AvalonBay Communities, Inc. (AVB) Earnings Call Transcript & Summary

Great. Welcome to the 2:45 p.m. session at Citi's 2022 Global Property CEO Conference. I'm Nick Joseph with Citi Research. Pleased to have with us AvalonBay, CEO, Ben Schall. Session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those joining us here today in person to ask management any questions, please step up to one of the mics we have located in the center aisle of the room. If you're joining us remotely, simply type them into the question box on the screen, and they will come directly to me, and I will do my best to ask them during the session. Ben, I'll turn it over to you to introduce Avalon and the members of the management team, and then we can get into Q&A.

Great. Thank you, Nick. Thanks for having us, and thanks, everybody, for joining us today. I'm joined by Kevin O'Shea, our CFO; Sean Breslin, our COO; and Jason Reilly, our Head of Investor Relations. For folks who are not familiar with us, we are a $40 billion-plus, multifamily REIT, making us one of the largest multifamily REITs in the sector. We went public in 1993. And since then, we've delivered roughly a 13.5% compounded annual growth rate. Today, we own and operate 300 apartment communities, totaled about 90,000 units. And I'm going to spend a couple of minutes talking about key themes that are top-of-mind for us and driving our activities this year and then the years ahead. So first up, we are the most active developer of the public peers. We continue to see it as a meaningful differentiator for our platform. Today, we have roughly $2 billion under construction. We're delivering that activity at roughly 200 to 250 basis points of spread, when we think about where we're developing to our development yields relative to stabilized cap rates. And so that activity is leading to meaningful earnings growth and value creation this year and in the future years. We've also been actively building up our development rights pipeline, which, as of the first quarter, is now north of $4 billion. Second theme, as we're growing, we're also looking to optimize our portfolio. Today, we are roughly 2/3 suburban, 1/3 urban. That positioning provides us with the growth and the stability from our suburban platform, supported by demographics and migration shifts and in the near term, positions us to benefit from the urban recovery that's underway, and that, we believe, has meaningful room to run. The other part of our portfolio optimization, as we have been expanding in new markets, we started in Southeast Florida and Denver about 3 or 4 years ago. On our last earnings call, we put out a longer-term target of getting our portfolio to roughly 25% in our expansion markets and 75% in our established markets. As a third theme, Sean and team have been making significant inroads and significant investments in our operating model, both through technology and innovation, and we expect those investments to pay meaningful dividends in the years ahead. We've put out a target of roughly 200 basis points of margin improvement as an outcome of those activities, both from cost savings as well as additional revenue opportunities. And then the fourth and final theme that I emphasize is, AvalonBay is a recognized leader in ESG, and we continue to be focused on making the investments in our people and our communities and around sustainability to maintain that leadership position and continue to receive the benefits in the minds of investors, our associates, municipalities and our residents. With that, Nick, I'll turn it back over to you.

Great. Thank you. We're starting our session off with the same opening question. What are the top-3 reasons an investor should buy your stock instead of any other listed property company?

Yes, three, I'd highlight and similar to the themes I went through. One, the earnings potential and value creation [ setting ] from our development platform. Second, the earnings potential and growth to come from our investments in our operating platform. And then third, our portfolio positioning, continued growth and stability from the suburban markets and the benefits of the urban recovery underway.

Great. Why don't we start on kind of the operating update you put one out, I guess, on Friday. I think you mentioned that you are running a bit ahead of where you expected to be. So don't we walk through what's driving that kind of outperformance versus your initial expectations?

Yes. Nick, I'm happy to take that. So in our operating update, we did indicate that through the first two months of the year, revenue growth is running about 60 basis points ahead of plan. And if you take a look at what's behind that, about half of that relates to better occupancy than we anticipated. Turnover remains down a little bit below what we had expected and a continuation of the trends that we saw in the back half of 2021. And then the other half, really, is a function of both better rental rates and slightly-lower bad debt. In terms of the markets or the regions, pretty much every region is ahead, with one exception being Southern California, which is pretty much trending where we expected it. So overall, the environment continues to support strong occupancy, healthy rental rate growth, which is really driven by the lower turnover. We're seeing a pretty healthy demand across the footprint.

