As well as AvalonBay is positioned to endure the current economic climate, company executives insist that the firm never strategically prepared for a recession. Rather, company CEO Bryce Blair says the AvalonBay balance sheet gleans its resilience from its basic structure: uninterrupted cost effective capital streams to ensure portfolio performance and development opportunities in all economies.
“Where we are now goes back to our IPO in 1993 and the need for us to think about our balance sheet and corporate organization and strategy,” Blair says. “It wasn’t a change we made last year or the year before that in anticipation of today’s market conditions.” In strategy, the company decided to focus on best-in-class development in supply-constrained markets, with an organization marrying mothership efficiency with decentralized management and leadership. “All of that needed to be supported by a strong balance sheet designed to persevere through all phases of the business cycles,” Blair says.
Economics 101
This isn’t to say that life at AvalonBay is painless. The company is forecasting revenue declines between 1.5 percent and 3.5 percent this year as the weight of an expected 2 million to 3 million job losses impacts apartment fundamentals. Coupled with an expected expense growth of 3 percent to 4 percent, 2009 NOI is expected to decline within a range of -4.25 percent to -6.25 percent, resulting in a corresponding projected funds from operations decline of 5.5 percent by the midpoint of the year, according to the company’s 2008 fourth-quarter earnings call. “Our markets are clearly deteriorating, driven mostly be the economy,” says AvalonBay president Tim Naughton, who has been with the company for 23 years. “Markets are sputtering sideways. Occupancies are okay, although you would not say they were great, and you’d expect some pressure with the prospect of several million jobs being lost in 2009.”
Paradoxically, AvalonBay’s concentration of high-quality assets in equally high-barrier-to-entry markets is partially to blame for some of the portfolio stress. While still seen by analysts and company executives alike as a long-term strategic advantage, the portfolio has exposure to financial and trade employment sectors—particularly in New York, Chicago, and Los Angeles—that is catalyzing the deterioration in fundamentals.
“We think it is a great characteristic long term to be in the best quality real estate. However, in the current environment, AvalonBay will likely see more pressure on same-unit results than its peers, as its units are less affordable,” says Andrew McCulloch, an analyst with Newport Beach, Calif.-based Green Street Advisors, an independent research, trading, and consulting firm concentrating on publicly traded REITs. “In particular, AvalonBay has above-average exposure to the New York metro area, which will increasingly be negativelyaffected by sizable layoffs on Wall Street.”
Sargeant’s balance sheet will be a key defense against those exposures while AvalonBay navigates through the recession. If one were to grasp for business book clichés, his financial management tactics won’t resemble a back-to-basics approach as much as AvalonBay will maintain the straight and narrow and keep a simplistic transparent approach to balancing the books. Since his pre-Avalon career at former accounting firm giant Arthur Andersen, Sargeant has consistently applied the “think straight, talk straight” approach to the numbers, disdaining the use of synthetic transactions, opacity, and complexity in deal structures and capital management.
“I grimace when I see [the use of synthetic transactions and opacity and complexity in deal structures and capital management] because it is avoidable,” Sargeant says. “Business people have trusted relationships and work with smart people and often lean on that trust rather than trying to understand things. Well, it’s not about trust these days. It is about understanding what you are signing up for before you sign up for it.” As an example, Sargeant says he prefers to avoid synthetic transactions such as swaps and derivatives that could have unintended consequences not seen at the time of the transaction.
Conservative money management thus consists of an endurance contest in fiscal discipline, where ultimately it becomes the hold-outs and not the all-ins that enjoy long-term financial fortitude. Sargeant understands the ego that is drawn to the done deal, but also knows a longer-term satisfaction of outlasting the mediocrity supported by bull markets. “There is a thrill of excitement of doing an exotic transaction that makes the newspapers, but that is very fleeting, and it generally comes back to bite you,” he says. “I get more satisfaction out of delayed gratification than a quick pop, and delayed gratification comes with a clean balance sheet that is easily understood, that can stand the test of time when it comes to a 1998 Russian bond default, a long-term capital management meltdown, or a 2008 liquidity crisis.”
Harvesters of Value
AvalonBay executives don’t espouse a ‘who’s laughing now’ retort to the legions of distressed real estate players and capital-challenged REITs. There’s nevertheless some sense of vindication for resisting the call to push leverage limits for more than 15 years, at times in the face of intense criticism from investors. “We have built a machine around our skills, our decision-making, and our balance sheet to have staying power,” Blair says. “And over the years we have been challenged on why we maintain such a conservative approach. It’s for days like today. That’s the answer.”
