AvalonBay Communities, Inc. (NYSE:AVB) Q4 2023 Earnings Call Transcript

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AvalonBay Communities, Inc. (NYSE:AVB) Q4 2023 Earnings Call Transcript February 1, 2024

AvalonBay Communities, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Good morning, ladies and gentlemen, and welcome to AvalonBay Communities Fourth Quarter 2023 Earnings Conference Call. At this time all participants are in a listen-only mode. Following remarks by the company, we will conduct a question-and-answer session. [Operator Instructions] Your host for today’s conference call is Mr. Jason Reilley, Vice President of Investor Relations. Mr. Reilley, you may begin your conference.

Jason Reilley: Well, thank you, operator, and welcome to AvalonBay Communities fourth quarter 2023 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?

Ben Schall: Thank you, Jason. I am joined today by Kevin O’Shea, our CFO; Matt Birenbaum, our Chief Investment Officer and Sean Breslin, our Chief Operating Officer. We’d like to start by thanking our 3,000 AvalonBay Associates for delivering exceptional results in 2023. Your efforts and dedication are what make it happen, and your commitment to our purpose and culture makes us who we are as an organization. Thank you. As a brief recap on last year, as shown on Slide four, we achieved 8.6% core FFO growth for the year, a testament to our ability to grow earnings through unique internal and external drivers. Through the proactive management of our assets, same-store revenue ended the year up 6.3%, and NOI increased by 6.2%.

For external growth, our developments underway continue to outperform with $575 million of completions across six projects, delivering outside stabilized yields of 7.1%. We’re particularly proud of the results from our operating model transformation, where we are delivering enhanced value to customers and driving meaningful efficiencies. As highlighted on Slide five, our operating initiatives exceeded expectations in 2023, delivering $19 million of incremental annual NOI to the bottom line, which was $7 million or almost 60% higher than anticipated. Moving to Slide six and capital allocation, remain nimble in 2023, having shifted to being a net seller during the year, with four dispositions from our established regions for $445 million, $275 million of which we’d redeployed into acquisitions in our expansion regions.

We also started $800 million of profitable new development during the year, including $300 million of starts in the fourth quarter at an initial projected yield of 6.7%. We also continue to build our structured investment business this year, in which we provide preferred equity or mezzanine loans to third parties for new multifamily construction. We’re well positioned to underwrite this business given our development and construction expertise and our live proprietary data and we’re fortunate to be building this book of business in today’s environment, reflecting today’s rates and asset values. The commitments we made in 2022 and 2023, which now total $192 million, are set to deliver an uplift in earnings this year and going forward. Our balance sheet is as strong as it has ever been, with a key metric summarized on Slide seven, providing strength as we manage the business and flexibility as we consider creative opportunities that may arise during 2024.

Among a set of peers with strong balance sheets, we continue to experience some of the tightest credit spreads among all REITs, providing a meaningful financial advantage. Slide eight highlights our strategic focus areas for 2024. These focus areas draw upon our foundational strengths as an organization, while also recognizing our commitment to continue to evolve and our areas we are confident will drive superior growth over a multi-year period. Front and center are the next steps in our operating model transformation. At our Investor Day, we raised our target for incremental annual NOI to come from our operating initiatives to $80 million, $55 million of NOI from Horizon 1, and $25 million from Horizon 2. Second, we will continue to drive differentiated growth from our development and construction leadership.

The near-term focus is on execution of our projects underway, ensuring they deliver outsized value for shareholders and while new start economics are challenging in certain of our markets, this is the type of environment in which we’ve typically found some of our most attractive development opportunities. Third, as a continued multi-year approach, we have set a target of shifting 80% of the portfolio to the suburbs from 70% today, and set a target of having 25% of our portfolio in our expansion regions, up meaningfully from 8% today and given the cooling of fundamentals in the Sunbelt, we believe we can make this transition at a more attractive basis than we were able to a couple of years ago. We’re also making significant and very creative investments in the existing portfolio this year, ranging from apartment renovations to the creation of new Accessory Dwelling Units, or ADUs in certain markets.

Finally, and as a follow-up to my comments about our balance sheet, we are confident that there will be opportunities for us to both utilize our balance sheet capacity and bring our strategic capabilities to bear, be it operational, development, or by utilizing our scale to generate value for shareholders. As we assess the year ahead and moving to Slide nine, our baseline expectation is for a slowing economic environment this year. As we have in the past, we start with consensus estimates from the National Association for Business Economics, or NABE, which forecasts positive but very modest job growth in 2024 of 55,000 jobs per month. This muted growth tempers housing demand, while other factors such as rent versus own economics should serve as a balanced apartment demand, particularly in our established regions, where it is now $2,500 per month more expensive to buy than to rent.

