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

[indiscernible] everyone, and welcome to Bank of America's 2024 Global Real Estate Conference. I'm Josh Dennerlein. I think most of you know me, but in case you don't, I cover the residential REITs at BofA, and I'm really pleased to have with us today AvalonBay. We have Ben Schall, CEO, President and CEO, in the middle; Kevin O'Shea, to my right, CFO; and Sean Breslin, COO to the right. With that, I'll pass it over to Ben to kick things off, and then we can do Q&A and feel free to jump in.

Great. Thanks, Josh. Thanks for hosting us. Great to see everybody. I'll start off with some key themes that are top of mind, and I'll turn it back to you, Josh, to help facilitate Q&A. So I'm going to emphasize 5 items upfront that are top of mind for us as an organization. First, our operating momentum continues to be very strong. As part of our Q2 results, we increased guidance for the second time this year, projecting at this point, sector-leading both revenue and Core FFO growth. We issued an operating update last week, which generally showed that Q3 was trending in line with our expectations. And overall, I just think about our portfolio and what we're seeing across the country, the East Coast continues to outperform the West Coast and our East Coast and West Coast markets continue to outperform the Sunbelt. And then the second component is our suburban markets also continue to outperform our urban markets. So from our perspective, with a portfolio that's 70% suburban coastal, market dynamics are lining up well for continued strength for the remainder of 2024 and continued strength as we head into 2025. So that's emphasis area one. Second area of emphasis is we're investing significant amount of time and energy in and around our operating model transformation and making great progress there for folks that were at our Investor Day in November, we increased our target for incremental annual NOI to come from our operating model initiatives to $80 million. It should be about $10 million of uplift this year. which will get us to -- in the range of $37 million towards the $80 million target by the end of 2024. So my summary there is making great progress, also continues to be a nice runway as you think about future earnings growth. Third area of emphasis is that as the transaction market has though, we've continued to proactively reposition our portfolio towards our portfolio allocation targets. One of those is moving from 70% suburban to 80% over the coming years. And the second is we're about 8% in our expansion markets today and growing that towards our 25% target. We've sold about $500 million of assets so far this year at a cap rate of 5.1%, and we're redeploying that capital for the most part into our expansion regions. And my -- what I call out there as we think about that trade of making the shift from selling some older, slower growth, established region assets and redeploying it into the expansion region assets, we see that trade as a more opportunistic trade for us at this point in time as compared to the last couple of years. Fourth area of emphasis is our development platform really is shining today, reinforcing our leadership role in the sector, reinforcing our platform, having what we believe to be the strongest external growth profile with anyone in the sector. We have $2.5 million under construction today before equity offering, which I'll get to in a second. That was 95% match funded, so you think about future earnings and value creation to come from our external growth profile, very strong as you look forward over the coming quarters, projects underway and lease-up are outperforming and we did increase our development starts for 2024 by about $200 million to $1.1 billion. So incrementally feeling more optimistic about really tapping into that unique development engine that we have at AvalonBay. And then fifth, to kind of wrap it up from a capital perspective, we're in a terrific shape and a terrific spot today, continue to have one of the strongest balance sheets really in all of REIT land. And then last week, we opportunistically tapped the equity markets with an $800 million equity forward, primarily oriented towards next year's development starts. So be able to lock in capital that we think will have a spread in the range of 100 to 150 basis points of where next year's development starts. Could be. Again, another one of those items that sets up very well for us and continuing to deliver superior internal and external growth in the quarters and the years ahead. So we're excited about our momentum. And that's what's top of mind. And with that, Josh, I'll turn it back to you.

Yes. Maybe we start there with the development. Like what are you seeing on the ground that's getting the confidence to kind of one increase your 2024 development starts and then also just start thinking about the groundwork for 2025? And where are these opportunities to?

