to lease, I think it was 15% last quarter. I know you guys disclosed 6% last night. Just in terms of how you view kind of the last couple of months of the year here. I mean, do you anticipate kind of still having a loss to lease as you enter next year, or is kind of the rents that you’re going to run, so you’re going to sign in the next couple of months, probably going to heat up into the kind of that last 6%?

Yes, that's a good question. We won't account for everything, but a straightforward way to look at it is that in the fourth quarter, around 20% of our leases typically expire. Those tenants will receive renewal rent increases, which will affect the loss to lease. In the third quarter, closer to 30% of our leases expire, and that is when rent seasonality begins to take effect. Therefore, the third quarter tends to have the most significant impact due to the increased lease expirations combined with rent seasonality. The fourth quarter usually has a more moderate effect on the loss to lease compared to the third quarter. Does that make sense?

Yes, that does. That’s really helpful. Just a final one here, I think the kind of revenue disclosure around this kind of 2023 building blocks is all really helpful. Just wondering on the cost side, and apologies if you guys mentioned and I missed it. But look, I think some peers kind of across the resi space are talking about property tax expense increases kind of given various dynamics there, certainly inflationary impacts, right? I was wondering, maybe again, not asking you to guide here, but just maybe put a little bit of color around 2023 expense growth kind of building blocks or kind of potential headwinds there?

Sure. Let me share some insights on the top three or four expense categories. Starting with property taxes, which represent the largest portion of our expenses, we anticipate this year's figures will be just under 2%. However, we don't expect to maintain that 2% rate as we move into 2023 and 2024. There will likely be upward pressure due to rising rates and assessments, as others have mentioned. Payroll costs, similar to 2022, should remain tightly controlled because of our innovation initiatives, and you can see these details in the expense attachment of the earnings release comparing 2022 numbers. Regarding repairs and maintenance, we expect some wage inflation from our contractors and a potential increase in turnover. For utilities, there may be rate pressure in the first half of 2023 due to a procurement contract we entered into mid-2022. Additionally, while we will face some pressure from our bulk internet and smart access offering, we anticipate substantial profit growth from this segment, likely more than tripling the 2022 level. Overall, while we may encounter some operational expense pressures, we expect a significant boost to net operating income from the revenue generated by these activities. These are the main categories to consider for the upcoming year.

Matt, to your earlier point regarding renegotiating land pricing on the development rights pipeline, from the conversations you’re having with brokers and other market participants, are you getting the sense that land sellers are starting to capitulate on pricing? And if so, to what degree?

Yes, Alan, I would say it’s early. Land typically accounts for only 10% to 15% of the total cost of a project, possibly up to 20% in higher rent areas. Therefore, it doesn’t significantly impact costs compared to construction expenses. Land transactions tend to take a long time to finalize. The land deals closing now may have been negotiated several years ago, depending on the region—1 to 5 years in California or possibly just 6 months in Texas. They are lagging indicators. Although brokers' insights may be somewhat aligned, it will take time for this information to filter through the market. We are noticing these trends first in the transaction market, and gradually, they will influence the broader system.

I have a question about the reduced development starts. Ben, in your prepared remarks, you mentioned the possibility of compressed profit margins. I assume that refers to the difference between yields and market cap rates. If that’s accurate, what are you projecting for cap rates on the developments you are starting now?

John, the profits have come down. If you look back a year ago, we were running at development profits that were to the tune of 50% because the spread between where we are developing to the underlying cap rates was out to 250 basis points. That’s the type of arena. So, that has compressed. And what I would guide you to, as I mentioned before, is our focus on maintaining 100 to 150 basis points of spread between where we’re developing and where underlying cap rates are. There can be and like would be certain deals that are slightly below that. But as a group, that’s the approach.

On the development and lease-up going to almost 7% yield, is that specific to those projects because your overall pipeline is at 5.8%? So, I was wondering if it was just these projects and leased up are currently at those levels, or is there a difference in the way that you calculate the rent as part of that stabilized yield number?

Yes. Hey John, it’s Matt. To clarify, that yield pertains to four deals out of the 17 development communities that are currently in lease-up. These are the only four we’ve marked-to-market, and they are coming in at those levels. Initially, they were underwritten at about 6.5%, which made them some of the higher-yielding deals in the development book when we began, due to factors like timing and location, a lot of which are suburban Northeast projects. If the other properties experience a similar increase in rents when we mark them to market as they start leasing, that could raise the overall yield of the remaining properties by another 40 basis points. However, this will depend on changes in market rents from when we initiated the deals to when they start leasing. We may see less or more than projected, but for those deals, we noted that 40 basis points increase. So, just to clarify, the 5.8% yield on your overall development pipeline, that’s on your original underwriting, or is that based on the current market rents? So, it’s based on the current market rents on those four deals, which are the deals currently in lease-up, and the other 13 are at what the initial underwriting was. So like I said, the other deals have the same amount of with that overall 5.8%, we’ll probably rise to a 6.0% or 6.1% is a way to think about it. That 5.8% represents 4 deals that are in lease-up and 13 deals that are not.

So, two items. First, on the turnover, you mentioned in the presentation that turnover is still below pre-pandemic levels. I'm curious, as the actual numbers came in lower than expected for the third quarter, turnover still appears historically low. Were you expecting turnover to be even lower? If not, how do we envision turnover returning to pre-pandemic levels, especially since it seems that new rents are impacted while renewals are holding steady?