And so as you think about those positive trends and kind of the continued strength of what you saw towards the end of last year, how does that play into the pricing power as we enter the peak leasing season?

Yes. I mean, we're in a very good position. As we indicated on the last quarter call, in the back half of 2021, typically, what we would have seen is -- from sort of July and August, we'd see a deceleration in our asking rents. Given the robust demand that we experienced and relatively modest amounts of supply, rent sort of flattened out. So we went into 2022 with rents already at what would be a seasonal peak as opposed to a seasonal trough. And we have continued to grow off of that. So asking rents were up a couple of hundred basis points since the beginning of the year. [ Renewal ] offers are going out at levels that we're -- we feel really good about, sort of in the mid-teens. And we continue to see very strong resident retention, which supports good pricing power. So at the portfolio level, all the indicators remain pretty green for us. And then if you back it up from a macro standpoint, and just look at the housing market, overall, in terms of the affordability issues that are out there from a sale standpoint, the limited supply, et cetera, sort of the macro forces, from a housing perspective, set it up to be a pretty good year.

And as part of that update, I mean, kind of, it's -- urban is leading the charge, right, versus suburban? Obviously, they're both very good. How much of that is a comp issue? And how much of that is kind of true demand that you're seeing on the ground?

Yes. Good question. Certainly, urban is leading, just given it fell the most, in terms of rents going through the downturn. So it's bouncing back nicely. But even at that point, I mean, urban rents are still roughly at par with pre-COVID levels. So we think, there is more room to run. And then within our suburban footprint, our job center in suburban locations are experiencing, sort of, a similar phenomena, where if you look at Redmond and Bellevue in Seattle or Tyson's Corner in Northern Virginia, places like that, San Jose is an example in Northern California, they fell not quite as much as the urban job centers, but they fell harder than our, sort of, traditional suburban markets. And so both the urban and the job centers, suburban are leading at this point. And that is absent, sort of, a full recovery that has not yet occurred in many of those job center locations. You still have office utilization, kind of, in the high teens to low 20% range. And while I don't think we expect that to get back to where it was, sort of, pre-COVID, even if it gets back to 60%, 70%, 80%, there's still a very full reopening to occur, which we believe will manifest itself, based on everything that we see, over the several months, in terms of how people do come back to markets like San Francisco and D.C., in Urban Seattle, New York City, et cetera. So there are some reasons to be optimistic, in terms of future demand, beyond what we have seen on the ground to date.

So as you saw, kind of, the return to the office, certainly more last year, maybe on the East Coast, more recently, some news on the West Coast, how much of a lag before the return to the office have you seen, kind of, traffic pick up or leading indicators?

Yes. I mean, good question. As it relates to the East Coast, one thing I would say is, even though we've seen a little bit better utilization on the East Coast, it's still pretty weak. If you look at the, sort of, Kastle Systems' data for New York City or even D.C., it's still pretty low. They're in the 20% range, maybe pushing close to 30% now. San Francisco has been the weakest. But generally, what you see is, someone will start coming into the top of our marketing funnel, maybe 90 days out, and then looking to move when they expect the reopening. So what we -- we did start to see a more significant percentage of the population looking for apartments in more distant locations, starting in Q4, and actually move-ins' the same. So in Q4, we track where people come from, when they move to our apartments. We saw a significant uptick, relative to historical norms, people moving into our communities for more than 150 miles away. And that was led by the urban submarket, where relative to historical norms, people moving in from that distance was up about 30%, 40%. So kind of leading indicator is -- what's to come, and we expect more of that to come our way, both in the urban and job center, suburban locations, over the next several months.

I have a question, kind of, the inverse of that, from live QA here. In terms of the data you're seeing of -- when a resident leaves, are they staying within the MSA or kind of what markets are you seeing outmigration to?

Yes, we're not -- at this point, we're not seeing significantly, sort of, unusual trends. If you'd asked me that question, sort of, in June of 2020 or late 2020, I would have given you a very different answer. In terms of people to much more distant locations, lower -- areas with lower density because we track that as well, in terms of the to [ density of ] the environment that they're moving to. But at this point, in terms of the move-outs, we're not seeing anything that's unusual, relative to historical norms. So the front end, in terms of what's coming in, is very different, as I mentioned, based on the Q4 data. And we've seen that in January and February as well. And so we're going to continue to monitor that.