Nevertheless, given mixed signals and what we believe is higher uncertainty in the economy and capital markets, our approach is to remain nimble and be ready to proactively adjust based on how 2024 evolves. In an environment of uncertainty, one known factor is new multifamily supply. In our established regions, we expect new apartment deliveries of 1.6% of existing stock in 2024, and expect this figure to further decline to 1.4% in 2025. Importantly, these figures are in line with historical averages for these coastal markets, and this is quite a contrast with supply dynamics in the Sunbelt, which will have twice the level of supply and this elevated supply dynamic in the Sunbelt is expected to continue at least through 2025, simply a function of the reality that it generally takes two plus years to complete and stabilize a new development project and so as we assess 2024, we expect to be relatively well positioned given the stable demand and limited supply outlook in our established regions, but are forecasting a slower year of growth.

I’ll now turn it to Kevin to provide an overview of our guidance for the year and the building blocks of earnings growth.

Kevin O’Shea: Thanks, Ben. On Slide 11, we provide our operating and financial outlook for 2024. For the year, using the midpoint of guidance, we expect 1.4% growth in core FFO per share, driven by our same store portfolio and by stabilizing lease-up communities, partially offset by the impact of capital markets and transaction activity, as well as by slightly higher overhead costs. In our same-store residential portfolio, we expect revenue growth of 2.6% and NOI growth of 1.25% for the year and for our capital plan, we anticipate total capital uses of $1.4 billion in 2024, consisting of $1.1 billion in investment spend and $300 million in debt maturities. For our capital sources, we expect to benefit from nearly $400 million in projected free cash flow after dividends and to source $850 million in new capital, which we currently assume will be unsecured debt issued later this year.

An aerial view of a bustling metropolitan area with high-rise buildings and busy streets.

In this regard, thanks to our balance sheet strength and our A minus and A3 credit rating, we enjoy attractively priced debt today at around 5% on a 10-year unsecured debt that we can invest in development yielding in the mid-sixth range to support future earnings growth. We also project drawing upon $175 million or the $400 million in unrestricted cash on hand at yearend 2023, resulting in projected unrestricted cash at the end of this year of about $225 million. On Slide 12, we illustrate the components of our expected 1.4% growth in core FFO per share. We expect $0.15 per share of earnings growth to come from NOI growth in our same-store sources of growth with a $0.29 impact from capital markets in transaction activities. And with that summary of our outlook, I’ll turn it over to Sean to discuss our operating business.

Sean Breslin: All right, thanks, Kevin. Turning to Slide 13, three primary drivers will support same-store revenue growth in 2024. First, embedded rent roll growth of 1%, down approximately 50 basis points from where it was at the end of Q3 2023, which is consistent with historical trends, plus incremental lease rate growth throughout the year. Second, an outsized contribution of roughly 80 basis points from the projected 13% increase in other rental revenue, which is derived from our operating initiatives and third, about a 60 basis point improvement in underlying bad debt from residents from 2.4% in 2023 to an expected 1.8% in 2024. The cumulative growth from those three primary drivers is expected to be partially offset by a 30 basis point headwind from the projected $6 million year-over-year reduction of rent relief and a modest drag from net concessions and economic occupancy.

To provide a little more detail on underlying bad debt trends from residents, we’re expecting a 60 basis point improvement year-over-year, our forecast reflects an underlying bad debt rate of roughly 1.6% at year-end 2024, which is still more than double our historical pre-COVID rate. Moving to Slide 14, we expect revenue growth in our established regions to be more than double that of our expansion regions, which is primarily a function of the substantially lower level of new supply in the established regions and within our established regions, we expect better demand supply fundamentals on the East Coast as compared to the West Coast. Southern California is expected to produce the strongest same-store revenue growth, which is primarily the result of a substantial improvement in underlying bad debt on a year-over-year basis.

Transitioning to Slide 15 to address our operating model transformation, we’re tremendously proud of our team’s focus and efforts over the last couple years, which have produced approximately $27 million in incremental NOI. We expect to recognize another roughly $9 million benefit in our consolidated portfolio during 2024. The key drivers in 2024 include Avalon Connect, our bulk Internet and managed Wi-Fi deployments, along with smart access features. In addition, we expect an incremental benefit from our shift to a new organizational model, which reflects neighborhood staffing supported by centralized teams. While we have specific plans for 2024, our focus in these areas and others will continue to deliver additional value for associates, residents and shareholders for years to come.

