Avalonbay Communities Inc (AVB) — Q4 2022 Earnings Call Transcript

Thank you, Doug, and welcome to AvalonBay Communities fourth 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 hello everyone. I'm joined by Kevin, Sean, and Matt, and after our prepared remarks, we will open the line for questions. I'll start by quickly summarizing our 2022 results and highlighting our progress on a number of strategic focus areas. As shown on slide 4, from an operating results perspective, 2022 was a phenomenal year and one of the strongest in the Company's history, with 10.9% same store NOI growth and 18.5% core FFO growth. We ended the year with core FFO of $9.79 per share, which, just to reflect back, was $0.24 above our initial guidance at the beginning of 2022. On the capital allocation front, we proactively adjusted during 2022 as the environment and our cost of capital changed. In April, we raised approximately $500 million of forward equity at a spot price of $2.55 per share, which is still fully available. As the year progressed, we pivoted from our original expectation of being a $275 million net buyer to ending the year as a $400 million net seller, a shift of roughly $700 million in total. We also ratcheted down new development starts given the shifting environment to $730 million from our original guidance of $1.15 billion. Collectively, these moves put us in an extremely strong liquidity position and fully match-funded with capital secured for all of the development we have underway. We also made significant progress during 2022 on our strategic focus areas, three of which I want to highlight today. First, as detailed on slide 5, we continue to make very strong inroads on the transformation of our operating model. We captured approximately $11 million of incremental NOI from our operating initiatives in 2022. In 2023, we're projecting an additional $11 million of incremental NOI from these initiatives, and looking further out expect meaningful contributions in 2024 and beyond. This uplift is being driven by a number of initiatives including our Avalon Connect offering, which is our package of seamless bulk internet, and new developments Managed Wi-Fi, which we have now deployed to over 20,000 homes and expect to be at over 50,000 homes by the end of 2023. During 2022, we revamped our website and fully digitized our application and leasing process. What used to take 30 plus minutes of associate time can now be completed digitally in about 5 minutes. We also rolled out our mobile maintenance platform across the entire portfolio, allowing our residents and maintenance associates to interact much more efficiently and seamlessly. As a result of these initiatives, we believe we are enhancing the customer experience while also driving operating efficiencies, which over the past few years has resulted in a roughly 15% improvement in the number of units managed per onsite FTE. Turning to slide 6 as a second strategic area. We are focused on optimizing our portfolio as we grow. Our goal is to shift 25% of our portfolio to our six expansion markets over the next six to seven years. In addition to diversifying our portfolio, this shift reflects the reality that more and more of ABV’s core customer, knowledge-based workers, are increasingly in these markets. At the end of 2022, including our development currently underway, we increased our expansion market exposure to 7%, and subject to the capital allocation environment this year, we expect to be at 10% by the end of 2023. We're funding a large portion of this shift through dispositions in our established regions, which also allows us to prune the portfolio of slower growth assets and/or those with higher CapEx profiles, which should lead to stronger cash flow growth in the portfolio in the years ahead. Our third strategic focus area has been on leveraging our development expertise in new ways and in ways that drive additional earnings growth. More specifically, as detailed on slide 7, we are expanding our program of providing capital to third-party developers primarily as a way to accelerate our presence in our expansion markets. In 2022, this included a project start in Durham, North Carolina and a new commitment in Charlotte. During 2022, we also successfully launched our Structured Investment business, with over $90 million of preferred equity or mezzanine loan commitments made during the year. We believe that both of these programs will be increasingly attractive to third-party developers in 2023, and we're also fortunate to be building these books of business now at today's economics versus in yesterday's environment. Before turning it to Kevin to provide the specifics of our 2023 guidance, I want to provide some additional context on our underlying economic assumptions for the year. From a forecasting perspective, we are overlaying the consensus forecast from the National Association of Business Economists, or NABE, on top of our proprietary submarket by submarket research data and model. The NABE consensus assumes a significant slowing in job growth during the year, down to about 50,000 jobs per month by the third quarter and a total of approximately 1 million of net job growth in 2023. The output of our models is a forecast of market rent growth of 3% during the year. In a year in which we will need to be prepared for a wider set of potential outcomes than usual, there are a number of attributes of our portfolio, and particularly our concentration in suburban coastal markets, that we expect to serve as a ballast in a potentially softening economic environment. As shown on slide 8, the cost of a median-priced home relative to median income in our markets continues to serve as a barrier to home ownership and support demand for our apartment communities. This is in addition to the repercussions of today's higher mortgage rates, which make the economics of renting significantly more attractive. The other side of the equation is supply. In softening times, having an existing asset that is in direct competition with a recently built nearby project and lease-up can be particularly challenging. Our portfolio has some of the lowest levels of directly competitive new supply across the peer group at only 1.4% of stock, which we believe positions us well. And with that, I'll turn it to Kevin to detail our 2023 guidance.