Great. Maybe turning to the operating initiatives, you mentioned, kind of, the investments in the operating platform and the growth opportunity there. How do you think about that margin opportunity from a revenue side versus expense savings side?

Yes, good question there. So on the operating expense side, most of it relates to labor efficiency. And what we do is, we have taken, sort of, what we call a journey approach. We look at every customer journey that one has with us from the top end of the funnel, when they're searching for an apartment home to scheduling a tour, to line for it, leasing it, moving in, et cetera. And we started this [ effort ] a couple of years ago with lead management, and we automated all of the lead management activities, using a leasing assistant that is powered by AI. And so all the interactions that a customer have with us before they come to a community, is facilitated through the leasing assistant that is AI-powered. And so that gave us pretty good confidence, in terms of customer interaction, usability, the cost to come down, in terms of the technology, to allow us to deploy it. So that was sort of the front end of it. And so the expense side really relates to the automation and digitalization of all those processes, in terms of prospects and customers, all the way through their experiences with us. And we believe that, that will take about -- result in roughly an incremental 15% reduction in labor that we have. There may be more there, but we operate today at roughly 2.4 FTEs per 100 apartment homes. We're going to get that down to, call it, roughly 2.05, 2.1, somewhere in that ballpark. And so that's the expense side of the equation. And then on the revenue, on the top-line side, there's a number of different initiatives there. A few that I'd point to, just for the sake of time, is, we have not only Smart Access, but we have a bulk internet opportunity that we're bundling as [ Avalon Connect ]. And over the course of the next 2, 3 years here, that should generate basically incremental profit of about $30 million. So that will be driving top-line growth. There'll be some expenses associated with it, of course, but net profit of $25 million, $30 million. And then we're also offering renters insurance. We have a new renewal process that we are designing both from an automation standpoint, also from a data science standpoint, that should be optimizing that. So if you look at it, right now, our expectation is, it's about a 50-50 split between the revenue side and the expense side, in terms of the total improvement but yet to be seen, in terms of how much benefit will come through the renewal side, that could be more. We'll see.

On the expense side, how do you think about balancing -- making sure that it does impact resident experience?

Yes. I mean what's interesting, if you think about it from a consumer standpoint, the way we have run our business historically, compared to today's consumer brands, it is ]. I mean, we've acquired people to come to us to tour an apartment. They have to interact with somebody to sign a full application [ or lease ] and move in, keys, et cetera, as compared to most consumer brands. So the research that we have done is, our customers and prospects want to be able to do what they need to do, when they want to do it, if they need help, they'll ask. And so really, it fits perfectly with that mindset of being able to do everything on your own, when you want to. So if you want to tour an apartment, you want to do it at 7 in the morning, [ we'll ] do it 7 at night. No one has to be there, you can do it. If you want to apply, move in and all that at 8:00 at night, you can do that as well. So it's automated in a way that people have an experience that they're comfortable with and they -- it's consistent with what they expect from other, sort of, leading consumer brands. And so that frames the way we think about it, is sort of consumer led, associate friendly. It makes it easier for our associate and then the benefits to grow the company.

Maybe last question on the platform. What -- how do you balance being a first mover with any kind of technology versus waiting to see how it plays out and then implementing it?

Yes. So it depends on the technology. A good example for us is Smart Access. We were not a first mover on Smart Access, and it was probably a function of cost, a function of testing and durability, frankly, and then also being able to prove out what we thought the ROI was. So for us, we, over the last couple of years, have worked with enough of those companies to get it to a point where we felt comfortable with the durability of the technology, the cybersecurity issues that were associated with it, which had to mature, and various other avenues allow us to integrate it into our platform, our tech stack, and be able to deliver compelling value. So sometimes, just because it's a shiny new penny, we don't want to act on it quickly, particularly given the issues that I described from a cyber standpoint, from an integration standpoint, because it needs to be a seamless experience for consumers. It needs to be -- in today's day and age, needs to be highly secure, and we have to be able to underwrite the ROI. So for us, we have a flexible platform. We can integrate technologies as needed. And whether we buy, rent or build, depends on the technology and what it delivers.

