Located in New York City's Lower East Side Community, Avalon Chrystie Place was completed in 2005 at a cost of $149 million. The community has 361 rental apartments and more than 3,000 square feet of retail space.

AvalonBay Strives to Diversify its Portfolio and Expand Clientele in Competitive Markets

By Allison Landa

"We're focused on building a very strong organization of people. We hire the best people, build a strong culture and consequently, we have a very long-tenured employee base," says Bryce Blair, chairman and CEO of AvalonBay Communities, Inc. (NYSE: AVB). He makes it a priority to find and retain the industry's top talent in order to keep his company competitive. AvalonBay's four top executives have worked together for 17 years. "That speaks to a pretty strong culture here—people enjoy what they do and who they work with," he says.

That insistence on working with the best has been a boon to the apartment REIT, which develops, redevelops, acquires and manages communities in the country's highest barriers-to-entry markets. As of June 2006, AvalonBay owned or held interest in 160 apartment communities in California, Connecticut, Illinois, Massachusetts, New Jersey, New York, Rhode Island, Washington and the Washington, D.C. region; this makes for a portfolio that clocks in at approximately 47,000 individual rental units.

Avalon Mission Bay in San Francisco was completed in 2003. The community features 250 luxury rental apartments in a spectacular downtown San Francisco location.

True To Its Roots

In August 1993, the company began as Avalon Properties, Inc., an expansion of the multifamily apartment arm of Trammell Crow Residential Mid-Atlantic and Northeast Groups. In November of that year, the company went public. At the time of its IPO, Avalon Properties had a 22-community portfolio, with slightly more than 7,000 rental units.

In 1998, Avalon Properties merged with Bay Apartment Communities Inc., the successor apartment business of Greenbriar Homes. Bay also was a public company with more than 3,400 rental units in Northern California.The merged company was renamed AvalonBay Communities.

Blair says that from the time of its public offering up through the present, AvalonBay has retained a consistent focus on its long-term goals, rather than following fleeting industry trends. Those goals include creating a large portion of its portfolio from the ground up. "We're a very active builder," he says. "We've built about two-thirds of what we own with the long term in mind. We're also very active redevelopers who are constantly reinvesting in our portfolio, from our IPO in 1993 up to today."

AVALONBAY COMMUNITIES, INC. 2900 Eisenhower Avenue Suite 300 Alexandria, Virginia 22314 703-329-6300 www.avalonbay.com MANAGEMENT: Bryce Blair, Chairman & CEO; Timothy Naughton, President; Thomas Sargeant, EVP, CFO and treasurer Ticker SymBol: AVB, listed on the New York Stock Exchange • 52-WEEK HIGH: $125.87 • 52-WEEK LOW: $78.82

With $4.5 billion currently in the development pipeline, AvalonBay continues to stay driven by its desire to build. "It's a tremendous source of value creation for the company," Blair says. "It's definitely a core strength, and something we intend to take advantage of."

Blair estimates that approximately three quarters of AvalonBay's operations are focused on development, with the remaining quarter in acquisition. "That won't change dramatically," he says of the mix.

Analyst Rod Petrik of Stifel, Nicolaus & Co. gives that strategy a thumbs-up. "We believe that in this cycle, the external growth will be driven by development, and AvalonBay has one of the highest, if not the highest, development pipelines in the sector," he says.

Craig Leupold of Green Street Advisors agrees. "The company has one of the best development franchises in the apartment sector," Leupold says.

Diversifying Portfolio, Expanding Clientele

AvalonBay has changed its scope of offerings and its tenant base. The company began with a tight focus in one particular area: suburban garden apartments. "That was our genesis," Blair says. "Over the last decade, we have transformed the company dramatically from the focus on those suburban wood-frame apartments."

Today, AvalonBay has a more diversified portfolio, Blair says. "It's changed in the type of communities that we design and build. Instead of soley designing and building wood-frame buildings, we build everything from townhouses to high-rises. That includes constructing new communities and renovating 50-year-old communities. We try to capture housing for a diverse group of people, from the 25-year-old single person to the empty nester."

Those changes have come in response to AvalonBay's expanding customer base. "It's becoming more diverse," Blair says. "We have baby boomers who are moving on and looking for different things in housing. They can afford expensive products and they want more features. On the other hand, you have the echo boomers, who cannot afford as much. We target a variety of customers and we want to have a variety of products to satisfy them."