Thanks, Ben. On slide 9, we provide our operating and financial outlook for 2023. For the year, using the midpoint of guidance, we expect 5.3% growth in core FFO per share driven primarily by our same-store portfolio as well as by stabilizing development. In our same-store residential portfolio, we expect revenue growth of 5%, operating expense growth of 6.5%, and NOI growth of up 4.25% for the year. For development, we expect new development starts of about $875 million this year, and we expect to generate $21 million in residential NOI from development communities currently under construction and undergoing lease-up during 2023. As for our capital plan, we expect to fund most of this year's capital uses with capital that we sourced during last year's much more attractive cost of capital environment. Specifically, we anticipate total capital uses of $1.8 billion in 2023, consisting of $1.2 billion of investment spend and $600 million in debt maturities. For capital sources, we expect to utilize $550 million of the $630 million in unrestricted cash on hand at year-end 2022, $350 million of projected free cash flow after dividends, and $490 million from our outstanding forward equity contract from last year. This leaves only $400 million in remaining capital to be sourced, which we plan to obtain primarily from unsecured debt issuance later in 2023. From a transaction market perspective, we currently plan on being a roughly net neutral seller and buyer in 2023 with a continued focus on selling communities in our established markets and on buying communities in our expansion markets while being prepared to adjust our transaction volume and timing in response to evolving market conditions. On slide 10, we illustrate the components of our expected 5.3% growth in core FFO per share. Nearly all of our expected earnings growth of $0.52 per share is expected to come from NOI growth in our same-store and redevelopment portfolios, which are expected to contribute $0.50 per share. Elsewhere, NOI from investment activity and from overhead JV income and management fees are expected to contribute $0.19 and $0.03 per share, respectively, while being partially offset by a headwind of $0.10 per share each from capital markets activity and from higher variable rate interest expense, resulting in an expected $0.02 per share net earnings growth from these other parts of our business.

All right. Thank you, Kevin. Moving to slide 12 in terms of our operating environment. After a very strong first half of the year, we ended 2022 with several of our key operating metrics, including occupancy, availability, and turnover trending to what we consider more normal levels. In addition, following two years of abnormal patterns, rent seasonality returned with peak values being achieved during Q2 and Q3 before easing in the back half of the year. More recently, the volume of prospective renters visiting our communities increased in January as compared to what we experienced in November and December, which translated into a modest lift in occupancy, and we do see an amount of available inventory to lease as we entered February. Additionally, asking rents have increased about 100 basis points since the beginning of the year, which is beginning to flow into rent change. Based on signed leases that take effect in February, we're expecting like-term effective rent change to be in the low-4% range. Turning to slide 13. The midpoint of our outlook reflects same-store revenue growth of 5% for the full year 2023. Growth in lease rates is driving the majority of our revenue growth for the year, which includes 3.5% embedded growth from 2022 and an expectation of roughly 3% effective rent growth for 2023, which contributes about 150 basis points to our full year growth rate. We expect additional contributions from other rental revenue, which is projected to grow by roughly 16%, about two-thirds of which is driven by our operating initiatives, a modest improvement in uncollectible lease revenue, and a slight tailwind from the reduced impact of amortized concessions. We're assuming that uncollectible lease revenue improves from 3.7% for the full year 2022 to 2.8% for the calendar year 2023. Of course, this improvement is more than offset by a projected $36 million reduction in the amount of rent relief we expect to recognize in 2023. The combination of the two reflects a projected 80 basis-point headwind from net bad debt for the full year 2023. Moving to slide 14. We expect our East Coast regions to produce revenue growth slightly above the portfolio average, while the West Coast markets are projected to fall below the portfolio average, and our expansion markets are projected to produce the strongest year-over-year revenue growth for the portfolio. One point to highlight is that the reduction in rent relief will have a more material impact on our reported 2023 revenue growth in certain regions and markets, for example, Southern California and Los Angeles. We have footnoted the projected impact for each region at the bottom of slide 14 and enhanced our disclosure in the earnings supplemental, so everyone has visibility into the impact of the change in rent relief as compared to underlying market fundamentals. Turning to slide 15. Same-store operating expense growth is projected to be elevated in 2023 due to a variety of factors. The first is just the underlying inflation in the macro environment, which is impacting several categories, including utilities, wage rates, etc. Second, we're expecting greater pressure on insurance rates, given the increase in the number and severity of various disasters over the past couple of years, combined with a relatively light year of claims activity in 2022. We're rolling all that cost pressure into the organic growth rate of 4.8%, you see on the table on slide 15. In addition to the organic pressure in the business, about 170 basis points of additional operating expense growth is coming from the phaseout of property tax abatement programs, primarily in New York City, and NOI accretive initiatives. The phaseout of the property tax abatement programs is projected to add about 70 basis points to our total operating expense growth for the year. While we'll generate some incremental revenue during the phaseout period, the ultimate benefit will be the extinguishment of the rent-stabilized program for those units in a particularly challenging regulatory environment. The impact from initiatives reflects a few key elements of our operating model transformation, including our bulk internet, Managed Wi-Fi, and Smart Access offering, which, as Ben referenced, is bundled and marketed as Avalon Connect. While we expect to recognize an incremental $5 million profit from this specific initiative in 2023, it's adding about 150 basis points to OpEx growth for the full year. There's a modest impact from our on-demand furnished housing initiative, which is also generating a profit for 2023. And finally, we expect additional labor efficiencies to offset some of the growth in other areas of the business as we continue to digitalize and centralize various customer interactions.