Nick, what we do is -- related to Sean's comment, but -- where we do have the ability to lead is thinking about how do we take that technology and incorporate it into our new development activity, right? So [ Conso ], which is our most recent brand, has an opportunity to provide much more technology-led experience for our consumers, right? And so by being a developer and being able to be on the forefront of thinking about evolving of the product, it allows us to take this investment, think about expansion opportunities through [ Conso ] but then also opportunities to roll that out through other brands, Avalon, AVA and eaves.

What's been your biggest surprise since taking over CEO?

I continue to come back to the breadth of products that we operate and develop. I think it's a -- I don't think it's fully appreciated, right, a lot of investors, a lot of people, kind of, think about Avalon and the urban environments. But a lot of the legacy and the core of the company really goes back into the suburbs, right, and everything from townhomes to lower-density product to mid-rise. And I think it's a real advantage for us, going forward. It allows us -- ties a little bit in my comments around evolving the product. But also, as we're thinking about expanding into new markets, right, we can approach those markets with a breadth, right, to think about it, how do we actually optimize our entry to get the earnings growth that we're going there for, in an appropriate, risk-adjusted way?

What's been the biggest frustration?

I'm glad we're more and more back together. I spent a lot of the first year out in the field. I was able to make progress there, getting deep into the organization, getting to develop relationships together. But as an organization to now be back, this is a place with an amazing group of people, with a really special culture, an evergreen culture that was one of the origins of the company. And so to be able to be in person and reinforce that as leaders, looking forward to the coming year.

Maybe we turn to development. You mentioned the 200 to 250 basis point spread, currently. As you think about, kind of, the current inflation today, you're obviously getting the benefit on the rent side, construction cost side. How does that play out, in terms of the value creation opportunity on projects to be started in the near future?

Yes. So one, when we're starting from a position of 200 to 250 basis points, that's a pretty attractive starting position. So there is a built-in margin of safety in there. To date, we underwrite -- when we underwrite new deals, we're underwriting today's costs relative to today's rents. And they've been keeping relative pace with each other. So our development activity right now, what's underway, is in a 5.5% to 6% yield. The projects that we're starting this year, we expect to be in a similar type of position. And it's something, obviously, we're monitoring. I mean, our Development business, when you think about our development rights pipeline, part of the beauty of it is, these are development rights, right, generally, that we control through options, right? And so we -- one, we have constant check-ins as those progress -- as those projects are progressing, also allows us the ability to, sort of, toggle up and down, depending on what's happening at that point in time, of the top side of that equation to the bottom side.

And where are you seeing the most pressure today, in terms of costs?

I'd say, it's more regional, right? So I mean, there are, down here, obviously, some cost pressure. Denver is under some cost pressure. So -- also places with a lot of rental growth to it. Those are probably the areas of note. Lumber, obviously, continues to be top-of-mind, and that's been on somewhat of a roller coaster. So our long-term investment in the development and construction platform, and I think people hear us talk about development, but also our construction platform, right, the professionals that are there and the relationships that we have, we self-perform in our core markets. So the long-term relationships that we have with [ subcontracts ] is there, definitely keeps us on the preferred list and has allowed us to manage through some of the issues, you've been hearing about, in the broader marketplace.

How do you think about building out those relationships in the expansion markets?

It is. It's part of our measured approach in the expansion markets, is to get the experience and the relationships with those local contractors. And so you've seen it in Southeast Florida and Denver. We typically start with an acquisition or two, that allows us to get Sean's team on the ground, right, start to get that local knowledge. Our early developments tend to be in partnership with a local developer: one, because they've got a site that's ready to go; but two, we can leverage their knowledge base and their relationship with a contractor. And then, over time, we gradually shift to the more AvalonBay type of way. And so we're actually about to make that shift in Denver with our own fully-owned development starts and a shift over there to be self performing on the construction side. And so Florida is a little bit behind that, and then you'll see our additional expansion markets of Austin and Dallas and North Carolina travel on that similar path over time.

And how does that play out in terms of spend, either capitalized or expensed, in terms of building out those teams and then, kind of, eventually getting the benefit through development?