Yes. So -- we're the most prolific developer of anybody with a peer set, and we gave a stat in our Investor Day, but just to emphasize it for the group. Again, you look at over the last 10 years, we developed more at AvalonBay than the rest of our peers combined. And when we talk about development at AvalonBay, this is through our fully integrated development and construction platform, which is not true of most others. So I start there because we're living and breathing on the ground, live data every day. We also have some really long-standing relationships with subcontractors, which in today's environment is allowing us -- the subcontractors looking out and saying, "Yes, things are looking a little softer, business may be a little bit dryer". Who do they want to do business with? They want to do business with people like AvalonBay, and they're willing to lean in, in and around pricing. So actually seeing construction costs start to come down in a number of our markets, particularly when we're at a point where we're starting and going at the bid. Right now, I'd say, broadly speaking, kind of in the 3% to 5% range. You asked sort of where are we seeing these opportunities. I'd say the most attractive opportunity set right now that we're seeing is in our Northeast regions, tough, particularly in the suburbs, these are tough markets to get approvals for, but we get our outside share of them based on our long-standing relationships with these towns. And yields in those markets right now are in the 6.5% to 7% range. This is yield on cost on an untrended basis. Next up would be our expansion regions. And generally, what we're seeing there is development yields in and around sort of the 6% range. So -- and that's -- those 2 regions are the bulk of our activity, kind of 45% in our East Coast regions, 45% in our expansion regions, where it's been the toughest for new development starts has been out West. And that's partially because you haven't seen rents in some of those markets recover the same way you've seen elsewhere, and we haven't seen the construction costs savings that we're starting to see. But some of that dynamic is also starting to shift. So we're starting on the margin feel a little bit more optimistic about development starts out West as well. So we haven't put out a target for next year, but the ability to lock in opportunistic capital in the circa kind of 5% initial yield type of range and then have the prospect of applying that to development starts in the mid-6 type of range. That's a pretty powerful vehicle.

And when you think about like where the development platform is going versus maybe what it was at the start of this year, I guess like are there shifts like the Northeast suburban development? Is that more attractive today than it was a couple of months ago? Or is it kind of a steady state as where the opportunity set is going?

I think across our regions, it has improved. I think we have seen the earliest movements on construction costs in our East Coast established regions. Those are places which generally there was less development going on. We're starting to see that happen in places where there's been more activity and the subs are getting a little bit hungrier. That's probably the -- so that's been one change. Rents, kind of the top line, not in all places, but in a number of our markets are feeling like we're at a stable level there. So getting more confident in our ability to underwrite top line. And then the third piece, when we talk about 100 to 150 basis points of spread, we do it to our cost of capital, we also want 100 to 150 basis points of spread relative to underlying asset values. And so as there's been more transaction activity, it's also given us more confidence about sort of where that baseline of market cap rates is today. So you triangulate those 3 together plus this unique skill set we have and our ability to raise capital is what has us leaning in.

And then that 6.5% to 7% return on invested capital that you flagged, I think -- I don't know if that was just for the Northeast suburban markets, like, we've seen an uptick when you've done developments over the last couple of years with the ultimate kind of return on invested capital, how does that figure compare to where your deliveries today have been trending?

Yes. So our projects and lease-up have continued to outperform the set that we have underway right now are outperforming by about 40 basis points, and are trending to a 6% yield. Now that set of projects we funded with capital from yesterday, right? So they had their own 150 basis points of spread. It was just sort of a different point in time that we locked it in. So that was sort of that batch. The batch before that one had some really high levels of profit, we're sort of delivering in like the 6.5% range against a similarly low cost of capital.

Any questions on development? So one of the things I've been really focused on with like all REITs is just the operating platform and improving that platform, it's reach should to be more than just a collection of assets. It should be 1 plus 1 is at least 2.5, right? Can you walk us through that operating model transformation, like where are you today? Where do you see it going? Have you laid out some NOI targets, but just kind of where can you take this? And where are you leaning into?

Sean, do you want to...

