艾芙隆海灣社區公司 (AVB) 2006 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen. Welcome to the AvalonBay Communities third quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS].

I would like to introduce your host for today's conference, Mr. John Christie, Senior Director of Investor Relations. Mr. Christie, you may begin your conference.

Thank you, Holly and good afternoon and welcome to AvalonBay Communities' third-quarter 2006 earnings conference call. Before we begin, please note that forward-looking statements may be made during this discussion, there are a variety of risks uncertainties associated with forward-looking statements and actual results may differ materially. There is a discussion of these risks and uncertainties in yesterday's press release as well as in the Company's Form 10-K and Form 10-Q filed with the SEC.

As usual the 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 available on our website at www.avalonbay.com/earnings. We encourage you to review this information during your review of our operating results and financial performance. With that I will turn the call over to Bryce Blair, Chairman and CEO of AvalonBay Communities for his remarks.

Thank you, John. Welcome and thank you for joining us on our third quarter conference call. With me on the call today are Tim Naughton our President, Tom Sargeant our CFO and Leo Horey our EVP of Operations. On our call I will provide an overview of our results for the quarter and summarize our investment in Capital Market activity. Leo will comment on the portfolio performance and then all four of us will be available to answer any questions you may have.

Let me start with a brief review of the quarterly performance. Last evening we reported EPS of $0.57 and FFO per share of $1.11. The year-over-year growth in FFO per share of 22% was driven primarily by strong growth and same-store sales NOI of 9.7%. This is the strongest NOI growth we have seen in over five years and reflects both the strength of our markets and of our portfolio. As a result of these strong quarterly results and our expectations for the fourth quarter, we've raised our full year outlook to a new range of $4.36 to $4.40 per share.

The theme of our most recent annual report was Positioned For Growth. This phrase was boldly printed on our cover and within the body of the report we identified five strengths we felt positioned us for strong growth in '06 and beyond, the five being the strength of our markets, the strength of our portfolio, the strength of our development pipeline, and finally the strength of our balance sheet and of our organization. Each of these five strengths contributed in a meaningful way to our strong performance this quarter and in our decision to raise our outlook for the full year.

In terms of the strength of our markets, demand remains strong with job growth in our markets tracking the national rate at about 1.5% for the full year. Demand is further helped by the cooling of the for-sale market which has resulted in fewer buyers and consequently more renters. Looking at just the homeownership rate, it has declined by 0.5% from its peak of just over 69%. 0.5% may not seem like a lot, but on a base of 110 million households in this country, it translates into an additional 550,000 renters.

The strong demand is being met by modest net new supply. Over the 10-year period from '95 to '04, net new rental production averaged about 250,000 units per year. If you look at the net rental production for last year and projected full-year '06, it's projected to average less than 100,000 units per year. This is a reduction of about 60% from the prior 10-year average. These are -- the numbers I am giving are net numbers after taking into account the high level of conversion activity during the recent period. Financially, we're experiencing probably the strongest fundamentals that the apartment sector has seen in over 10 years. The fundamentals are even stronger in the coastal markets where we are concentrated. The strength of our markets and the strength of our portfolio have combined to result in NOI growth of 9.7 and 8 to 9% for the full year, the highest annual growth rate since 2000.

The strength of our development pipeline continues to add both our earnings and our NAV growth. During the quarter we completed two communities and started two others. The two communities were both in Southern California, Avalon Camarillo in Ventura County and Avalon Del Ray in Marina Del Rea. These two communities total about $120 million and represented an additional 560 apartment homes. The two communities we started during the quarter were Avalon Bowery Place II, which is an additional phase of our Chrystie Place development community in lower Manhattan and Avalon Encino, a $60 million community in L.A. As of the end of the third quarter we had $1.4 billion under construction, and an additional $3 billion in the planning and approval process.

Another example of our development strength is our ability to execute on complicated developments and bring them in on schedule and on budget. We've had an excellent track record with regard to our construction performance, having completed about $2 billion in new construction over the past four years at a total cost of 1.9% under original budget. This is particularly important given the extraordinary cost pressure that the industry has experienced over the past couple of years. Just this quarter, we reported combined savings of almost $9 million on our Mission Bay and Bowery Place developments. Both of these are complicated urban high rise deals, yet we're able to execute both under budget and one to two quarters ahead of original schedule.

While development can certainly be a risky part of any development company's business, we have a 20-year plus track record of developing in most of our markets. Contributions from our growing development activity will become even more important into '07 and '08 as our increased development volume begins to stabilize. In terms of balance sheet strength with debt to total capitalization of only 23% which is the lowest in our sector, we have ample financial capacity to pull through our large development pipeline. This quarter we capitalized on that strength and executed $500 million of unsecured notes at an average rate of 5.7%.

Being positioned for growth is one thing. Being able to execute on it is another. Our ability to execute on our opportunities is based upon the capabilities and the stability of our organization. Our corporate strategy and our organization have been remarkably stable over the years which has given us the ability to really focus on our core business.

Our officer group has an average tenure of 10 years. This is not years of real estate experience which would be much higher. This is just years at AvalonBay. 10 years. If you look at the foremost senior executives, Tim, Tom, Leo and myself, we average over 18 years at AvalonBay. Organizational and strategic continuity like this is very uncommon today and is certainly a strength of ours which has contributed to our strong results. So while we're certainly pleased with our quarterly performance of almost 10% NOI growth and FFO growth of 22%, what we're most proud of is the steps we have taken over the years to position us for growth, long-term growth based upon thoughtful market selection, portfolio quality, development capabilities and pipeline and balance sheet and organizational strength. These are the strengths that have and we believe will continue to serve us well.