All right. Thanks, Sean. Just broadly speaking, development continues to be a significant driver of earnings growth and value creation for the Company. At year-end, we had $2.4 billion in development underway, most of which was still in the earlier stages of construction. The projected yield on this book of business is 5.8%. And it's worth noting that our conservative underwriting does not include any trending in rents. We do not mark rents to current market levels until leasing is well underway. On this quarter's release, only 4 of the 18 projects underway reflect this mark-to-market. But those 4 are generating rents $395 per month above pro forma, which in turn is lifting their yields by 30 basis points. We expect to see similar lift at many of the 14 other deals as they open for leasing over the next two years. And of course, this portfolio is 100% match-funded with capital that was sourced in yesterday's capital markets when cap rates and interest rates were significantly lower than they are today. If you turn to slide 17, we do expect roughly $900 million in development starts this year across 7 different projects with roughly half in our new expansion regions, and we will continue to target yields at 100 to 150 basis-point spread over prevailing cap rates. We expect the majority of the start activity in the second half of the year and are hopeful that we will be able to take advantage of moderating hard costs across our markets as these budgets are finalized. We have started to see early signs of this in a few of our latest construction buyouts as selected trade contractors have become much more motivated to secure new work. As always, we will continue to be disciplined in our capital allocation, and our projected start activity could vary significantly from our current expectations depending on how interest rates, asset values, and construction costs all evolve over the course of the year. Turning to slide 18. While our recent start activity has been modest, we have been building a robust book of future opportunities that could drive significant earnings and NAV growth well into the next cycle. We have increased our development rights pipeline to roughly 40 individual projects, balanced between our established coastal regions and our new expansion regions, providing a deep opportunity set across our expanded footprint. Most of these development rights are structured as longer-term option contracts, where we're not required to close on the land until all entitlements are secured. In addition, in the current environment, we are certainly seeing more flexibility from land sellers who are willing to give us more time as costs and deal economics adjust to all of the changes in the market. We continue to control this book of business with a very modest investment of just $240 million, including land held for development and capitalized pursuit costs as of year-end. For historical context, as shown on the chart on the right-hand side of the slide, this is a lower balance than we averaged through the middle part of the last cycle from 2013 to 2016, even though the dollar value of the total pipeline controlled is larger today than it was then, providing tremendous leverage on our investment in future business. And with that, I'll turn it back to Ben for some closing remarks.

Thanks, Matt. To conclude, slide 19 recaps our successes during 2022 and highlights our priorities for 2023. All of this is only possible based on the tireless efforts of our AvalonBay associate base, 3,000 strong. A personal thank you to each of you for your dedication to making AvalonBay even stronger as we continue to fulfill our mission of creating a better way to live. You're the heart and soul of our culture, and we thank you. With that, I'll turn it to the operator for questions.

Thanks. And thanks for the call, presentation. It is always helpful as a lot of additional info. So, I always appreciate that. Maybe just starting on development in the transaction market. You mentioned the 100 to 150 basis-point spread. Can you quantify expected yields on the '23 starts and maybe what the current transaction cap rates are you’re seeing in your markets?

Sure. Hey Nick, it's Matt. As you're likely hearing from others, there isn't much activity in the current environment. Everyone seems curious about how the transaction market will develop throughout the year. Most trading appears to be in the mid to high 4% cap rate range, depending on the specific market. There are definitely assets that aren't trading. From what we can tell, that's where the majority of transactions in our markets seem to be settling right now. For reference, the developments we plan to start this year are projecting yields around the low 6% range today. This aligns well with the spread I mentioned, which is solidly in the 100 to 150 basis-point range.

Thanks for the information. Regarding the ongoing reallocation of capital into expansion areas, do you anticipate any differences in cap rates between purchases and sales, or as you reallocate capital this year? Additionally, where should we expect asset sales to take place, specifically in which established markets?

Yes. If you look back at what we've done over the last four or five years, we have rotated a significant amount of capital, primarily focused on the Northeast. You can expect this to continue, with ongoing asset sales primarily from the New York metropolitan area, with some from Boston, a bit from the Mid-Atlantic, and selectively a little on the West Coast, but mostly from the Northeast corridor. Regarding the cap rate spread, it seems to have tightened somewhat over the last year or two because there has been more upward movement in cap rates in the regions where we're buying compared to those where we're selling. This is due to the fact that those selling regions had more inherent growth in the rent roll and lower cap rates a year or two ago, and as interest rates have increased, buyers in those markets have been more focused on yield than growth. Therefore, there has likely been less adjustment in those areas. I expect there might be some dilution, but probably less than what we've seen in the past couple of years. Additionally, we have changed our strategy from buying an asset and then doing a reverse exchange to fund that purchase to selling first, which allows us to understand the pricing of the asset we are parting with and to inform our willingness to pay for new acquisitions. We've transitioned to a strategy of selling first and then buying second.

And Nick, yes, in terms of the environment today, I just want to make sure you have the right expectations for activity now versus later in the year. We're testing the market with a couple of potential asset sales generally on the sideline on acquisitions until we see how those assets, one, if we decide to trade on them and how the pricing is and then we'll evaluate the potential trade into the expansion market through other acquisitions or potentially use those proceeds for other capital allocation decisions.