AvalonBay's West Coast Senior Vice President of Development Steve Wilson attributes the shift in the company's focus on markets with higher barriers to entry. "Our offerings have broadened to include a higher concentration of high-rises," Wilson says, adding that he's also seen development locations shift to more urban areas. "In general, I think there's a shift back to cities. You're starting to see people spending less time in their cars and more time enjoying entertainment and culture. People want to live where they work and play, and they are willing to pay premiums to live in those types of locations."

UPSIDE-DOWNSIDE A.G. Edwards & Sons Rating: HOLD (7/27/06) Target Price: $115.50 "Assuming a continued slow demand for home sales and a meaningful decline in home prices, an increase of these homes could enter the rental market. However, having identified this possible risk scenario, we do not believe there will be much impact on AVB's ability to maintain above average growth in cash flow from operations." Morgan Stanley Rating: STRONG (7/27/06) Target Price: $114 "AVB's very strong 2Q06 results were a penny ahead of our expectations and generally uneventful. While we like the company and expect them to post some of the strongest growth over the next several quarters, at 26.3-times 2006 earnings (14 percent above its historical average), we continue to believe this is already reflected in the stock price." Bear Stearns & Co. Rating: PEER PERFORM (7/28/06) Target Price: $122 "AvalonBay has solid growth prospects, but the stock has had a great run over the past couple of years, and, at current levels, feels expensive. That said, apartment sector fundamentals continue to improve, as do the conditions in AVB's core markets, and capital continues to pour into the sector pushing prices higher." Stifel Nicolaus & Co. Rating: HOLD (7/28/06) Target Price: $115.53 "We believe development continues to be a key factor in AvalonBay's above-average bottom-line growth this year. Our 2006 FFO estimate represents recurring growth of 14.9 percent. Yields on development are currently estimated at 7 percent, but growing rents and a potential easing in construction costs should positively impact yields at stabilization."

Wilson points to Avalon at Mission Bay as a prime example of demand for urban-centered living in premium locations. "We feel very strongly about Mission Bay," he says of the 303-acre Mission Bay land development near San Francisco's AT&T Park baseball stadium. AvalonBay has completed one tower there and is in construction on a second. "I think Mission Bay's success to date has been in direct correlation with the acceleration of housing, biotechnology and the expansion of the University of California, San Francisco. It's amazing how Mission Bay has been able to reinvent itself a couple of times. It's a very desirable area and a planner's dream."

The first Avalon at Mission Bay tower was completed in 2003 and stands 16 stories high, encompassing 250 residential rental units as well as 7,800 square feet of retail space. The second tower will stand 17 stories high with 313 total residential rental units. It will also offer 8,600 square feet of ground-floor retail, an indoor basketball court and a rock-climbing wall. Between the two towers, 40 rental units have been set aside as affordable housing.

Mission Bay's location adjacent to an urban center with high barriers to entry, as well as access to jobs and cultural opportunities, reflects a major attribute that AvalonBay prefers. "You get the benefits of a world-class city like San Francisco, but you can get out fairly quickly. For example, lots of people live in Mission Bay and commute about an hour south," Wilson says.

He sees Mission Bay as emblematic of a larger trend: expensive housing markets giving a boost to rental markets. "Housing affordability is a major driver of rental demand," Wilson says. "Unless there is a major home price correction, the value proposition decidedly favors rental in most major markets, certainly the AvalonBay markets. Sprinkle in consistent job growth and rental fundamentals and the outlook is strong."

Hot Cities

AvalonBay's specialization in areas with high barriers to entry is a key business component, according to Blair. "Our strategy is the New Yorks, the San Franciscos, the Bostons," he says. "It's more difficult to put into place, but once you do, you're going to have less competition. Therefore, over the long term, your investment is going to perform better and ultimately deliver stronger returns."

AvalonBay operates in 16 markets that are some of the country's tightest in terms of land, a bonus as far as Wilson is concerned. "One thing about the high-barrier markets is that you're always going to manage the supply in those areas," he says. "It's not like in Denver or Phoenix where you can still develop new areas. In San Francisco or Seattle, it's very difficult to come in and flood the supply, which we believe is going to give us a competitive advantage in the long term."