Yes. So the operating model transformation really is a function of sort of 3 primary things for us: first is around leveraging technology to provide more digital solutions for customers and our associates that drives labor efficiencies. The second is the centralization of various support requirements from a labor standpoint to the extent that self-serve activity is not 100% foolproof, but it is, call it, maybe it's 80% as an example. And so we're outsourcing to our centralized team as opposed to the on-site team, some of the interactions that are required there. And then the third piece is around the organizational model on site, which is how we have described taking pods of communities, 2 or 3 communities, 600 units and then leveraging that to a neighborhood, we call it, which maybe is averaging 1,500 units with 1 set of leaders and then roving staff throughout that neighborhood. And it's a combination of those activities plus some connectivity services providing to residents that are really targeting to deliver $80 million of incremental NOI over the next few years. So where we are in the journey is, by the end of this year, we will have delivered about $37 million, $38 million out of that $80 million. There's an incremental $10 million of this year, about $6 million of that relates to connectivity services, about $4 million from the labor efficiencies that I identified. So there's roughly, call it, another $40 million, $50 million to come at beyond 2024. And what we're seeing is that thus far, on the labor side, we can get incrementally more efficient through the digitization. The piece that will be coming that we haven't yet rolled out is AI support for those transactions that I mentioned, which will be the layer between the digital solutions and the centralized team. And so over time, the on-site team will continue to get more efficient, that centralized support will also get more efficient as more of those questions from prospects and residents are handled by AI. And so we've done that for lead management now for 4 or 5 years, but other interactions were just on sort of the early -- the early innings of that is the way I describe it. It's still will be more juice to come from that as we deploy that over the next few years. So I'd say it's still early to your point in terms of the operating model transformation, both in what we'll generate from it and some of the things that we sort of have in R&D that are not yet reflected in the $80 million.

What Sean just ran through is obviously leading to a tremendous amount of internal growth. It's also exciting is we're taking that skill set and now also bringing it to external growth. And specifically, when we're thinking about new developments or new acquisitions, driving an incremental 25 to 40 basis points of yield by having that asset on our platform and benefiting from what Sean just ran through. And that was not the case a couple of years ago. So that speaks to the investments we're making, what we think about the increasing benefits associated with scale and particularly investments in technology, centralization and neighborhooding.

Let me ask a follow-up on that. So it seems like most of the benefit of the $80 million comes from labor efficiencies, that might -- was there a revenue component as well in that?

Yes. There's a combination of things there. So the $80 million target, about $30 million of it represents incremental revenue and profit -- incremental profit associated with resident connectivity services. So that's the Internet offering, that's smart access, those particular components. The balance of it is more around labor efficiencies at this point in time. There are other things that we have in R&D that ultimately will drive incremental revenue that are not yet reflected in the $80 million. And so that would be to come. So there's some stuff on the revenue side. And then the AI side will enable some additional labor efficiencies, particularly at the centralized call center that we have, that we'll talk about over the next couple of years as we firm those up.

Is there maybe a pushback from those on the connectivity side -- how is that working [indiscernible]?

Yes. I mean, generally, what we're seeing is we can negotiate agreements to deliver that service at less than retail cost. So to the resident, what they look at it, they will either see a discount to what they are currently paying to pick a provider, Verizon, AT&T, et cetera, et cetera, or maybe it's breakeven, when you bundle it in with some smart access cost as well. So for the most part, what we've seen from residents is there's initially some hesitation more around what are you trying to charge me for -- but then typically, what happens is, and people go look at and are educated about, tell me what your Verizon Bill, you talk about a salesperson in front of you with a customer, tell what your Verizon bill is, this is what we would call deliver to you for that same 1 gig of service as an example, then they get it and say, okay, now I understand. I'm getting the benefit of you providing the service to the entire community as opposed to buying it on a one-off basis. And it's always on -- it's available -- in our new communities is available throughout the community, everywhere, all the common areas, pool areas, et cetera. So they see it as a convenience factor because they have to deal with a cable company as an example. And then also that it's building wide in a lot of cases where it makes it much more seamless for them -- and then you got the cost factor.

Any questions from the field? So Sean, maybe -- yes -- you mentioned AI and it's obviously a huge hot topic. And last June, we did a dinner with you guys around NAREIT. And there was a discussion about like AI and how you have all this data. You're a big developer, you have all these touch points. And I think like a big part of it was kind of putting the data together to kind of start processing it to make better decisions. Like where -- any kind of update on that front? And does that play into your comment, Ben, about like the external growth opportunities with the operating model transformation? Or is that kind of a side comment?