Thanks. Those ones being tested are in the Northeast?

They are, one in the Northeast and one in the Mid-Atlantic.

I guess, on page 13, you kind of break out all the drivers of growth. I was just hoping you could maybe tell me the areas where you have kind of the most confidence and the least confidence, where there could be upside, downside and if you also think about that by region. I guess, what areas are you thinking there could be upside in your forecast and potential downside?

Yes, Steve, this is Sean. I'll address that. In terms of upside and downside, first, regarding the different categories shown on slide 13, there are a few key points to highlight. On the lease rent side, as Ben mentioned, we have certain macroeconomic assumptions like job and income growth incorporated into our models. Any changes in the economic environment will influence this, along with the timing of those changes. If we don't see significant impacts from a slowing economy until late this year, it would affect 2024 more than 2023. Additionally, bad debt is another area we are all trying to assess in specific markets, though it is more difficult to forecast. We're starting the year with an underlying bad debt rate of about 3.1%, and we anticipate it will decrease to around 2.3% by year-end, with more improvement expected in the second half due to issues in Los Angeles and sluggish court processes in the Northeast. These elements could sway the overall situation depending on how they evolve. There may also be some upside, as recent extensions in places like Los Angeles County are getting shorter, indicating progress. Geographically, tech markets in Northern California and Seattle have shown more sluggishness, with the Mid-Atlantic region also experiencing slow government return-to-office initiatives. The outcome in the tech market will likely affect those areas. In contrast, New York City, Boston, and Southern California are performing well. Overall, there seems to be a bit more risk associated with the tech sector, but we have stabilizing factors in other regions. So, when considering everything together, it comes out to be relatively neutral.

Okay. Thanks. And then just on development, maybe for Matt, as you think about construction costs and what's happened with inflation, and I assume that that's starting to moderate. But how did that get factored into the $900 million of starts? And presumably, the yields are somewhere in that 6% to 6.5% range on what you're going to start. But I guess, what kind of cushion or upside could you possibly see if inflation continues to moderate?

Yes, it's a question of whether hard costs or rents are slowing down more. Currently, we believe hard costs are stabilizing. It's challenging to determine the exact state of hard costs until we have concrete plans to bid and are fully prepared to begin. We’re noticing on a few projects that started in the third and fourth quarters, once we begin moving earth and subcontractors realize the project is legitimate, they are returning with higher price estimates. We're also seeing some savings in the buyout process, whereas a year or two ago, we were experiencing a consistent 1% increase each month. That is no longer the case, and the trend is starting to shift. It varies regionally and depends on the local availability of subcontractor resources. We anticipate that hard costs in many areas where we plan to initiate business this year will likely be lower compared to what we experienced in the third and fourth quarters of last year. We noted that our project starts are backloaded this year, partly due to the natural progression of deals and partly because we believe it will be more advantageous to negotiate with trades during the summer as they begin to feel the pressure from a slowdown in new work.

Ben, just going back a little bit to your comments on the capital recycling side. I'm just curious how significant the volume of assets are on the market within your expansion markets that meet your underwriting criteria from a location quality perspective. And also curious if that 6 to 7-year time frame you outlined to achieve that rotation into the expansion markets, is that just a function of what you can sell in any given year?

Thank you, Austin. Regarding transactions, we are currently marketing a few assets for potential sale. Our transactions team is closely monitoring the buying side of the market, but we are not actively underwriting any specific deals at this time. We have comprehensive market-by-market analytics that help us identify which submarkets and types of products to focus on across various price points. When we decide to resume our trading activity this year, we will be prepared to increase our efforts. In response to your broader question about our time frame, we aim to reach a 25% target over the next 6 to 7 years. We have made significant progress in recent years through trading, acquisitions, and our development funding program. We are optimistic that in a challenging environment with less abundant capital and potential market dislocations, opportunities may arise that allow us to accelerate our activities. Our cost of capital will need to be viable to support this plan, but we may find ourselves in a position later this year where such opportunities become available.

Yes. That's helpful. And then, I'm also just curious, with the available dry powder that you have exiting this year, I'm curious what's sort of the most development you'd be comfortable starting in a given year? As you guys highlighted, you do have significant deliveries in 2024, which will accelerate the NOI contribution. And I'm just curious what kind of volume we could see you do maybe as you get into next year and beyond if the environment is sort of appropriate for accelerating starts.

Yes, broadly speaking, I would suggest that this isn't a strict target. However, we aim to have around 10% of our upper enterprise value under construction at any given time. Currently, we are below that mark, which reflects our cautious approach to development starts over the past couple of years due to the operating environment. We do have the opportunities available, as Matt mentioned. We maintain control over our pipeline at a relatively low cost and are currently focusing on restructuring deals in our favor due to changes in the land market. Our team is experienced and has been doing this for a long time. An important factor will be how we assess the spreads, particularly the relationship between rental trends and cost trends and our goal of maintaining a spread of 100 to 150 basis points over underlying cap rates and our cost of capital. These will be the indicators that prompt us to become more aggressive in our development approach.