Turning to Slide 16 to address our same-store operating expense outlook, we expect roughly 340 basis points of organic expense growth, another approximately 140 basis points from profitable operating initiatives, and roughly 75 basis points from the expiration of various tax abatement programs in the portfolio, primarily in New York City. As it relates to our initiatives, the 140 basis point increase is driven by 170 basis points from our Avalon Connect offering, which I mentioned earlier, partially offset by reductions in payroll. As I’ve noted in the past, the deployment of our Avalon Connect offering, which will ultimately enhance portfolio NOI by more than $30 million, will pressure expense growth during the deployment period. We expect to be fully deployed by the end of 2024, so the operating expense impact will diminish materially as we move into 2025.

So now I’ll turn it over to Matt to address our capital allocation activity. Matt?

Matt Birenbaum: All right, great. Thanks, Sean. Turning to Slide 17, we’re planning another year of accretive activity across all of our various investment platforms in 2024. We expect to break ground on seven new developments, representing $870 million of investment at a weighted average yield in the mid-6% range, grow our SIP business by another $75 million with rates on new originations in excess of 12% and expand our investments in our existing portfolio that we discussed a bit at our Investor Day, where we see opportunity to further increase our activity to roughly $100 million at yields of roughly 10%. In the investment sales market, activity levels are still low, but most market participants do expect a gradual increase in transactions as the year progresses.

Our plan is to access this market as part of our portfolio management strategy, selling assets in our established regions and redeploying that capital into acquisitions in our expansion regions. We expect this activity to be roughly neutral on both a volume and return basis, buying and selling in equal amounts and at equivalent yields. As Ben mentioned, the dynamics of this trading activity look to be more favorable in ’24 than they might have been in the recent past, as some short-term operating challenges in our targeted expansion regions may present the opportunity to acquire assets significantly below replacement cost. Of course, the market for all of our investment activities is highly dynamic, and we are prepared to pivot and adjust our plan in response to potential changes in the macro environment as the year evolves.

Turning to our existing development underway, Slide 18 details the impressive results that continue to be generated by our current lease-ups. The four development communities that had active leasing in Q4 are delivering rents $260 per month, or 8.4% above our initial underwriting, which is translating into a 20-basis point increase in yield. As a reminder, in general, the rents we quote on our developments are current market rents as of the time we break ground, and we do not trend or update these rents until we achieve significant actual leasing velocity close to completion of the project. While market rents certainly didn’t grow as much in 2023 as in prior years, there is still some lift to come when we mark the rents to market on the $855 million of lease-ups we expect to open throughout the course of 2024.

We estimate this increase at roughly 5% based on where market rents are today at these specific communities, which would provide those deals with about 30 basis points of increased yield as well. And with that, I’ll turn it over to Ben to wrap things up. Ben Schall Thanks, Matt. Slide 19 provides our key takeaways. We were very pleased with our execution in 2023 and expect to continue to be relatively well-positioned in a year of slower growth in 2024. We will continue to evolve and execute against our strategic focus areas, including harvesting tangible benefits from the investments we are making in the transformation of our operating model and on the capital front, we will remain nimble, adjusting to the environment as it unfolds, while also being on the lookout and ready to take advantage of accretive opportunities that may present themselves this year, opportunities where we can utilize our leading balance sheet and draw upon our unique strategic capabilities.

With that, I’ll turn it to the operator to open the line for questions.

Operator: Thank you. We will now be conducting our question-and-answer session. Our first question comes from the line of James Feldman with Wells Fargo. Please proceed with your question.

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Q&A Session

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James Feldman: Great. Thank you. Good afternoon. So, I’d like to go back to Slide 14, and I was hoping you could talk us through what your blended rent outlook looks like in each of these regions or broken out by these regions and then if you could talk about how you think it might be different in the first half versus the back half of the year, just given the pace of supply coming online.

Sean Breslin: Yeah, Jamie, this is Sean. Why don’t I give you the sort of blended rent change we expect across the portfolio for the year, so that we can talk about all the individual regions. That’s a lot of data. We might want to do that offline, but in terms of the broader portfolio, our expectation is to deliver rent change of roughly 2% in 2024, which would reflect renewals at roughly 4% and new move-ins at essentially flat and as it relates to the first half versus the second half, if you think back to 2023, where we achieved 3.4% rent change, a good portion of that rent change, a stronger portion was in the first half of the year. So we do expect to see some acceleration in rent change, all else being equal in the second half of 2024 relative to the first half, assuming that obviously the economic environment is consistent with our expectations.