Leo will now provide additional color regarding our portfolio and our market performance. Leo?

Thanks, Bryce. As Bryce mentioned, I will focus my comments on operating results for the quarter. Last night we reported same store NOI growth of 9.7%. This is the strongest NOI growth since the second quarter of 2001 and continues a trend of positive same store NOI growth that began approximately two years ago. Growth was broad based across our markets with occupancy of 96.6% or greater in all six of our regions and double-digit NOI growth in four of our six regions.

Third quarter NOI growth is the result of a 7.3% increase in revenues coupled with a modest 2.4% increase in expenses. We expect these positive results to continue in the fourth quarter, resulting in 2006 NOI growth for the upper end of the 8 to 9% range that we provided during the second quarter conference call. We are also optimistic that these results will carry forward into 2007. Focusing on revenues, the year-over-year increase for Q3 was the result of a 0.4% increase in occupancy and a 6.9% increase in rate. Occupancy improved by 0.3% from Q2 to Q3 and was 96.8% for the quarter. Entering the fourth quarter, preliminary October results remain encouraging as occupancy is stable and the change in rate is rising into the low 7% range.

As we have discussed on previous calls, future increase in revenue will need to come from increases in rate as occupancy has remained stable in the mid to high 96% range since Q4 2005. Equally as encouraging on the revenue side is that market rents for Q3 grew by almost 6% while concessions continued to decline to approximately $230 per move-in. This represents a 71% decline from the previous year.

Turning to expenses, the 2.4% year-over-year growth for Q3 continued the trend of modest increases that we have reported in previous quarters. The year-over-year change was driven by increases in utilities and insurance that were offset by more favorable results in bad debt and marketing. While we are not immune to the inflationary pressures impacting property taxes, payroll, utilities and insurance, we continue to work aggressively to contain our overall expense increases by refining our current operating practices.

For example, the percentage of leases generated through the internet increased from approximately 24% in 2003 to 45% year-to-date 2006. This allowed us to reduce our marketing cost per lease by approximately 45%, largely by eliminating the use of print media which is down approximately $2 million during the same period. This is serving to offset more significant increases in other expense categories.

Looking more closely at our portfolio, results in northern California, Seattle, the DC Metro area and northern New Jersey remained particularly strong. Northern California is led by San Francisco and San Jose where the year-over-year rental revenue increases were approximately 10%. Northern California represents approximately 22% of our same store NOI, so this is encouraging given that market rents in the region remain approximately 18% below the peak levels experienced in 2001. Improving office vacancy rates increasing permit activity for office construction, and rising household incomes also suggest that this trend is sustainable.

Seattle continues to be propelled by strong job growth and limited new supply. Boeing and Microsoft continue to add jobs and Google and Eddie Bauer are leasing large blocks of office space in downtown Bellevue. Coupled with modest levels of new supply this market is poised for continued strong performance.

The DC Metro area continues to perform well as a result of some of the strongest job growth in the country. Approximately 60,000 jobs will be created in 2006, and an additional 50,000 jobs are projected for 2007. The 15,000 apartments that were converted to condominiums since 2004 also support this demand picture.

Finally, while the demand supply statistics for northern New Jersey are more modest, the AvalonBay portfolio benefits from its proximity to New York City and more specifically to Manhattan. For example, we know that approximately 60% of our residents at Avalon Cove in Jersey City work in Manhattan. Our northern New Jersey communities are clearly benefiting from their proximity to New York City and from the condominium conversion activity along the New Jersey waterfront. Boston, however, remains a market challenge by modest job growth and the continued delivery of new apartment homes.

On the positive side, the out migration of households has slowed from the levels experienced over the past four years and office vacancy rates are improving. We continue to realize renewal rent increases in the 5% range but concessions remain high for new move-ins. The outlook for the next 12 to 15 months is for slow but steady improvement as stronger job growth helps absorb the supply pipeline. In closing, we are encouraged by our third quarter operating results and are optimistic with our prospects for Q4 and into 2007.

As Bryce highlighted, projections for our markets include moderate but still positive job growth, a continued wide gap between the cost to own and the cost to rent, and modest delivery of new apartment homes in the majority of our markets. These factors contribute to favorable apartment fundamentals that will continue to propel growth in our portfolio. With that I will turn the call back over to Bryce.

Thanks, Leo, and Holly we'll now be pleased to take any questions at this time.

[Operator Instructions] Your first question is from the line of Jon Litt with Citigroup.

Hi, it is Craig Melcher here with John. Leo, I wanted to go back to one of your comments you made on the revenue you're experiencing in October. Were those numbers on a GAAP basis or was that on a cash basis?

Those numbers are on a GAAP basis.

Do you know how the numbers looked on a cash basis throughout the quarter?

I don't have those numbers in front of me. I am sorry, Craig.

And in terms of concessions that you're giving, are you giving any concessions outside of Boston in your portfolio?

Craig, we use concessions for lots of reasons. The answer to your question is yes. Obviously overall the amount of concessions has declined both sequentially by about 27% and year-over-year by over 70%. Are we using concessions in other markets? Yes. We typically use them as a marketing tool, though. In Boston they're the most significant.

And just a question on the Bowery Place II rents, looks like they're below what they are for the first phase. Is there anything specific with that?

Craig, Tim Naughton here. In terms of Bowery Place II, some of it is just unit mix, and the first phase actually is probably the -- has the more prominent views of the three buildings that ultimately will be built there. So it is really more a combination of views than unit mix.

Thank you.

You're welcome.

Your next question comes from the line of Rob Stevenson, Morgan Stanley.