Yes. So there is some upfront costs, right, when we're making an investment in these expansion markets, and that's part of the assessment, right, that we -- to make this work, right, on us to generate the value. We need to have our people on the ground, right, and build up those franchises. And so in the expansion markets, we are, in some way, leading with the people, right? And so there's a little bit of an additional drag there. But relative to the long-term benefit of the expanded opportunities in those markets, well worth it, in our minds.

And you've been able to find the right people in these markets as well, just given the labor challenges we're hearing?

Yes, definitely a focus. Our ideal situation is where we're combining both an AvalonBay person, someone who's relocating, knows us, knows our culture, could be a big part of hiring, with a local person who has on-the-ground knowledge and those on-the-ground relationships.

And then on the development rights side, you talked about the opportunity there. How are you finding, if at all, kind of the entitlement process and zoning process changing, just given, kind of, more of, maybe, regulatory overlay versus a need for housing, overall?

Yes. In our -- the bulk of our activity and the bulk of our buildup in the development rights pipeline is in our established markets and the track record and the credibility that our developers have in those markets, right? These guys have been successful for 20 or 30 years with us in places where not -- there's not a lot of support for additional multifamily housing. If there is an opportunity, we tend to be at the top of that list, right? So you could take an example of a defunct suburban office product, right? A local guy owns an office building, he loses his main tenant. That guy goes into the town and says, "What can I do with this project?" The town says, "Call Ron at AvalonBay, he can get this done for you." So it's that type of dividends that we get through the long-term investment in those platforms.

As you think about where the portfolio is going, you mentioned the 20% to 25% into these expansion markets, how did you settle on that? Obviously, I'm sure it's a bit fluid, but how do you think about balancing the market exposure in the mid and longer term?

Yes. It was -- we went through a fairly-detailed portfolio-optimization process, thinking about, and probably at the core of it, where our knowledge-based workers are today and how do we think about those trends on a go-forward basis. And then thinking about, "Okay, what is it going to take, right, in terms of building up those platforms?" We, obviously, have very established 20-, 30-year experience in platforms in our established markets. So looking there, what are the assets, slower-growth assets, assets we want to prune, right? And how do we think about a shift? Are we going to continue to invest in those markets? How do we think about a shift, over time, with a certain amount of capital into the expansion markets? On the expansion market side, part of it is size, right? I mean, these markets that we're going into, right, part one of the filters was being of sufficient size that we could get the benefits of having our full platform there, but also, be of sufficient size because we're not the only ones growing in those markets. right? And so we, sort of, thought about -- there's also a component of thinking about our relative share, right, that we can build up through a mix of acquisition activity and our own development activity.

As you think about the different buyer pools there, right, you're competing on the buy-in in some markets and selling elsewhere. I mean, when you think about cap rates and the desirabilities, do you think it's being priced appropriately?

It's -- it is a tough gauge today, right? We've seen significant run-ups in rents, right, and in values in both places, in our places we've been selling out of, right, which has been in a lot of the Northeast as well as places we've been moving into. In 2021, we're roughly at a similar type of cap rate from what we were selling to what we were buying at year end, roughly similar amounts. This year, I think the expansion markets on the acquisition side have continued to even get more aggressive there, right? So there's probably some spread, which speaks to our general approach about entering these markets in a measured way and also doing it through a combination of acquisitions and development, right, where we can garner some of the additional profit opportunity, recognizing that's going to take some time to get to a full-fledged spot on that -- on the development activity.

And how are you thinking about funding both the development side but also, kind of, the acquisition side?

Kevin, do you want to handle that?