Yes. So I'll take the first part on the AI side. So where we've been using AI is for about 4 or 5 years, as I mentioned, unlike management. So probably at this point, 90% of our interactions with prospects back forth questions you have about pricing, unit features, what's the application feed? Do you have a pet policy through text, e-mail and now voice are really driven by our AI platform. So that's all that. We are using data science and the data that we have to also address other areas of the business that don't technically qualify as AI but more around just the data that we have and the decisions that we need to make about the renewal offers that we make is a good example to customers and being able to use the vast amount of data that we have over a number of years to understand sort of price elasticity with customers in different markets, different floor plans, different times a year. And what's the incremental basis point lift that we can get associated with leveraging that data to make a better offer to the customer to begin with. So that's in the business. The other components of AI, like I said earlier, are really in the very early learnings for us. But we'll -- with the data that we have, well, we believe, result in better decisions in terms of knowledge of decisions that we have to make around pricing, marketing, so the entire funnel, as an example. But then also as it relates to the interactions with customers and trying to automate those as much as possible to deflect interaction with human labor, either again on site or at the call center. We think it's a significant opportunity that has not yet been deployed.

And then if you just think about shifting over the external growth, it is primarily that first bucket, right? So the simple way to think about it, Josh, is think about the $80 million that we're executing against both on the revenue and expense side, bringing on an additional asset. It's taken about neighborhooding as an example. We can do that more cost effectively than we traditionally would have looked at it thinking about an individual asset with individual staffing.

And you laid out those 4 areas of strategic focus, and you mentioned them today following up on the Investor Day. I guess, how do we think about them all kind of coming together in the many relative outperformance you could expect from your -- from AvalonBay versus maybe a traditional or a peer out there in the REIT space?

Our focus, our objective as an organization is to deliver superior growth and to drive that both through superior internal growth and superior external growth. And going back to the framework that we used at the Investor Day, I got on the external side, it was a very unique development platform that continues to shine. And then on the internal growth side, it's a combination of how do we think about portfolio allocation. How do we think about proactively managing our portfolio over time? How do we think about reinvesting back into our existing assets. and incremental opportunities on the operating model. And so when we put those together, what we're targeting, and this was in our Investor Day is above our baseline growth, being able to deliver incremental earnings growth in that 200 basis point type of range. And I feel like we're well on that path. We've done it over time, and there are different components and different ways we're leaning in, but we're very focused on the continued investments and how we continue to leverage our strategic capabilities to drive that outsized growth going forward.

I think, you used the term neighborhooding. I'm just wondering if the new operating model encourages you to think differently about asset location, clustering of assets concentration for critical mass?

It does. It definitely does. When we're thinking about within an existing portfolio, as we're thinking about sort of take our Northeast expansion markets where we've been selling assets. We do think about selling certain assets given potentially clustering benefits or lack thereof and when we think about new capital deployment in new markets. We do think about -- it may not be day 1, but over time, having a very clear view on where we want -- when we think about portfolio optimization, where we want to have those densities and building towards that goal given the efficiencies it can generate.

Following up on that 200 basis points above like the base level you flagged, could you remind -- I guess, sorry, could you expand on that 200 basis points more on just like how much of that might be coming from external growth, internal growth? And did you quantify once the base growth level that you're thinking? Or how we should think about at least macroeconomics?

Yes. So on the -- we did in the Investor Day, and we've got a slide in the Investor Day, which remember, Josh, sort of breaks out the 2 primary buckets, sort of external and internal. On the development arena, we think it can generate in the range of 125 to 150 basis points of incremental growth per year over a cycle. Obviously, it'll be different points in the cycle, sort of heavier, but kind of over a cycle, you're in that type of range. And then the combination of the operating activities, we were in the range of an incremental 50 to 70 basis points above and beyond the baseline. The baseline itself, we didn't quantify -- obviously, part of that is going to be cycle and market dependent. Over a long period of time, our business and multifamily business has delivered growth in the 2.5% to 3% type of range. So we're looking to deliver that plus our incremental drivers of growth and to do that consistently over a cycle.