Good afternoon, guys. Can you talk about the South Gates acquisition, what do you guys expect to put into it in terms of rehab and why this transaction wasn't done within the fund, how much is left in the fund to do?

Rob, it is Bryce. Why it wasn't done within the fund is it is immediately adjacent to an existing AvalonBay asset. Part of the appeal of the acquisition was the ability to acquire synergies by really operating them together, combining club house facilities, and that would have presented a conflict with regard to the ownership of the fund versus the ownership of AvalonBay.

We've been very careful through the structure and marketing of the fund to really avoid any such conflict. It made more sense for AvalonBay to purchase it directly and then to operate them together. In terms of planned renovations, we're working through that program now. It would be a planned redevelopment community, but the specific budget we have not yet set.

How much is left in the fund to invest going forward?

Rob, this is Tom. We are about halfway through, including pending acquisitions in terms of the capital that we expect to get out with the funds, so we're about $460 million including one pending acquisition and probably the fund ultimately would be somewhere between 850 and $900 million in total investments.

Okay. And then what's the expected cost to acquire your partners 51% interest in AvalonRun?

We are still working through the calculations. We basically agreed to the buy-sell and agreed to the valuation on the asset, but what we're working through now is how the waterfalls come through and the relative splits on the distribution. Until we work through those, it would be premature for us to comment on that on this call.

What sort of age is that property?

About 12 years old.

Okay. Thanks, guys.

Your next question comes from the line of Dennis Maloney, Goldman Sachs.

Good afternoon. Based on your original pro forma how would you characterize the lease up of your development pipeline? Is it going much faster and higher rents than originally anticipated, and given the strength of the rental market, can you envision raising your return expectations on development?

Tim Naughton here. In terms of the lease-ups, generally they are going either according to plan or just above plan. I think you probably notice in the press release attachments several of the communities reflected an increase this past quarter, particularly I think Bowery Place went up about by $300 if I am not mistaken and a couple of others went up between 50 and 100. We are seeing quite positive traction on the lease-up, probably the one exception is the Woburn deal in Boston, and Leo had commented on the Boston marketplace before.

In terms of the overall bucket, I think the second part of your question, the overall bucket of $1.4 billion in development, obviously the current projected yield on that today is 7.0%. That is based upon current rents in the marketplace today. For those that are leasing, and then the original projected rents for those who had not yet started leasing, we absolutely anticipate those yields will go up to that bucket. So that 7.0% for that group of communities we would expect that they would, their odds would increase not too dissimilar from what we're seeing in the stabilized portfolio.

Thank you. Could you talk broadly about how you underwrite your development products in different markets? For example, given the weaker outlook on a relative basis of say the Boston market, how much greater are your going-in yields or hurdle rates here versus California where the rent growth outlook is far higher?

Two things. Just in terms of the underwriting itself, it is consistent between markets in the sense that we're again underwriting on current rents and current development costs. But in terms of target yields or hurdle rates, certainly those two markets would have very different hurdle rates. California as you might guess, just given the growth on the West Coast and California in particular would have lower going-in target yields and Boston, Connecticut, some of the slower growing suburban northeastern markets would have higher yields, and then they probably vary from low to high around 100, 125 basis points to give you a sense of the scale.

And a question for Leo. What percent of income have renters typically spent at AVB apartments? Where do we stand now and at what point do people scream uncle?

Dennis, this is Leo. Typically we see around 22%, the national average is around 24%, and it varies by asset and by location. If you were talking about a high rise in an urban location, it would be in the high teens. If the property is located in a further out market, it might go up into the 24, 25% range. We haven't seen any case where we feel like we're pushing up against any type of ceiling.

I think Mark Biffert has a question or two.

Dennis, this is Bryce. I want to add to that. In terms of crying uncle, I think it is the homeowners who are crying uncle, not the renters. There has obviously been a lot written recently, and a recent report I saw it showed the percent of income being paid for a homeownership was in excess of 40% whereas Leo mentioned, the statistics for renters is about 20%. So that growing gap between that large gap between the cost of homeownership and the cost of rental bodes well for rental rate appreciation and poorly for home price appreciation.

That's a great insight. Thanks. Mark?

Previously you said on the last call you expected your development pipeline to be about $1.5 billion at the year end, but with the delivery dates moved up on the two projects, Mission Bay and Bowery of about $200 million, are you planning on having that be at about $1.5 billion at year end?

Mark, Tim Naughton. Generally in that range. We expect to start roughly three deals in the fourth quarter that equate roughly into the same amount as the deals we're anticipating completing.

I noticed on your New York City rents the average rent was actually lower than your Long Island and northern New Jersey rents. Can you explain why that is?

You're talking about on the stabilized communities?

Yes.

Leo, do you want to address that?

The three markets, the Long Island, northern New Jersey, and New York?

Yes.

Those are the three. It is really going to depend on where the properties are located, the size of the apartment homes, et cetera. You're looking at absolute rent levels. On Long Island, for instance, I know the apartment homes are very large there, so on an absolute basis those rents are going to be high. If you're in close location frequently the apartment homes are smaller.

Okay. Great. Thanks.

Your next question comes from the line of Alex Goldfarb, UBS.

Good morning. Actually I guess it's good afternoon. It has been a busy morning. Touching more on Manhattan, it looked like rents were only up about 5% yet given the euphoria in the market from the landlord's perspective would have expected that number to be a little bit higher. Can you give us some comment on that?

Sure. Our portfolio in New York doesn't include any properties specifically in Manhattan. Our same store properties. They're really focused in Westchester County with one asset that's in Duchess County. When you're making the reference, I think you're really looking at what's been going on in Manhattan whereas our properties lie outside of that predominantly, the same store assets.