Sure. So from -- looking at our outlook for the year, what you'll see is, we have been -- external capital needs of about $900 million, and we have an investment in development, that's sort of about $1.1 billion. So fundamentally, from the standpoint of funding acquisitions, the expectation is we're going to do so through dispositions of older assets in our existing markets. And we you saw last year, where we sold about $800 million of assets that were about 20-odd years old with embedded CapEx liabilities to fund nearly alike amount of acquisitions of newer assets and largely in our expansion markets, is probably the way we're going to go, in terms of funding that acquisition activity in our expansion markets. So really looking to trade out of older assets with embedded CapEx liabilities at or near the cap rates in which we leg into the new acquisitions and the new markets. And so that really leaves, predominantly, our -- from a fresh funding perspective, how we're going to fund the development in for this year of roughly $900 million in external capital we anticipate. Sourcing our plan contemplates that nearly all of them will be through the issuance of new debt and the balance through net disposition activity of asset sales. So that's the contemplation for this year. And of course, capital uses, capital market conditions, of course, change throughout the year. But that's -- when we look at the hierarchy of our 3 fundamental choices of funding, asset sales, unsecured debt and equity, we ranked, sort of, asset sales at the top, unsecured debt, kind of, closely behind that and common equity, a little bit behind that, but with all being relatively attractive as a source of capital for funding development. But focusing on those first two sources for this year.

Right. And as you think about kind of leverage, obviously, you've been running at lower than peer average, part of that is the development pipeline. Would you be willing to take leverage up, if -- to fund anything or how do you think about kind of current leverage levels and where you'd be comfortable with?

Sure. So Nick, I mean, we were at the end of the fourth quarter, taken the fourth quarter annualized at a net debt-to-EBITDA of 5.1x, which is at the low end of our target range, as you point out. Our target range of that metric is 5x to 6x. Hard to know in the current environment where we are in the -- are we in the early phase of the cycle, or it's such an unusual cycle to begin with. But typically, we run -- we tend to run, sort of, at the middle level of that target range towards the front part of the cycle, where we feel like we have some visibility on, and tightening it up, as we get towards the end of the cycle. Here, there's probably two points worth identifying. One is, obviously, we anticipate with same-store NOI growing at 10% this year, very strong EBITDA growth, which gives us increased leverage capacity. And while interest rates have ticked up quite a bit, we did 10-year debt at around 2% in September. We're probably looking at 10-year debt in the high 2s or around 3% today. It's still particularly attractive, relative to our returns on development. So therefore, is an attractive source, just on a nominal basis. But when you look at combined inflation in the equation, it's also an attractive source. And so we have both the capacity and an attractive rate, when we look at debt issuance this year. So even if we were to fund virtually all of our external capital of $900 million for the issuance of debt, we would still end the year at net debt-to-EBITDA in the low, around 5x. So even with that debt issuance, we're not leveraging up on that metric, and that really speaks to the strong embedded NOI growth and EBITDA growth that we anticipate. And what we would do thereafter, we'd probably -- with more confidence in the duration and the durability of the cycle, we'd be more willing to move that number up into the mid-5s.

What's your #1 ESG priority in 2022?

There's a number of them. I was going to highlight, one would be our continued investment in our people, associate engagement, developing those teams, keeping them engaged at high levels.

I wanted to ask on the retail and the Upper West Side condo development. What are you thinking, as it continues to be leased up? What's the long-term plan for that retail that you own?

Yes. It's likely to be monetized. It's kind of a question of when, right? So we're in the process. We've got a small space that's remained to be leased, and then we'll evaluate the opportunity for sale.

Could that be this year? Or is it...

Could be this year or next year.

And then, what is the biggest growth opportunity that you believe the market is not giving you credit for?

I'd focus on additional earnings growth from our development platform and from our operating initiatives.

All right. We did have a question on inflation, the ability for -- if inflation is higher than -- I guess, the question is wage growth, how long do you think that kind of the current rent levels could persist before that gets too far out of ?

Yes. I mean, the housing fundamentals and the multifamily fundamentals should remain relatively strong, if they stay in check. If there is an extended period, then that would be concerning. I'd overlay on that an increased focus on the importance of the home, right, for folks, partially is in a work-from-home environment. And then, as an output of that, potentially spending more of their wallet for their -- for our quality home experience.

Great. We have our rapid-fire questions to end the session. What will same-store NOI growth be for the apartment sector, overall, so not Avalon, overall in 2023, and this year, it's 12% across the average?

For 2023, 7%.

Where would the 10-year U.S. treasury yield be a year from today?

210.

And finally, will the apartment sector have more or fewer public companies a year from now?

Fewer.

Great. Thank you very much.

Yes. Thank you, guys. Thanks for joining us.