Yes. Alex, it’s Sean. Just to try to be clear, we expect it to be lower, independent of the historical norms. And the reason we had a belief is if you go back and look at the turnover that we experienced in Q1 and Q2 relative to last year as an example. The first quarter of this year, turnover was 35%. Last year, Q1 was 44%. Q2 this year was 46%. Last year, it was 50.8%. Q3 ended up being basically on top of last year. So, we had two quarters earlier this year, where we were pushing rents pretty aggressively that there was a pretty wide spread on a year-over-year basis. So we expect Q3 to continue that trend of being below what we experienced last year, even though we were continuing to push rents. And that was not the case. It was essentially on top of last year. So hopefully, that answers that question as it relates to turnover and our expectations.

That does. And the second question is I think initially, there were three markets that you guys highlighted as being weak, Northern Cal, Seattle and the Mid-Atlantic. You addressed Northern Cal and Seattle to Jeff Spector’s question. Mine is if Mid-Atlantic, if I heard correctly, that Mid-Atlantic is one of the weak ones. That’s a market that just perennially for the past decade has been sort of anemic. So, was this a case where the market you thought would rebound and it just didn’t or it’s weaker than sort of the normal stuff that goes on? Obviously, that market gets placed with supply.

Yes. One thing we should clarify, Alex, is that when we mentioned weaker performance, it was only slightly below our expectations. The revenue miss was just $0.01 on $600 million for the quarter, so it's not a significant amount. We continue to see solid growth in those markets. For instance, in the Mid-Atlantic, the rent change in Q3 was about 10%, California was 9%, and Seattle nearly 12%. However, the deceleration in those numbers was a bit quicker than we expected. I would advise against labeling these as weak markets that are declining rapidly; instead, the pace of decline was just a bit more than we had forecasted in terms of rent changes. In absolute terms, these figures are still quite healthy, significantly above historical levels when considering long-term rent growth across our locations. Specifically regarding the Mid-Atlantic, there are three major areas, including Northern Virginia and the District of Columbia. I would say that the District and a couple of spots in Northern Virginia have struggled the most, particularly D.C., where office utilization is currently the second lowest in the country, just after San Francisco. Many professional and government jobs don’t necessitate being in the office. We are seeing some positive trends in that area, but it's not quite at the level needed to achieve stronger overall results from the Mid-Atlantic region, including D.C. In terms of absolute job growth, this region has been the weakest this year. We are facing a combination of lower job growth, and among those jobs, not everyone needs to be in the office. We need to see improved trends in the data for the market to gain more momentum.

Thank you. And this might be a little bit more theoretical. But your comment on underwriting developments at 100 to 150 basis-point spread to market cap rates. I mean, how do you think about cap rates going higher and the risk, especially by the time developments are delivered? Just kind of what are your thoughts around that? And how do you bake that into your underwriting?

Hey Jamie, it’s Matt. I’d like to mention a couple of points. The first and most crucial aspect is match-funding. When we match-fund a deal with permanent capital from the start, whether we're sourcing equity or debt or selling an asset based on current cap rates, if cap rates end up being 100 basis points higher by the time the deal is completed, we've still secured that spread. Typically, the opposite occurs. In fact, over the last few years, we've finalized deals when cap rates were significantly lower than they were during our funding process. The equity forward is a good illustration of this, as it allows us to lock in capital based on the cap rate or yield of our stock at that particular time. That’s the first point. Additionally, as I mentioned, we don’t trend rents and NOIs, but generally, rents and NOIs tend to be increasing, which provides a bit of an additional cushion for conservatism.

As you think about underwriting today, what are you baking in for that cushion on the revenue side?

We evaluate the current net operating income, rents, expenses, and costs to determine a spot yield. We then compare this with a spot cap rate or asset value as if the asset were being sold today. Typically, our analysis shows that when properties stabilize, they achieve yields that are higher than our initial underwriting because we do not factor in growth at that stage. Instead, we project growth using a 10-year forward internal rate of return model for long-term returns, but this growth is not included in the yields we report.

Okay. And so, you’re using spot expenses, too? Is that what you said?

Yes.

Yes. And how do you think about the risk of that?

Typically, when a deal stabilizes, rents and operating expenses tend to change. The largest component of operating expenses is property taxes, which depend on the asset value. This is likely to be the main factor in how operating expenses adjust compared to a few years ago. This usually occurs because the assets are worth significantly more than what we initially estimated, resulting in more value creation. Overall, if rents and operating expenses increase at the same rate, it will lead to a substantial increase in net operating income, and we operate at a very high margin, allowing for operating leverage.

My question is around the strategic initiatives you guys started with industrials around co-working space. Just wondering if you could talk a little bit about the economics of that business, the size of the opportunity and potentially what it could contribute to your bottom line?

Sure. I would frame it just in the context of our overall initiatives of activating retail space at the bottom of our buildings. A couple of different components of that, one of which was we self-started our own small but self-started own co-working program at a project out in California, which we call Second Space. The industrious relationship, which you referenced, is a pilot to further tap into their network of potential clients, as we think about our Second Space product. But it’s an area where we’re actively talking with multiple users, and we think it’s somewhere we can help create some incremental value, particularly to our residents above by creating activated space at the ground floor.

And you’re just renting the space to industrious, so there’s no kind of shared revenue model or anything like that?

It's a shared model rather than a traditional retail model.

Thank you all for joining us today. I appreciate the dialogue and look forward to seeing many of you at NAREIT soon.