The same-store assets; okay, then that's helpful. Touching on Boston, and forgive me, maybe you mentioned this in the opening comments, but given the weakness that seems to be there and obviously you have more developments coming online, have you guys given some thought to paring back your exposure and would you care to quantify how much you would pare back?

Alex, Tim Naughton here. I am not sure that I care to quantify exactly how much we would want to pare back. But just generally dropping back in Boston, we're obviously very active on the development front. We have five deals currently under construction. I think they total around $350 million. As you know if you follow the Company, we really have a great history of creating really an extraordinary amount of value through the development process in Boston, and even those five deals that are currently under construction, those are all above the average yield projected for the overall development portfolio into the 7s, so we continue to create value. That's from a development standpoint, so that's kind of the development side of the story. In terms of the portfolio investment strategy side of the story, I think you can expect that we will start to trim our position a bit in Boston much like we've done in Connecticut over the last year or two to meet some of our allocation objectives as well as our own notion of the long-term view of the market.

Okay. And looking at the disposition market for a moment, as you guys continue to sell assets, the -- can you provide color on the total return expectations of the buyers? Are those remaining constant? Are they up? Are they down?

Well, most of the deals that we're selling would probably qualify as core deals to the buyers than generally what you're hearing and the way that we view it based upon our own projections is probably underwriting to unlevered IRRs in the 7 to 7.5% range. That's off of a cap rate that's generally going to be an initial year cap rate of 4 to 4.5% in most of our markets I think most would probably be underwriting in the 4 to 5% growth rate and NOIs over a six or seven-year hold with some kind of reversion on the cap rate of maybe 75 base points.

And then the final question. Just touching on the dividend for a moment, it would seem that I just wanted to understand your flexibility in managing towards your taxable income. It would seem like you guys have been doing well this year. And given that a lot of the development doesn't come on until middle of next year or so, where we would see depreciation ramp back up, just wanted to understand how much flexibility you have in managing your taxable income and how that relates to the dividend.

Alex, this is Tom. We have some flexibility. The IRS doesn't afford you a ton of flexibility. I would say that on the depreciation point which is a good one, it is actually kicking in sooner. The average capitalizations for the assets that we're redeploying capital to is quite large. We're actually getting the benefit of the depreciation in terms of reducing taxable income, so we have some flexibility. We are certainly managing within our overall taxable income ranges, and feel like that with the disposition volume and the NOI growth, that we'll be able to manage our taxable income and continue to pursue the dividend policy that we've been pursuing over the last few years.

Thank you.

Your next question is from the line of Brian Legg, Millenium Partners.

Looking back historically, if I calculate your cash NOI growth this quarter as 11.9% and you said the highest back in Q2 '01 was 11.1%, was that 11.1%, was that a cash number back then or was it a GAAP number?

The old number, the 2001 was a GAAP number.

It was a GAAP number? So the cash do you have any idea -- I am trying to think are we at a cyclical high here? And my next question is, are you continuing to push rents into the seasonally softer periods so that '07 rent growth could be even better than the '06 rent growth and you haven't captured all that rent growth?

I will answer the first question and then I might ask you to repeat the second one.

Sure.

For Leo. In terms of cyclical highs, we're about where we were in 2001 if you were to restate the same store portfolio back to 2001. Our rent growth or rent levels are about the same. I wouldn't say that we're at a cyclical high. I think there is room to run in terms of rent growth supported by the large gap between the cost of rent and the cost to own demographics, and then just basically limited supply compared to the job growth. I wouldn't say we're at a cyclical high at all. I think we're back to where we were at the last cyclical high. That's an answer to the first question. You might want to repeat the second part of your question for Leo's benefit.

Leo, simply are you still pushing rents going into the seasonally softer period and because -- and have you been pushing rents throughout the year? Clearly your sequential growth rate is up in the rent growth so that you could expect maybe that rent growth will be just as strong in '07 as it is in '06?

Brian, going into the fourth quarter we're absolutely -- we absolutely continue to push rents aggressively, and I think the key consideration is the fact that we manage our expirations consistent with historic traffic patterns, so about 20% of our expirations occur in each of the first and fourth quarters, and then the balance occur in the second and the third quarters. As a result, as we enter the fourth quarter, it may be seasonally lower prospect traffic, but we have seasonally lower expirations, and that allows us to continue to push rents aggressively, and we will do so.

And this is Bryce. To add one thing, while we are certainly optimistic regarding the fundamentals of our business, not just for '06 but '07 and '08, a couple of things just on the cautionary side. Job growth next year is projected to slow relative to '06, about 1% versus 1.5% this year, and supply will undoubtedly be -- net supply will undoubtedly be higher because we won't have had the benefit of the conversion activity which we're still feeling the benefit of today. So while net/net we're positive, I just wanted to highlight that there are a couple things in terms of future expectations that would moderate growth a bit into '07.

Great. Thank you, guys.

The next question comes from the line of Craig Leupold, Green Street Advisors.

Touching on your last answer, Bryce, from a supply standpoint, is there any risk that we would see that we're surprised by the amount of supply that maybe comes back in the market through either busted condo deals or deals that were started with an anticipation of being for sale that end up for rent? And then also, could you comment on what you're seeing in terms of land prices and are we seeing any adjustments there that might bring supply back in the market more quickly than most of us maybe expected today?

Let me take the first part and Tim can comment a little bit on land prices. I don't know that we'll be surprised. Certainly if we're doing our job, we're tracking those condominiums that are coming back as rental. Just as an anecdotal story, right down the street from our office here on Eisenhower Avenue in Alexandria, there is two towers under construction. One tower was planned as a condominium, one tower was planned as rental. Today they're both planned as rental. So, is that happening? Yes, it is. Those towers are still nine months away from completion, and we know it is coming, and we're factoring that in.