Maybe, Austin, just to add this is Kevin here. As we've discussed in the past, the development activity we undertake is typically influenced by three factors: the opportunity set, our organizational capacity, and our funding capacity. Regarding our funding capacity, we are positioned to initiate and self-fund through free cash flow, asset sales, and leveraged EBITDA growth, aiming for somewhere between $1 billion and $1.5 billion in new development annually. If the equity market is favorable, we can increase that number. Therefore, our target for funding is approximately $1 billion to $1.5 billion, in addition to any funds we can secure from equity markets, contingent on the availability of opportunities and our organizational capacity.

Got it. But it's fair to assume, with where leverage is today, that capacity may be a little bit greater?

If you look at it from a leverage standpoint, we are currently at 4.5 times net debt to EBITDA, with a target range of 5 to 6 times. This gives us the ability to borrow significantly. If we identify opportunities in development or transaction markets, we will consider the current cost of debt for funding those activities. Fortunately, we have one of the lowest costs of debt capital in the REIT sector, with the ability to secure 10-year debt at around 4.7%. This will be an important factor in deciding how much we want to utilize our leverage capacity for further investments.

In terms of your outlook for your Structured Investment Program, are you seeing any deals in the market that are in distress or might be in need of capital and could be opportunities for you? And then, what gives you confidence on generating returns of 12%?

Yes. I can take the first one. I'm not sure I heard the second one. Confidence in…?

Returns of 12%.

It's Matt here. Are we seeing distress? No, but I would say we're not really in that market. The SIP is focused on providing mezzanine capital or preferred equity for new construction projects, specifically for builders creating new apartment communities in our markets. We engage at the initial stages when they are assembling the capital to finance the project. Given the rise in interest rates and the decrease in construction loan proceeds, developers are seeking to fill that gap. Previously, they might have secured 60% to 65% in construction loans, but now it's down to 50% or 55%. Consequently, our investment has shifted from around 65% to 85% of that stack to approximately 55% to 70% or 75%. Interest rates have increased, and there are transactions occurring in the 12% range. Some developers are in need of short-term bridge financing, especially those who began projects two to three years ago, as their construction loans are maturing and they lack sufficient refinancing proceeds to cover those loans and their mezzanine financing. So, there’s a slight movement towards recapitalizing newly built assets, but that is not a market we are currently exploring. We remain focused on new construction.

And Chandni, this is Matt. I want to highlight that in the broader market, we expect our capital through the SIP to be more appealing to developers this year compared to the previous couple of years. This situation allows us to be more selective concerning the quality of the sponsor, the amount of capital they are investing, and our assessment of the underlying real estate. We don’t plan to hold onto these SIP deals indefinitely, but we conduct thorough underwriting to ensure we are comfortable with the possibility of owning the assets if necessary.

Great. As we consider the headlines about tech layoffs, January saw a significant increase in layoffs, much higher than in November. When reflecting on November and December, we noted a slowdown. However, towards the end of January, rents picked up slightly. Given that we are still processing these daily headlines, including news from Disney this morning, are you noticing any early signs in your conversations with tenants regarding move-outs or lease discussions? What reassures you that things are heading in the right direction and that we're not facing a drastic decline?

Yes. Chandni, that's a good question. I'm not sure there's a notable answer to it. I can tell you about what we're seeing. But in terms of how it unfolds, I think that's what everybody is trying to understand well. What I would say is just based on the data that we collect from residents as it relates to relocation, rent increase, etc., etc., we're not seeing anything that's material at this point that would indicate that there is a significant issue underlying the economy and some of the tech markets. So, relocation has actually come down in terms of reason for move-out. Rent increase is up a little bit. But not surprising, rents have gone up quite a bit over the last 12 to 14 months. So, I don't think those are indicators that are a surprise to us, and there's nothing yet in the data that would tell us that there's a significant underlying issue. Now the question, I think, that a lot of people have is severance, unemployment, etc., etc., is that sort of supporting people for a period of time. And they are, in fact, transitioning into new roles into other organizations. And there's a little bit of this sort of rotational effect from maybe some of the tech companies that took on more employees that they needed to during the pandemic and now they're rotating into other organizations, more mainstream corporate America. It's hard to tell all that, but we're not seeing anything specifically in the data, and we're not hearing a lot anecdotally from our teams on the ground saying that there is a significant issue there. I was in San Jose last week speaking to our teams, targeted people on the ground. And they're just not seeing it yet. The sandbox and the headlines are there in terms of layoffs, but it's not showing up in terms of the front door yet. So we're being proactive in some of those markets in terms of how we're thinking about extending lease duration, how we look at lease termination fees and other things to hedge a little bit. But thus far, it's not showing up in the data.

I wanted to ask about the same-store expense guidance. I appreciate the presentation overall, but I'm particularly interested in the slide that breaks down the different components. Specifically regarding the tax abatement, I’m curious if this is a one-time occurrence or if it will recur in the coming years. I'm trying to determine the appropriate recurring run rate for same-store expenses to use as a reference.