Is there anything in the -- like when I think about that like baseline growth at 2.5% to 3%, like I think a lot of that was maybe anchored in from gross GFC to COVID, where like inflation was really low, interest rates are really low, maybe the economy is a little bit weaker and things are still recovering out of the GFC. Like is that still kind of the framework to think about on a go-forward basis? Or is it something shift in the macroeconomic environment that maybe apartments can grow at a higher rate in the future, at least on the revenue side?

Yes. So I'll call out a couple of things and Kevin, you should weigh in here. So on the plus side, and Matt Birenbaum, our CIO's made this comment, I think he puts it well, to a certain degree, our suburban coastal portfolio is better suited for where demographics are headed over the next 10 years than it was over the prior 10 years. So if you think about what the core renter is going to look like, where they want to live, what their preferences are, look at continued supply restrictions, that sets up very well for our portfolio. Now on the flip side, and maybe this is a little bit where were going, there are some potential headwinds that didn't exist before. And so refinancing headwinds, right, exists across all of REIT land that will be a headwind for us. Now on a relative basis, given that we trade at some of the tightest spreads of any REIT, that will impact us less, but it is potentially a headwind depending on where rate stabilize and where we're borrowing over the next 10 years versus where we borrowed over the last 10.

I may add just a couple of things, that was well said that -- I think for our Investor Day, we looked at our rent CAGRs over our 30-year history. And I think they averaged somewhere around 2.8%, 2.9%. So that equated to something around in the range of inflation plus 50 bps given our market footprint, which then and still is today focused on our established coastal markets that benefit from supply constraints and other things that make them desirable. So the notion that, that over that time frame, rent could grow it a little bit above inflation, made some sense, that may still be true. But of course, there's a little bit of a natural limiter on how much you can grow above inflation given the fact that it's coming from our residents whose income themselves need to more or less grow somewhat in line inflation [indiscernible] we're looking for a more educated resident that can tap into higher levels of growth. But I think thinking about rent growth in our markets being somewhat above inflation, it seems to make sense. There's 30 years of track record behind that, and we're continuing to cull the portfolio, make sure it's ever well mapped to our target resident.

Questions?

Maybe just thinking about -- I feel like it's been a hot topic. I've probably had to break out the last 2 years, just -- are you seeing anything in the broader transaction market that looks interesting, like is there any signs of distress. I think in the past, maybe you said like or I've heard at least like it's like there could be distressed, but there's a lot of capital out there. Any opportunities that you guys are seeing that we...

Let me start with and then I'll get to your kind of the specifics of that question. I made the comment before about, I think, the opportunity of trading assets from our established regions and redeploying into our expansion regions is more attractive today. typically, we've looked for somewhere in the range of 50 basis points of incremental IRR from what we're buying versus what we're selling. For this last batch of assets, that's closer to 200 basis points. And so part of that's growth profile, a big part of it is CapEx profile. We're selling assets that are on average 15 years' old, 20 years' old and buying assets that are 5 to 7 years' old, sort of emphasis, point one. Second one is, as we've been growing in our expansion regions, we've made some very conscious choices about the -- how we want to optimize that portfolio for long-term growth. And this is different than some of our peers, and it's really pushed us to focus on the buying side of buying assets that are lower density, lower price point, kind of in the 5- to 7-year-old type of range. We have not bought assets and lease-up as an example. Those tend to be assets higher up in the price point and tend to be in submarkets facing more continued competition. And we've seen the benefits of that. And with the poster child from a market perspective, I point to you right now as you look at the rents growth being generated out of our Denver portfolio. Our update there was sort of in the 3% type of range, which is not what's happening in broader Denver and is definitely not happening in sort of the urban submarkets of Denver. So those conscious choices are leading us to optimize that growth over time. Now coming back to your question. The -- on the distress side, no, have not seen much, I'd say, sort of over the last year. For the most part, things that potentially could have gotten distressed -- for multifamily -- quality multifamily assets, things that we would have been interested in, either are lenders were willing to extend out and/or equity capital is willing to put in some more equity capital to buy the time. Given the -- given where cost of capital is headed generally across the industry, given some of the pendulum shifting back to real assets in multifamily, and they're probably less likely that there'll be distress in the coming months. It's not to say there's not dislocation and opportunity, right, generally -- the supply dynamics that exist in a number of these Sunbelt markets, it's going to be with us for a while, the refinancing needs, right, all the refinancings that were done 2 or 3 years ago, that's going to be there. So I'm not of the view that it's like a spot point in time we need to take advantage of, but at the same time, I'm not necessarily thinking about dislocation. For us, as we're thinking about potentially larger opportunities, we really want to focus on opportunities where we can both leverage our balance sheet strength and bring our strategic capabilities to bear right, to really find opportunities where we can mean, as an example, further into some of these operating skill sets, really find opportunities. We're having those assets on our platform. They can be worth more because that's how we can generate outsized returns.