In terms of deals that are completed, that are partially sold, and now are going to be partially rented, that's a little bit of a different animal. It is a little harder to track. It is not directly as comparable with us, and I think we're less worried about that than we are the prior example I gave of something that hasn't yet even started selling and therefore can easily start to be leased. If you look at national data of the total amount of multi-family permits issued, that's been relatively constant over the past seven, eight years in the low 300,000 range. It has been the split between rental and for sale that has been quite volatile last year being about a 50/50 split. And that I think we all should expect will come back to more historical norms where 75, 70% will be for rent, 25%, 30% will be for sale versus the 50/50 that we've seen over the last 18 months or so.

In terms of effect on land prices, Tim?

Sure, Craig. In terms of land prices, you really need to look at it land that was suitable for condo versus land that was always planned for rental. Land that's suitable for condo construction which was probably about three quarters of the land in our market, we are I think in the early stages of seeing some correction in pricing. I think I mentioned last quarter that a seller still hadn't changed their expectations. That is starting to correct. We are seeing expectations easing a bit now that many sellers realize they don't have a condo alternative and aren't likely to have one any time soon. Speaking for AvalonBay we've had a number of deals just in the last 60 days that where sellers have been willing to reset land prices over the numbers we were originally talking to them about on the order 15 to 20%, and that's really just enough to kind of get it so that it just starts to make sense as a rental. In California those are still -- those numbers are still -- probably start with a 5, and on the East Coast, you're still stretching to make a 6 in many cases. For land that was always planned as rental, we really haven't seen any easing on that. There's obviously plenty of capital and target yields. If anything, it will probably come down a bit on new rental construction.

Okay. And, Tom, a question for you. Obviously you guys went with a straight debt deal given that converts are the capital source du jour. Just curious on your thought process of doing a straight debt deal as opposed to a convert deal.

There is a lot of possible answers. I think the way to answer the question is that we do enjoy a lot of flexibility in options, and every time we go into the capital markets, we look at what we think is the absolute best alternative capital source for the Company at that time. And when we were issuing the $500 million in debt that Bryce mentioned on the call, at that time we felt like it was a compelling time to issue straight debt. We achieved a blended rate of 5.7% for an average term of 7.5 years. The spreads were extraordinarily tight, 80 basis points on the five-year deal and right at 100 on the 10-year deal. We were very pleased with the execution and felt like at that point in the market given market conditions it was the right capital market choice for AvalonBay.

Okay. More detailed question on attachment three on your balance sheet, you're showing operating real estate held for sale at $64 million. From attachment two it suggests that there is no income being thrown off from that asset held for sale. Is that land or what does that $64 million relate to?

The $64 million is Avalon Del Ray which is planned to be put into a joint venture in the fourth quarter. We're selling a 70% interest. So although it is held for sale, it is still a continuing operation because we will continue to be involved with it. It is a little bit of a strange duck, but that's how it shapes out in terms of GAAP disclosures.

Why would that be $6 million less than your costs on Del Ray?

I am sorry. Repeat the question.

It is on $64 million, but your costs on Del Ray are $70 million. I am assuming you haven't started depreciating yet. I am just curious as to why it is $6 million less than your costs.

We're not selling the whole thing. There is -- part of it is gross costs and part of it is how much we're retaining. We also had a markup on the land that we contributed to the venture.

Okay. I will follow up with you off line. Thanks.

Craig, the other thing to remember about that deal is we had an impairment loss in 2002 that we took against it, so that's also going into the mix.

Okay. Great. Thanks.

Your next question comes from the line of Ross Nussbaum, Banc of America Securities.

Looking at the D.C. area, have you seen any change in the level or the quality of traffic that's been coming into the door and what's been going on in the market there?

I had a little trouble hearing your question. What I think you said is -- have we seen any change in the level or the quality of traffic. The truth is we haven't. It is running about the same level as a year ago. Our traffic in the mid-Atlantic, D.C., is performing well. Obviously I mentioned there is quite a bit of job growth there, and we've been getting strong revenue growth as is reflected in the schedules.

Sure. I guess, Bryce, more generally have you begun to see any divergence in cap rates between your high quality of well-located assets and those that may be somewhat less desirable? And in general, where do you see them trending over the next few quarters?

You tailed off the latter part. You said in general something.

Where do you see them trending over the next few quarters?

I will let Tim address those questions.

Sure. In terms of cap rates, I don't know that we're seeing much differentiation in terms of the stuff either that we're pursuing or selling, but that generally tends to be frankly more higher quality in terms of the submarkets, we don't have a lot of tertiary markets, submarkets we would be selling or buying assets in. And generally they're tending to bunch up around the 4's, around 4% on the West Coast, almost doesn't seem to matter which submarket it is in, probably a little lower in northern California, probably maybe 4%, maybe just a little bit above that in southern Cal and same in Seattle. Some of the suburban northeastern markets, probably a little higher, probably in the mid-4's, but you're not seeing divergence from something from the mid-3's to the mid-5's. We're not seeing anything like that, at least in the deals we are either pursuing or selling.

Okay. And then I guess this is sort of related to the condo question earlier, but with the slowdown in condo construction, do you think that will cause rental developers to pick up activity in the near term, particularly given the trend that we have seen in rents over the past few months and years?

Yes, I do. I think that rental developers became condominium developers when that was profitable and the reverse you have to expect will be true as the condominium market cools. So we are planning to some of that. We're seeing some of that, and we factored some of that into our expectations for '07 and beyond.

Are there any areas around the country where you're seeing it more than others?