Yes, Adam, that's a great question. I can share that if there are changes regarding the assets in our portfolio, including what we trade and sell, it will be relevant. For the assets contributing to the phaseout of the tax abatements in our 2023 same-store category, one will phase out by the end of 2023, two will phase out by the end of 2024, and the other four will extend an additional two or three years. Therefore, we will experience some fluctuations over the next few years as assets gradually exit that phaseout. Additionally, we will gain some benefits each year during the phaseout in the form of an incremental fee. Ultimately, as we exit the program at the end of the phaseout, we expect a positive impact on rents, especially considering the challenging regulatory environment in New York. While I can't provide exact guidance for the years beyond 2024 regarding potential headwinds from this activity, there will be some headwinds in the coming years.

That's really helpful. Thank you. I have a follow-up regarding the expansion markets, which may experience better job growth. That makes sense, but I'm thinking about the supply side of things. It's widely known that some of the expansion markets, particularly in the Sunbelt region, are currently facing elevated supply, potentially for the next 12 months. How are you approaching this? Are you planning to just endure the supply challenges, anticipating less supply afterward due to financing issues affecting new developments, or do you think the concerns about supply are exaggerated, and the next year might not see as much supply as expected?

Yes. Let me handle it big picture and others can add on. The first comment I'd make, our portfolio allocation objectives, these are long-term objectives, right? We're setting these because we think they're the appropriate allocation to have over the next 20 to 30 years, right, not necessarily based on the supply and demand dynamics out of the next couple of years. With that said, we do expect the next couple of years and potentially with some reversion to the mean on the rent side and the high levels of supply could lead to more muted growth in some of these high-growth markets. We're fortunate we don't have any new deliveries. We have very limited deliveries coming on line over the next couple of years. So most of our activity that you hear us talking about, including our own development, which we're now starting, and our developer funding program, those are projects that are going to be coming on line in 2025, 2026, which currently looks like could be some lighter years from a supply perspective.

Yes, I would like to add that we are mindful of both submarket and market selection as we develop our portfolio in these areas. A good example is our portfolio in Denver, which has performed even better than the market overall. Most of the assets we have acquired are suburban garden properties located in areas with tighter supply. While there is a considerable amount of supply in Denver, the majority of it is concentrated within the city limits, and we have not purchased any assets there. Last year, we completed one lease-up development in Rhino, and we have another one currently under construction, but we are focusing on a strategy that emphasizes suburban acquisitions.

Thank you. Thanks for all the color and additional disclosure on uncollectible lease revenue. It did strike us a surprisingly high in New York and Southeast Florida. And I was wondering if you can comment on that. Is this due to affordability? And could you see this potentially remaining high, just given what's happening in the economy?

Yes. John, it's Sean. Yes, New York certainly has been high in certain pockets. Even pre-pandemic, places like Long Island took forever to get through the court process. So, that's not necessarily a significant surprise. And as you might imagine, the environment is relatively pro-resident friendly. And so any opportunity as they get to sort of kick the can down the road through the court system, we've generally seen that happen over the last 12 to 14 months. As I mentioned earlier, I think a lot of that is slowly coming to an end, and things are opening up, but it is moving slowly. And you basically have the same phenomenon happening in Florida. Things are moving along. Obviously, it's not as kind of 'pro-tenant friendly' is a place like New York by any stretch. But courts are back up as a lot of cases that have just been on the docket for months and months, and it's taking time for things to move through the system at this point in time, just much longer than average. So, in terms of is there a particular reason in Florida, I wouldn't say necessarily that's the case. It's a market that has had higher bad debt historically. So, we're not necessarily surprised by that.

And John, from an overall portfolio perspective, I know you know this, but just for the broader audience, I mean pre-pandemic, right, our traditional bad debt number was in the 50 to 75 basis-point range. So, still a significant runway from the types of figures we're assuming for this year over the next couple of years. It may take a while, given Sean's comments, but we're hopeful we'll be headed in the right direction.

Okay. My second question is on page 11 of your presentation. You show the NOI contribution from development completions, which is very helpful. I'm just curious why you estimate that '23 NOI will be about half of last year's. Just given if you look at the first half of this year's deliveries versus the first half of last year, it looks about the same.

Yes, John, this is Kevin. I'll address this and others may want to add their thoughts. To forecast the NOI from communities that are being developed, you need to start with when we actually began construction. As I mentioned earlier, we started to ramp up in 2021. Typically, most developments take between 8 to 10 quarters to finish, which leads to deliveries, and then subsequently to occupancies, where revenue growth begins. There tends to be a lag in this process. The bar charts on slide 11 of our presentation are not intended to directly indicate when we expect the NOI to increase. Instead, they display when deliveries occur. Therefore, you need to consider that occupancy will follow deliveries, and NOI will follow occupancy, which creates a lag effect as it moves through the profit and loss statement.

I'm sure the next question will be earn in on deliveries from last year, but I'll save that for a later call. Thank you.

Just had two quick questions on the transaction market side. Matt, in regards to the asset sale commentary being out of the Northeast corridor as well as California, when you think about dispositions in California, are they wholly owned dispositions, or would you look to enter into a joint venture for property tax reasons on the West Coast?