James Feldman: Okay, thank you for that. And then we appreciate the detailed buildup to your revenue and your expense side, but as you think about each of those buckets, where do you think there’s the most variability? Where do you have the most opportunity to maybe push a little more? Where do you think you could pull back maybe on the spending side by the time yearend rolls around?

Sean Breslin: Yeah, no, good question. Taking them in the two pieces on the revenue side, obviously a significant driver is the macroeconomic environment and we provided and Ben referred to some of our assumptions. So we are expecting a slowdown given the roughly 2.7 million jobs that were produced in 2023 as compared to the current expectation for ’24, being close to 700,000. So that’s outside our control, but obviously we’re well positioned to the extent things accelerate and we think we’re also well positioned somewhat defensively given our portfolio if things deteriorate. So outside of that, I’d say what we would see is a more substantial improvement in bad debt would certainly be a tailwind. Over the last several months, bad debt rate from residents has sort of flattened out a bit and primarily as a result of what’s been happening in the court system, residents that are behind getting free legal advice and things of that sort.

So we started to see greater improvement in the court system in places like the greater New York region, parts of the mid Atlantic, etcetera, that would certainly give us a significant benefit outside of just the macroeconomic view and whether we were able to push rents harder or softer in the environment. On the expense side, a good portion of it is baked in terms of what we have. There’s about two thirds of it are expected year-over-year increase is driven by number one utilities, which is really where our Avalon Connect offering comes through and that’s a pretty embedded program we’re on plan. We expect that to be where we thought it would be. Property taxes, there’s a portion of that related to the pilots, but obviously to the extent assessments come in at different levels or rates throughout the portfolio during the year, that would certainly help us out.

The rest of it is kind of ins and outs in different areas, and so I wouldn’t expect a significant shift, but there are modest shifts from line item to line item that might move around with, payroll benefits and things like that.

James Feldman: Okay, yeah, very helpful. I guess lots to keep our eye on. Thank you.

Operator: Our next question comes from the line of Adam Kramer with Morgan Stanley. Please proceed with your question.

Adam Kramer: Hey, guys. Thanks for the time. Just wondering in terms of kind of puts and takes, the $870 million development starts, just kind of what can maybe drive that to the high end? What would cause you to maybe pull back and maybe push some of that out to 2025? And if you think about kind of timing during the year, what’s kind of the view on those starts in terms of when they may, just generally take place over the course of the year?

Matt Birenbaum: Hey, sure, Adam. This is Matt. As it relates to the pace of development starts across the year, it is more back half loaded. I don’t think that we maybe have any starts in Q1 or maybe one. So, we’ll see how that develops across the course of the year. It really is idiosyncratic, though, based on the timing, permits, buyout of various projects. So, the things that might cause it to ramp up or down is really just changes to the deal economics. If rents accelerate or degrade more quickly than we expect in any particular submarket where we’re planning to start a deal or if hard costs surprise us either to the good or the bad, that could cause us to either pull some deals forward and start more or conversely push some deals further out.

Ben Schall: Yeah, Adam, it’s Ben. Just to reiterate, some of our key themes from prior conversations, and we remain very focused on the spread between our development yields and underlying market cap rates. That’s the value we create, and we need to be appropriately compensated for the development risk and then the other component is obviously where we’re raising the capital, both the source of it and the cost of that capital. So those are the higher level elements that we triangulate around, and then there’s the deal specifics that Matt referred to.

Adam Kramer: Great. Thanks, guys and just on the January like term effective rent change, I guess the new rent specifically, and not asking you for kind of each of your markets individually, maybe just at a high level if you could display, I don’t know if you want to kind of go through West Coast versus East Coast versus kind of Sunbelt, maybe just kind of general trends breaking down that January new lease number I think would be helpful.

Ben Schall: Yeah, why don’t I give it to you by Coast. So on the East Coast, we’re trending sort of in that low 2% range. The West Coast was modestly positive about 50 basis points, and the expansion region is essentially flat.

Adam Kramer: Great. Thanks, guys.

Operator: Thank you. Our next question comes from the line of Austin Wurschmidt with KeyBanc Capital Markets. Proceed with your question.

Austin Wurschmidt: Great. Thanks. Good afternoon, everybody. Sean, appreciate the same-store revenue growth guidance breakout between the established and expansion markets. I think you referenced that that’s primarily supply driving the delta between those two projections, but I guess if you remove some of the bad debt improvement, some of the other initiatives and just focus more so on that lease rate growth piece, how do those two regions stack up versus one another?

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