Maybe D.C. seeing a little bit more here.

Yes, I think probably where the condo business is just more active, D.C. and Southern California certainly.

Yes.

Great. Thank you.

Your next question comes from the line of Christeen Kim, Deutsche Bank.

Hey, guys, great quarter. Just a couple questions. I know it may be premature to start talking about '07, but, Leo, you mentioned the 8 to 9% same store growth in '06 should continue forward into '07. I am wondering if you can elaborate more on the revenue side, if we can extrapolate that we should see a comparable amount of revenue growth in '07 as in '06?

Christeen, the first part of your statement was accurate. It is a little early to start talking about '07. We're not prepared to give any revenue projections although we did try to give macro comments with regard to the positive momentum we see going into '07 but also some moderation in job growth and increases in supply. So we think '07 will be a strong year, but there are some reasons why it will probably -- it could be more modest in '06 but stay tuned for our fourth quarter call when we'll give guidance for '07.

Okay. And also on the rent side, you guys have had some pretty good rent growth, and it seems like the perfect storm very little supply and you know very skewed rent-buy decision but you say you're not pushing up against a ceiling. What is keeping you from going beyond the 6.9% you guys did this quarter? What is the limiting factor?

Christeen, this is Leo. I wouldn't tell you that we haven't pushed up against it. I just said quarter after quarter that we are getting pushback from residents. When I look at some of the other metrics that is we measure, our conversion ratios aren't changing. We're sustaining our conversion ratios. Traffic isn't changing. From a new move-in perspective we're being successful and we are pushing rents. On the renewal side we're pushing it. We're watching the reasons for turnover, but our turnover hasn't spiked. They've remained in historical norms. We get some pushback, but we continue to make progress.

Great. Thanks.

Your next question comes from the line of Paul Morgan, FBR.

Hi. This is Steve Radanovic with Paul. Just a quick question on sorted of looking out on the development pipeline and funding going forward given the tremendously liquidity on the balance sheet, do you expect that the mix sort of debt to equities from dispositions is going to be in the 80%/20% mix or how are you looking at that?

This is Tom. Right now this year we have about $700 million we're funding for development, and if you were to think about $500 million in debt and $250 million in sales proceeds, that's not that far off. And I think going forward you will see a disproportionate amount of our development pipeline being funded through debt and less through asset sales primarily because at 23% leverage we have plenty of room to add to leverage to the balance sheet. Over the last few years we've been delevering preparing the Company for the next phase in the cycle. We're now in that next phase and we're looking to delever the balance sheet up modestly over time, and I think 80/20 is probably about right. I really haven't thought of it that way, but that's probably approximately within 10%, correct?

And on the topic of dispositions, do you have anything under contract for the fourth quarter? I know your guidance suggests maybe you'll sell something, maybe not.

Steve, Tim Naughton here. We are in marketing with one asset right now, and to the extent that would be the only asset that would be sold in the fourth quarter.

Great. Finally what was the cap rate on the Southgate purchase? Do you have that?

I don't have that handy in terms of the market cap rate, but again generally in the D.C. area, market caps are in the 4's. That asset is in Columbia, Maryland, it's probably mid-4's. That is a redevelopment that I think we're projecting doing a kitchen and baths program, we thought we could add value and would have a stabilized yield in the low-5's.

Okay. Great. Thanks.

Your next question comes from the line of John Stewart, Credit Suisse.

I was wondering if you can give us a bit of background on the reason for the lowering EPS guidance, the changes in previously planned dispositions, what happened there?

John, Tim Naughton here. We -- I think we alluded to this last quarter. There was one asset in northern California that we were pursuing a sale with that was to a converter that ultimately was canceled, and we chose not to sell the asset. That had an extraordinary gain. It was an asset that we had owned for some time, and when we decided to take that out of the disposition pool, that accounted for all the change in the EPS guidance.

That's off the block entirely, that's not just a shift in timing?

Correct. Correct.

And, Tom, sorry if I missed this, but it looked like there may have been something unusual going on in the operating expenses in the Midwest that drove the 20% NOI growth. Can you comment on that?

This is Leo. In the Midwest we have just -- it is based on a comparable period that's been favorable. It is pretty much across the board. There is nothing specific you would point to.

That drove expenses down 13%?

There is no specific category. I could give you some -- I will tell you that redecorating is down, maintenance is down, marketing is down, office and administration is down. It is pretty much across the board, the savings that we're getting.

I would add Chicago is our single smallest portfolio, so it has been quite volatile in the expense category when you have a smaller base.

Got it. Okay. Thank you.

Your next question comes from the line of Karin Ford, KeyBanc Capital Markets.

Good afternoon. A question for Leo. Just going back to your -- I appreciated the color on the expense growth and why it was as low it was this quarter again. Do you think that Avalon's below peer expense growth is sustainable going forward, the savings you're getting on the marketing side that's offsetting some of the insurance and other items?

Karen, I would point to the last couple of years. Last couple of years I believe we've been just in '04 on a year-over-year basis I think we were just below 2%. Last year we were about 2.5, I believe. I will tell you that it is an absolute area of focus for us, and can I assure you that we're not going to have expenses going up? No, I can't assure of that, but I will tell you through the procurement program that we've been using, this technology that we've been deploying and the absolute emphasis on managing and containing expenses by the operating group I would certainly hope that we remain in the lower port of the peer group.

Okay. Second question is there has been a lot of talk about condos coming back into the rental market. What about on the single-family side, say in your Westchester or Connecticut markets? Are you seeing any single family homes coming back into the rental market and competing with your higher-end apartments?