So maybe just hitting on that, it sounds like you're finding most attractive opportunities for the 5- to 7-year-old assets. I guess, what's driving that? Like is no one else really looking for those assets? Or is it some kind of unique capability you have to identify those? Like what...

I think it's been a -- we're not necessarily pushing for sort of upfront, maximize yields. We are really focused on long-term growth profile. I think that's a component of it. And we're not alone in that front in terms of the public peers will also take a long-term approach, but that is different than some private players. We also -- I think we take a particular view around longer-term portfolio optimization. And a part of this gets into -- we know we're going to be developing in these markets over time. And for the most part, development going to be at the upper end of the spectrum. And so we push ourselves as an organization as we're thinking about buying what are the types of assets that will balance our overall portfolio to be able to deliver that long-term growth. So that's also sort of a unique lens that I think we bring to investment activity.

And then you have 2 like supplemental programs to leverage your balance sheet and your development platform. Can you remind us where you are in getting those up to the stabilized level and kind of -- what kind of opportunities you're seeing to have those go into those programs?

Yes. So we have 2 programs and both of them, what I would call as we've institutionalized them over the last couple of years. The first one is our developer funding program and this is where we provide 100% of the capital stack to third-party developers. And generally, we're using it in our expansion regions where we don't necessarily have the presence or the track record that we have in our established regions, to partner with really high-quality developers who have sites that are close and ready to go. We own the asset long term. We influence the design and development of it. We do the lease-up of it. It's a version of our own development, but we're utilizing a third-party developer. So that program, particularly at this point in the potential cycle, what's exciting there, the premise of it was we're going to always be doing our own development, and we're going to ratchet that up and down. But there may be points in the cycle, either our cost of capital or what we're seeing as the opportunity on development where we could tap third-party developers through this DFP program to lean more fully into external growth. So when you have those green light kind of lean a little bit more fully in and also, when you don't have the green light, you don't have the organizational dynamics of sort of leveraging it down. So the DFP program is, I think, in a pretty strong spot right now, it's established enough -- there -- we've done some business with people -- real rapid people in the marketplace. And so those types of folks increasingly want to do business with us and see the appeal of partnering with AvalonBay. So that one we're leaning more into today maybe than we were a year ago. The second program is our structured investment program, which we call SIP. And there, we are providing preferred equity and mezz on new construction multifamily. We have about $200 million of commitments there. We are fortunate in that we built up that $200 million book effectively in today's world versus yesterday's world. And so our first maturity is an example, like our average maturity isn't until 2026. So sort of on today's economics with today's structure in a better spot in the capital structure. We're putting those dollars to work in the 13% range. That has been particularly with the rigor that we bring to the underwriting process. That has been a tougher box to fill in today's environment, just generally because new multifamily construction has been tougher. Now that potentially could start to change a little bit, but between the 2 in terms of where we're leaning a little bit more heavily in capital investment, more of our orientation is around DFP than it is SIP today.

So we're basically out of time right now. We do have 3 rapid fire questions. They're multiple choice. They're very difficult. The first one is, do you expect real estate transactions to increase once the Fed starts to cut? Yes or no?

Yes.

And if yes, when do you expect them to pick up: a, 4Q '24; b, first half '25; or c, second half '25?

First half '25.

How would you characterize demand for space today: a, improving; b, steady; or c, weakening?

Steady.

Last one is, last year, the majority of companies at our conference stated they expected to ramp up spending on AI initiatives in 2024 and how would you characterize your plans over the next year: a, higher; b, flat: c, lower?

Higher.

You passed. Thank you. Thanks everybody.