It's a good question, Alan. So far, the only partial interest sale we've completed was the New York joint venture we established back in late 2018. The disposal we've executed in California has been limited, and there haven't been many wholly owned disposals recently, just fee simple sales. We've discussed that selling a 49% interest allows us to avoid a property tax reset. The potential property tax reset was likely more significant last year when considering the asset values compared to today. There has been some adjustment, making the gap not as wide as it was, but it's something we've considered for the future.

I'm interested to know if you are beginning to observe a shift from a portfolio of premiums to potential portfolio discounts as the financing markets become more challenging, and whether this makes acquisitions more appealing to the AVB team.

Yes. I would say the portfolio discount today is 100%. Most transactions are occurring with their own portfolio due to the current state of the debt markets. Generally, we are seeing deals that involve assumable debt or modest deal sizes, typically around $100 million or $150 million or less. A year or two ago, debt was very cheap, allowing for larger portfolio purchases with significant debt. However, that trend has reversed. The expectation is that as the debt markets stabilize, we will begin to see larger asset sales come to market later this year, which everyone is anticipating. There was considerable discussion at NMHC about whether these transactions would happen. I believe that this year, a much larger proportion of total transaction volume will consist of individual deals rather than portfolios.

Back to slide 11. I understand your comments about timing in response to John's question, but regarding the upward trend in deliveries, does that provide any insight into your perspective on the overall macro environment, the economy, and the possibility of a recession? I assume you prefer to deliver when conditions are strong. Can you share your thoughts on this and what you envision for the overall landscape as we approach 2024?

Yes. Hey Rich, this is Kevin. I'll start here. Others may want to join. So, in terms of slide 11, just to sort of recap, it shows the timing of apartment deliveries from completing development over '22 through '24. And that is really a lagged effect of what happened 8 to 10 quarters previously. And if you kind of just step back and look at the last few years for us and tie it with a comment that I made in Austin's earlier question about kind of our typical start capacity, as you know, we typically try to start somewhere in the $1 billion to $1.5 billion range. If you look over the last three years, on average, I think we started about $700 million or $800 million when you include the $200 million or so in 2020 and $1.7 billion or so last year. So it's been below trend level of starts over the last few years, which with the lag is created in the last year or so and then probably for maybe the better part of the next year, a little bit of a below-average trend NOI realization from the lease-up portfolio. So that's just sort of how mechanics work. In terms of your question about what does this say, I think really, our lower levels of starts is more reflective of the volatility and the uncertainty of the environment over the last few years when we were looking to start jobs. As we look at where we are today, certainly, the Company is in a terrific financial position to start not just the $875 million that we have in the plan for this year, which, as an aside, is a below-average level of starts generally. But we are in a position to start a whole lot more, not only because of our lower level of leverage today, which gives us debt capacity. So we are looking to lean in and increase development starts in the next two years if the environment is broadly accommodative of our doing so and is a reasonably stable environment from a capital markets perspective and a macroeconomic perspective with respect to the likelihood of realizing decent NOI growth. So, that is kind of our general look at the macro environment, and our capacity is there to sort of ramp things up as we want to do so. As things stand in terms of what's already underway, we are well positioned just on the $2.2 billion of development under construction that's essentially paid for to deliver robust NOI growth irrespective of what we start in the next year or two. So I don't know, Matt, if you want to add.

Yes. Rich, just to clarify, those deliveries, the way they show, that die is already cast. So, they'll deliver into the market that it is at that time. We're not smart enough to say, yes, we deliberately plan to have fewer deliveries in '23 because we thought there might be a recession two years ago, just playing out that way because we had less start activity a couple of years ago, as Kevin said. But, those are all underway, and we'll take those deliveries as soon as we can get them.

Our next question is on the developer funding program. Can you talk about the economics of that relative to everything being done in-house, assuming a fee paid to the third-party developer and all the different moving parts there? And if this program is sort of like a stepping stone for you to get into these markets more efficiently in that over the course of time, you kind of would revert back to the more conventional approach to development longer term. Is that the way to think about it?

Yes, I'm happy to address that. The consumer response has been positive. Our brand was founded on customer research that indicates there are many individuals looking for a new apartment but don't necessarily require extensive on-site services or amenities that Avalon and several of our competitors offer. Our aim is to provide these offerings at a rental price that is 10% to 15% lower than that of a fully amenitized Avalon or a comparable property in the same submarket. However, based on our initial experiences, we suggest the discount may be closer to 7% or 8%. There are significant savings in upfront capital costs, as we don’t invest in features like pools or fitness centers. Additionally, there are savings in ongoing operational expenses since these spaces aren't maintained or cleaned, which also leads to lower capital expenditures since there aren't any retail spaces to remerchandise. Typically, we might spend between $7,000 to $10,000 per unit on amenities at new builds, so we are saving a substantial amount here. Furthermore, on the operational expense front, we can save a couple of thousand per unit in controllable expenses. This results in a comparable yield, but it caters to a different market segment, helping us reach further down the pricing spectrum and thus broadening our market reach.

So, two quick ones. First, initially on the DP, I think in response to the questions, you said that your intent wasn’t to own the deal at the end but then in a subsequent question you referenced, it's a good way to accelerate into the market. So maybe I misheard or maybe it's just a way of how you look at deals in different markets, maybe they’re markets that you're looking to more grow in, use DP to actually own the deals versus other markets where it's more of just an investment because you already have an establishment. So I just want to get some clarity.