Karen, in truth we don't see a lot of that. Where the real challenges come from is what Bryce alluded to earlier, when an entire community comes forward and goes to rental, a home, here, there, or even an investor condo, they're just not marketed the same. They don't bring the same level of services, et cetera, so that has not been a big area of competition for us. We're not seeing a lot of that.

We certainly don't see a lot of interesting Karin as you mentioned Westchester. I happened to be up at the Avalon in Bronxville which I know you're familiar with, and that is a community, it's a really incredibly beautiful community and an incredible location. And over the years we have benefited by people as they moved out of their homes to renovate they've stayed with us at the Avalon, and from the community manager did mention that a couple of people she had lost to people moving now into a home that was for rent that had sat on the market for too long. So certainly it is happening, but I would absolutely agree with Leo, that it is not a major factor. It is not like it is going to be a watershed event. But you're going to see it here or there, particularly in the very high-end communities like in Bronxville.

Very helpful. Thank you.

Your next question comes from the line of Anthony Paolone, JP Morgan.

Can you give us an update on your testing of revenue management through the portfolio and what the results have been like so far?

This is Leo. We continue to test revenue management. We're in that process. We've been doing it in a number of communities. I believe it is six communities for a couple of months now. I would say that it is premature to give you any specific results. I can tell you that the associates onsite feel good about the experience that they've had as well as the prospects because of the variety of opportunities or choices that they're given but to give you anything specific, it would just be premature right now.

Does that mean that there's plans or not plans to maybe try more communities or just not yet?

We haven't come to a conclusion. When we're certain that we believe that it is creating value, especially for what it costs, then we'll move forward. But right now it is just premature. We have control properties against properties that are using revenue management, and certainly we are comfortable and believe in the concept, but we need to see that it works effectively in our portfolio, and we just haven't come to that conclusion yet.

Thank you.

Your next question is from the line of Richard Paoli, ABP.

Hey, guys, just a couple questions. One, I don't think I heard it spoken about, but the G&A, the sequential tick down from the third -- from the second quarter to the third, is there anything there, and what should we look like and what would a run rate be looking like? And then I have a couple follow-ups.

Rich, there really wasn't any one thing that I would point to that suggests any that we have -- any one thing that drives that decline. It is a bunch of little things. It is bonus and annual compensation adjustments, it is some in-sourcing of internal audit that we used to outsource. In the third quarter compared to last year, we had in last year's numbers about $200,000 of accruals for litigation. There is not one single thing I would point to. I would say the current run rate in the third quarter is a fine run rate for the rest of the year but we'll re-up on our outlook in January and reset the numbers.

Great. And you kind of mentioned one of the things I was thinking about with one the core portfolio performance being strong, development coming in as you mentioned, you know, under budget and probably ahead of time on some -- on some projects, and then just the sheer performance in the share price relative to, you know, the overall REIT index, what is compensation, how is that tied to that and could you just remind us what that entails and would that pop up in fourth quarter or would that be a first quarter if there was any kind of increase in that? And then I have one more question.

Well, we'll give you one more after that. Our compensation is very much tied to performance as hopefully you would expect. It is tied to a number of different metrics, total shareholder return on both an absolute and a relative basis to our peer group, FFO targets on an absolute -- FFO growth on an absolute and a peer basis as well as performance of construction, operating expenses, customer service. We have a whole host of metrics that we use to drive performance. Certainly one should expect that as we achieve or exceed those objectives that compensation follows accordingly. Obviously the converse is true as we saw in some of the dark days of '01 and '02 when things were going the opposite way. In terms of when you would see it, we do accrue for that throughout the year. So at the end of the quarter, we make an estimate of where we're going to come out for the year and we start to adjust the bonus or stock accruals so it doesn't happen at any one point in the year as long as we're estimating on an accurate basis. Do you have anything you might want to add to that?

Just one other point, and that is stock options because of the increased volatility and the increased stock price and all the components that drive the calculation of the cost of options. Those are -- that cost is going up. We do calibrate it back to a total value, but there is some impact in compensation expense related to increased cost for options.

Okay. And then I have one other question and I am not sure if you guys would have this level of detail handy and maybe I could get it off line, but on attachment 14, I guess way back where you're calculating NOI from encumbered assets and unencumbered assets, I was curious if we can't get it obviously now but maybe in the future, could we put what the corresponding book value of the real estate that matches each one of those line items? So what's the book value for the NOI, the one that corresponds to the established communities? And the thought there would just be to track what the return on invested capital is over a period of time. And I guess that's incredibly helpful, especially on the redevelopment projects where you're seeing you guys spend a certain amount of money with obviously some type of targeted return, and it would be interesting to see how that, the change in book value correlates with the growth in NOI over a multi-period time frame.

Okay. Rich, I will say this. We do evaluate our disclosures every quarter. We have a disclosure committee. We'll take that to the committee and ask them to look at that. We do provide some segment reporting, though, in the quarterly reports.

It seems like some of the items that are kind of spread out through the report where if I -- there is a lot to go through in the earnings season, but I hear you.

We'll take a look at that.

Okay. It is almost like you could put the pieces together and if they're in there, why not just kind of move the column over a little to the right and just make it easy on us lazy -- thank you.

We'll take a look at it.

All right.

Your next question comes from the line of Steven Rodriguez, Lehman Brothers.

Good afternoon, gentlemen. Just one question. Could you speak a little more about how your recent development projects have come in approximately 2% under budget in the face of rising construction and labor costs, et cetera?