"Development is the key challenge that certainly faces everyone in the industry. We’re not immune. Land prices have escalated dramatically; it’s very difficult to develop new apartment communities." —Bryce Blair

Wilson points to the premium on land and labor costs as the downside of operating in such tough markets. "These are typically condo locations, so you compete with the condo market," he says. "Costs, generally speaking, are higher in the biggest cities. There's a premium at these locations, but we firmly believe that over an extended period of time, throughout the real-estate cycle, we will be compensated appropriately for taking the risk."

Currently, Seattle is a market of particular interest to AvalonBay. Active in the late 1990s, the Seattle market was hard-hit by layoffs of Boeing aircraft employees in the wake of the Sept. 11 terrorist attacks. But Wilson says the city has shown signs of revival over the past year and a half—a trend that mirrors much of the nation in terms of economic resurgence.

"Avalon had persevered and kept working the protected entitlements of the deals that we had in place, so when we saw the economics of the rental business turn around in the last 18 months, we were able to break substantial ground," he says. "We like the look of Seattle. Job and rental growth are tops in the country, and the Seattle market looks like it has some legs. We're judiciously starting to expand our business there."

Coping With Challenges

Morgan Stanley analyst Robert Stevenson says strong second quarter 2006 results portend a bright future for AvalonBay. "We believe AvalonBay's market concentration and large development pipeline make the company one of the most attractive in all REITdom," he says.

		Condo Conversions Losing Steam? In recent years, the low interest rates that have undermined apartment fundamentals have given rise to...

However, Stevenson says he believes a softening in condo demand may mean apartment REITs could face the problem of oversupply. "AvalonBay operates in several markets that could experience oversupply from the rapidly deteriorating condo market," he says. "This could prompt supply coming back on the market, dampening apartment fundamentals."

Blair has an opposing view, claiming that rental demand will increase as home sales continue to decrease. "Over the last two years, the sales market has been extraordinarily strong, which has hurt our business because people have moved out of condos," he says. "That has reversed itself pretty dramatically. The for-sale market has slowed, and many other markets have come to a screeching halt."

Petrik agrees. "Certainly home sales are down, which should benefit AvalonBay as well as other apartment companies," he says. "We do believe that in the private markets, apartments are still in pretty high demand."

Blair says AvalonBay's second quarter 2006 earnings show the company's best performance in six years. "We are seeing our NOI for the year in the range of 8 percent to 9 percent," he says. "That's a reflection of a strong economy, a slowing sales market, and the performance of our assets. The housing markets where we operate are so expensive that people cannot afford to own a home or a condo. People are seeing the benefits of rental housing and we're optimistic about our fundamentals."

As an active builder, Blair sees development and construction costs as a primary concern. "It's the key challenge that certainly faces everyone in the industry," he says. "We're not immune. Land prices have escalated dramatically; it's very difficult to develop new apartment communities."

Petrik also believes the company's challenges are external. "Some of the older product in San Jose—they assumed that from Bay—may still be a little soft. They have challenges in front of them, but it's more submarket- and market-related than internal."

Looking Ahead

Overall, Stevenson says he sees good days ahead for AvalonBay. "We have a continued solid outlook for apartment operating fundamentals over the next 12 to 18 months," he says. "Continued job growth and a slow-down in the for-sale housing market is driving demand, and supply remains in check. We like AvalonBay's assets, markets and operating execution."

Petrik agrees. "We look at AvalonBay as being one of the real blue-chip names, not amongst the apartment companies, but out of all REITs," he says. "They build a quality product. Over the last few years when fundamentals were very soft in the apartment markets, they would capitalize on their very high-quality portfolio and were able to sell a number of them off to condo converters. That allowed them to take advantage of the downturn in the cycle. Now we're clearly in a recovery for apartments. You have pricing power back with the apartment companies."

Leupold also has a positive outlook, citing AvalonBay's strength throughout its history. "Certainly the company's been one of the better-performing apartment REITs over the last 13 years or so," he says. "Currently, it's continued to perform quite well, both in terms of returns for shareholders as well as how the company has done product-wise."

Blair says he sees a continued focus on personnel, as well as an ongoing drive to create value in AvalonBay's prized high barriers-to-entry markets. He also lists excellent customer service as well as responsible management of the company's large development pipeline as strong priorities for the future. "If we follow these principles, we will grow and deliver great shareholder return," he says. "Talk is cheap, but the proof's in the pudding in the ability to deliver strong results over time."