Yes, Alex, it's Matt. I think you're referring to our two different programs. The Developer Funding Program involves assets that we own from the start. We fund the construction of these assets, and they go into our portfolio right away. The Structured Investment Program, on the other hand, is the mezzanine lending program. This is focused on generating earnings and leveraging our capabilities. This is the program Ben mentioned, where we do not anticipate owning those assets, although we are prepared to do so if necessary.

What distinguishes the two programs? Your team is quite diligent in your underwriting and deal selection. Why have two separate categories? It seems like you're essentially choosing assets that you would want in your portfolio, so what explains the difference between them?

It's a very different investment profile. The SIP we're lending 20 to $30 million for three years, call it at 11% or 12% and then we're getting paid back. And we're actually focused on doing that in our established regions, where we're not necessarily looking from a portfolio allocation point of view to grow the portfolio, but we have the construction and development expertise to underwrite it and to understand what it takes to do that kind of lending. The DFP is very similar to the way we would underwrite development or an acquisition that we expect to own for the long term. And that's 100% focused on the expansion regions.

I wanted to touch base on that Avalon Connect and furnished housing same-store expenses. I like what you broke out on page 15. How should we think about the associated same-store revenue from those programs?

Yes, that's a good question. As I mentioned in my prepared remarks about other rental revenue growth, if you look at it overall for 2023, approximately 60 basis points or so of our revenue growth is linked to the various initiatives I identified.

So, does that include Avalon Connect, furnished housing and the labor efficiencies?

They include Avalon Connect and furnished housing, there's no labor efficiencies and revenue. That's on the expenses side.

Okay. Yes, that makes sense. For the Avalon Connect and furnished housing, are those kind of onetime bumps to same-store expenses, or is that something that carries through on a go-forward basis and you have offsetting same-store revenue growth as well?

Yes, that's a good question. Currently, we expect both Avalon Connect and furnished housing, as well as labor enhancements, to experience further improvements over the next couple of years. We believe they will stabilize around 20 to 25 percent. Overall, we anticipate these programs will contribute approximately $50 million in additional NOI to the portfolio, with about $18 million expected to flow through the P&L for 2023. This means we are roughly 35% of the way to that goal. There will be some pressure on operating expenses for the next two years, particularly for furnished housing and Avalon Connect, until they stabilize. However, this is a highly profitable endeavor that will significantly enhance earnings in the coming years when considered as a whole.

I'm on for Tayo today. Just one question. I know your portfolio strategy is to invest in the expansion regions. But just wondering if the rent control and the regulatory, I guess, noise has contributed to any strategic changes in how AVB is thinking about portfolio construction going forward. Thank you.

Yes. Thanks, Sam. Short answer is when we arrived at our portfolio allocation decisions a couple of years ago, it incorporated in the prospect of the regulatory environment. And so, it continues to be a motivator on why we want to get our exposure in the expansion markets at a minimum for diversification as it relates to various regulatory dynamics.

I guess sticking with rent control, I mean, have you factored in at all any changes in your '23 guidance? And where do you see the most risk, whether at the municipal level or state level?

Hey Jamie, this is Sean. That is probably a very long answer. What I would say is that housing affordability is a significant issue in the country, primarily due to the lack of new supply. We, along with our peers in the industry and industry associations, continue to educate federal, state, and local governments about effective solutions to address the concerns they are hearing from the electorate. It will require ongoing efforts to ensure a proper understanding. As for what might happen in 2023, that's purely speculative at this point and wouldn't be appropriate for us to discuss.

It sounds like you have $600 million of unsecured debt that you intend to replace with $400 million of new unsecured debt. Is there a price point that would make you consider other funding sources besides the new $400 million? Also, could you share your thoughts on the current pricing and where it might be headed?

Yes, Jamie, when creating a capital plan, it's important to evaluate what our needs are and identify the most efficient source of capital to meet those needs. Our current budget suggests that raising $400 million primarily through the issuance of additional unsecured debt is the most cost-effective option available to us right now. While other sources might come up, our options are fairly clear: we can consider asset sales or common equity, but common equity is not attractively priced at the moment. Asset sales could be a possibility, but there's currently less transparency and liquidity regarding pricing in that area. That's why we've chosen unsecured debt as our preferred option. We have the time and flexibility to consider this further, especially since we have ample liquidity with no funds drawn from our $2.25 billion line of credit, allowing us to determine the best capital source for addressing that maturity.

Okay. That makes sense. And then how early can you take out the $600 million?

Well, the $600 million consists of two pieces of debt, $250 million in March and then $350 million in December. And so, their bond offering, typically, can't be prepaid materially before they are due, absent some yield maintenance payment. So, it's just part of our business that, as an unsecured borrower, we typically have $600 million to $700 million of debt coming due in any given year. This is a typical year for AvalonBay. So, it's not a particular concern. It's just part of the business of financing our company, and we typically have two pieces of debt that usually total about $600 million. So, kind of a regular way year from our standpoint where we got the first part coming in March and the second one in December.

All right. Thank you. Thank you for joining us today. And we look forward to visiting with you in person over the coming months.