Steven, Tim Naughton here. I think Bryce had alluded to that over the last four years that cumulatively we've come in at 2% under. Clearly some have come in more and some have come in right at budget and there have been a couple that have come in over budget. Typically when you see it in the development pipeline, our costs are -- our budgets are more or less committed at that point where we bought out the jobs. And typically, there is a contingency that's embedded in that, and the 2% more or less represents generally one of two things, either saving the contingency or some portion of the contingency or having brought the job in ahead of schedule, and therefore, we see some savings on capitalized interest and (MULTIPLE SPEAKERS) et cetera.

Timing. So you would say most of it is a timing issue, springing in earlier than scheduled?

No. Some of it is. Some of it is just saving contingency or effective buyouts because a buyout doesn't occur all up front. It occurs in the early parts of the job over a few months.

One other thing, Steven, just to add is it may not be that familiar to all of you, we are our own builder for the vast majority of what we construct. That is different than many of our peers. We act as the general contractor. We have our own estimating, our own procurement, our own design groups. Those functions allow us to not only get better estimates up front with which we start but a better ability to manage the process throughout that time period. So it is something that we are quite proud of, we've invested a lot of time and resources in and we think is a real strength of the company. That's why I incorporated it in my remarks really to call attention to it because I think all too often you hear about jobs going over, but to have a couple billion dollars over the last four years in this very volatile market coming in under budget is certainly something we're quite proud of.

Okay. Great. Thank you.

Your next question comes from the line of Dave Rodgers, RBC Capital Markets.

Bryce, one question for you. I was curious relative to your comments about the strength of the rental market and seeing potentially some condos come back. Is Avalon or the investment fund taking a look at those deals or spending any time underwriting those acquisitions?

We are certainly taking time to look at deals that were previously planned as condo that are now being marketed as rental absolutely. We also are looking at some deals that are under construction that were planned as condos that are rental. We're not spending much time, we're not really spending any time to my knowledge looking at deals that are partly sold. Those are really the three categories of opportunities, and the first two we're certainly very interested in.

Okay. Thank you. And then a quick question for Tom. Do you know what the average rate is on your debt coming due in 2007?

It is in the mid-6's, but I can double check that off line and get back to you.

That would be great. Final question, maybe for Tim. Bowery Place II -- does that include the affordable component of that last construction phase, and can you break out the cost for that as well as the retail component?

Dave, in terms of -- it does include an affordable component. We do not break out the affordables from the market rate from a cost standpoint -- from a capital cost standpoint. We do break out generally the residential from the retail component that includes about 16,000 square feet of retail and of the just under $62 million, about 54, $55 million of that is allocated to the residential and 7 to $8 million to the retail.

And this project in particular was still the one that had a separate building for the affordable that would be externally managed, correct?

No. There is no -- I think we're referring to the -- when we started Chrystie Place One, we also sold or contributed a piece of land for the construction of the Phipps House, which is satisfying some portion of the affordable requirement for all three phases of Chrystie/Bowery Place. There are some units though scattered within the three buildings as well, affordable units scattered within the three buildings.

Okay. Thanks for the clarification.

Sure.

Your next question comes from the line of Alan Calderon, European Investors.

Wanted to see if you can comment on the high cash balance a bit and whether it is still high today versus the end of the quarter?

This is Tom. When we're spending $700 million a year in development, we've got a good amount that goes out every month, so we still have a balance. By the end of the year we expect that we'll actually have a balance out on the line, so we'll go through all the cash that's on the balance sheet by the end of the year through both the development spending as well as the settlement on our buyout of our joint venture partner at Run.

Thank you very much.

Your next question comes from the line of Jon Litt, Citigroup.

Hi. This is Skyler Cho with Jon Litt. I was wondering if you can tell us a little bit about what's happening with non-land development costs.

Tim Naughton here. It is basically construction costs, I guess. Non-land development costs?

Things like materials and labor.

Yes. In terms of construction costs, generally we're seeing a moderation of the rate of increase. They're still increasing overall year-over-year but it is decelerating somewhat. We're probably seeing mid-to high-single digit increasing construction costs. Some materials are coming down, some are going up. For instance, lumber is actually at a four or five-year low currently, and we're actually taking advantage of that through some bulk purchases and through centralized procurement as Bryce mentioned. In fact, just this past week, we made a $2 million purchase on OSB which is essentially plywood lumber that we think is going to save us a few hundred thousand dollars across a number of deals. Generally we're seeing mid- to high-single-digit growth rates still in construction which when you compare it to NOI growth, particularly when it amounts only to about 65% of total capital costs, we're now -- I think this quarter we sort of hit an inflection point in that NOI growth rates are actually outpacing total development costs on the deals that are putting into the development pipeline.

Your next question is from the line of Paul Morgan, FBR.

Hi. Sorry. One quick follow-up. What was the turnover in the quarter?

Turnover for the quarter was 70%, it was down 4% from a year ago, and just to give you complete, it is 58% year-to-date which is down about 3% from the same period last year.

Great. One final one I promise. The three new development starts, where are those located? Can you comment on that?

I think -- are you talking about the two in third quarter or the three we anticipate in the fourth quarter?

The three in the fourth quarter.

The three in the fourth quarter -- one in Southern California, and -- actually, if you look on the development rights schedule, I think it is just the top three that are on there.

Okay. Great. Thanks.

At this time there are no further questions. I would now like the turn the conference back over to management for closing remarks.

Thank you, Holly, and thank you all for your time today. I am sure we'll see many of you at NAREIT in November, and hopefully as most of you know or all of you know, during NAREIT, we are participating in a product tour on Tuesday, and we're hosting a tour and reception at Mission Bay on Wednesday afternoon. If you like to attend and have not yet replied, if you would respond back to John Christie, we would appreciate that and look forward to seeing you in November. Thank you.

Ladies and gentlemen, thank you for your participation in today's conference call. This concludes the program. You may now disconnect.